Credit derivatives were supposed to redistribute banks’ credit risk but how much of that risk has been transferred outside the banking sector is unknown. Does it matter? Natasha de Teran finds that the CD market now offers a wealth of alternatives to suit any bank.
Cheerleaders of the credit derivatives market have long talked loudly about the ability of these instruments to transfer risk. More recently, the spectacular growth in the size and complexity of the market has meant that worries over potential operational hazards have distracted from the question of how effective credit derivatives have been in transferring risk outside the banking system. Do they do the job?
In late 2003, rating agency Standard & Poor’s (S&P) published a controversial report that questioned the efficacy of the credit derivatives market in doing just that. The authors of the report estimated that only about $100bn of the $3000bn notional amount of credit derivatives outstanding at that point represented a true transfer of credit risk from banks’ lending and trading activities to other market participants. S&P claimed that the bulk of activity had simply redistributed risks inside the banking system.
Advocates of the credit derivatives market were quick to jump to its defence, with many disputing S&P’s figures. Others were less bothered by the numbers, arguing that because banks were paid to manage credit risk – and were thus theoretically equipped with the best skill sets to do so – there was no need to worry about this. The key, said defenders, was that risks had been redistributed and that individual banks’ concentration risks were reduced.
Applause continues
In the three years since the S&P report was written, a wealth of new investors has entered the market, volumes have almost tripled and credit derivatives technology has evolved dramatically. Senior figures in the financial industry have continued to applaud the way in which the instrument can be used to transfer risk, but how much risk has been transferred to non-banking institutions is still unknown.
Notably, however, the bankers that use the instruments to mitigate or manage their own institutions’ exposures no longer appear to be making any great claims about the amounts of risk they might have transferred outside the banking system. Rather, they focus on how the developments in technology and in liquidity have allowed them to identify, isolate, price and transfer pockets of risks in the system. And they seem more strongly convinced about the instruments’ value than ever before.
Recurring risks
“Every bank’s curse is that it tends to amass a lot of recurring risks from the same credits. It thus makes every sense for us to set up origination and distribution models to manage those risks,” says Chris Cloke-Brown, head of capital and portfolio advisory at DrKW in London. “The most straightforward way to do that is through credit derivatives, as there is far less reason for this method of risk transfer to upset client relationships or to break loan covenants. And while it is still true that most of the risk transfer within the credit default swap (CDS) market has been in redistribution, there is nothing wrong with this. The bottom line is that banks’ expertise lies in managing credit; they have capital and must put it to work.”
Michael Dickinson, a member of the transaction team in the portfolio management group of BNP Paribas’ investment banking group, is another vocal supporter of the instruments. He credits the market for much of the recent evolution of the portfolio management discipline. “Portfolio management units and skills have continued to grow along with the credit derivatives market – 10 years ago, there was much less pressure and opportunity to diversify and reduce concentration risk,” he says.
Market evolution
If there was one particular factor that hindered banks’ abilities to transfer particular risks in the earlier days of the credit derivatives market, it was a lack of liquidity in the credits they were trying to hedge. But if the experience of the loan exposure management group (LEMG) at Deutsche Bank is anything to go by, things have moved on considerably. According to Stuart Lewis, global head of the LEMG unit, when the bank first hedged its corporate and investment bank’s loan book in 2002, less than 60% of its international loan exposure could be hedged in the single name CDS market. Today, Mr Lewis says the bank has found liquidity for about 85% of its international large-cap exposures.
Stuart Lewis: taking the securitisation route
For other large and sophisticated credit derivative users, there are more alternatives. Daniel Berman, responsible for credit products marketing at JPMorgan in London, says that some loan groups are also beginning to use the increasingly popular iTraxx credit indices as macro hedges, either as a temporary measure or as a portfolio-level management measure.
Another popular strategy is to buy out-of-the-money put options on single names or an index of names to get some protection against the market gapping-out in the future. “These have the advantage of having much less carry than a straightforward CDS trade. For a small premium, the put option buyer would have a six-month to one-year option to buy five-year protection on the given index or name,” says Mr Berman.
The SME problem
For the smaller regional banks that have exposures to concentrations of particular credits that are unlikely ever to become liquidly traded in the CDS market, there are plentiful alternatives, according to bankers. Mr Berman says that JPMorgan is increasingly coming across small regional banks that elect to sell CDS protection on names to which they do not have exposures. “This helps them to diversify their loan portfolio, by enabling them to move out of their core market and into names they would not naturally have access to,” he says.
Another route for smaller firms with mid-cap and small-cap loan exposure is to seek protection via CDS from larger banks, which then repackage the risk in the form of a bond or a note. “This can be done particularly when the credit is known to traditional real money investors, say, who don’t want to or can’t do a CDS trade but who are willing to take exposure to a given entity in note form as an alternative to taking it on as a straightforward equity investment,” says Mr Berman.
Many of the larger banks have strong regional networks, do a lot of small and medium-sized enterprise (SME) lending and, like their smaller peers, face the same issues in laying-off and diversifying these risks. Even Deutsche Bank’s LEMG has faced similar challenges. Mr Lewis says that because the single name CDS market for mid-cap credits features limited liquidity, Deutsche has mainly used the securitisation route to mitigate these risks. He now credits the rapid growth of these techniques with enabling LEMG to price and distribute not only its large cap risk, but also more offbeat illiquid risk. He admits that LEMG has faced “myriad valuation and execution challenges” in doing so but says that the bank has nonetheless been successful in reducing the net risk in its loan portfolio by about one-third since December 2003 – primarily utilising CDS and collateralised loan obligations (CLOs).
“Though credit portfolio management groups such as LEMG significantly contributed to the growth and increasing diversity of the CDS market, we will still encounter liquidity issues in the mid-cap single name market. As that market evolves, LEMG will continue to review its loan book on a portfolio basis and address each risk with the appropriate instrument,” says Mr Lewis.
Securitisation solution
DrKW’s Mr Cloke-Brown says that the securitisation market has become the most used method for overcoming this, even by smaller institutions such as the cajas de ahorro (savings banks) in Spain. “Investors – including banks from other regions – naturally see these as very attractive assets that give them an alternative form of straightforward economic exposure to the given country. For the smaller banks this can be quite a lot of work – and expensive – but as more deals get done and there is greater familiarity, costs will come down more and more.”
According to Mr Cloke-Brown, this risk-swapping between entities both large and small is an increasing trend. Because many banks have been finding it difficult to source as many loan assets as they would like, but still face a need to diversify, it is making increasing sense for them to risk-swap rather than just setting out to reduce concentrations.
Risk transfers trend
A current development that will encourage more of this, he says, is a progression in the credit derivative market away from single name default swaps, towards risk transfers of portfolios of risks. To do this, a bank would build structures containing, say, 50-100 credits and, as the originating bank, would retain the first 3% of losses, selling the next 3%-8% of losses to another bank.
“This makes sense from both sides,” says Mr Cloke-Brown. “The originating bank transfers some risk out and reduces its concentration levels, protecting itself from too much of the same risk. And the investing bank, which might not necessarily know too much about the assets or the borrowers, is able to diversify by investing into broad portfolio of new exposures and rely on the expertise of the originating bank.”
With the explosive growth in technology and volumes, the future could be seen as a risk merry-go-round, with credits endlessly being transferred inside the banking system to form a perfectly balanced jigsaw. However, bankers say that is unlikely – not so much because there will be pockets of less sophistication but because banks will still be in the business of holding and managing credit.
