Illiquid credit risk
For illiquid names, it becomes difficult – if not impossible – to provide delta hedges so that true single tranches can be manufactured by a trading desk.
The dealer’s role is one of arranger, sourcing risk and then placing it with investors. On the other side, the investors are also unlikely to be using credit models to make investment decisions, relying more on credit rating or less quantitative analysis (such as adverse selection mitigants or reputational risks).
The capital markets are witnessing a huge demand for credit risk of all types from a variety of bank and non-bank investors. In addition, investors (banks and non-banks) are expanding their credit assessment capabilities, and thus their ability to take on riskier credit investments (lower-rated tranches, lower-rated or difficult-to-analyse underlyings, or even full portfolios attaching at 0%). Spreads have continued to fall in many asset classes and parts of the capital structure as a result.
The successful trade will offer a bank the ability to hedge either Basel II or economic capital while offering investors an asset they cannot easily access elsewhere. In this way, opportunities can be identified for lower partial moments to selectively hedge certain credit risks inherent in bank portfolios, while also approximating where the market price of any one slice of risk may be based on the external rating.
Banks may be able to hedge some real risk at less than fair value to the originator (based on the bank’s own correlation assumptions), while still offering something new for investors (new, real, uncorrelated credit risk).
This is effectively what ABN AMRO did in the North Sea Island CDO (see figure 2 download file). The bank sold protection on the rated, mezzanine risks of a proprietary portfolio. Investments such as the A3-rated class notes of North Sea Island are of great interest to investors, and the bank is keen to keep the equity and senior risks.
The settlement amount
One of the most interesting challenges is to solve the settlement issue. This issue is two-pronged.
First, investors need a transparent method of measuring how recoveries behave and the process for achieving recoveries. This is especially important because many investors’ main goal is to access the origination and work-out abilities of a loan book. They want more than just the market settlement mechanism of the traditional CDS contract.
Second, investors do not want to be adversely selected during the settlement process by, for example, settling on the worst asset on the bank’s balance sheet. ABN AMRO has used two mechanisms: modified pay-as-you-go and cash settlement with 24-month work-out.
Adverse selection mitigation
In the new world of economic capital, Basel II and IAS32/39, there will be significantly less incentive for originators to retain the first loss of portfolios (capital deduction plus reconsolidation). And holding an equity tranche is not necessarily the best way to ensure that interests are aligned.
But there are other ways of ensuring that originators are in the same boat, as well mitigating other risks, such as cheapest to deliver. A co-investment in each credit risk transferred to the vehicle is a must in true risk-relief trades, unless the portfolios are granular or the portfolio is selected by some objective rules.
This is especially important where client confidentiality does not allow the bank to reveal the borrower.
Concentration risk
For liquid, traded credits, individual CDS hedges are well suited to manage the concentration risk that is resident in the loan books of larger banks. However, there are few alternatives for illiquid and non-traded corporates, for which banks should be more concerned and more motivated to hedge concentration risk. This is an obvious need because it is likely that the most profitable relationships (therefore, worth more than the credit spread) are likely to be regional clients, for which there may be little other debt outstanding. These are often also private companies.
A securitisation using a CDO not only does not shed much economic risk, but also limits the amount of a large exposure that can be hedged with this technique, due to granularity requirements. This leaves most banks with excess credit exposure to a portfolio of relationship names. These are not likely to go into default but the potential ‘tall-tree’ exposure still causes worry to both rating agencies and risk managers.
There is currently more interest in the hedging of vertical slices or first losses of such portfolios, but few individual banks are likely to have a diversified portfolio of such risks. As such, the pooling of concentration risk assets by combining the portfolios of a few regional banks is likely to be a high-growth area.
This supply is one side of the market. The keys to continued development of the hedging vehicles for bank portfolio managers will depend on many factors. Although significantly more offers of risky tranches or portfolios are likely, the total amount of the demand has yet to be determined.
These opportunities are attracting new entrants into the market, keen to use their credit skills to either earn income while diversifying their credit portfolio or by cherry-picking assets that may have hidden value when structured in a different format. These new investors vary from banks that are diversifying into other regions, to traditional investors moving into other illiquid asset classes and hedge funds willing to take credit risk at below fair value. Listed credit funds and insurance companies are also increasing their exposure to the less liquid end of the credit spectrum.
It remains to be seen if the demand in the current benign credit environment will continue if overall market conditions turn or if it will only take a few isolated defaults to scare off these new classes of investors. A promising sign is a discussion overheard at a recent conference on structured credit, where the experienced investors were bemoaning the number of “novices” who, by not differentiating by riskiness of investment, were driving all deals to the same (low) spread levels: “What this market needs is a few credit events.”
Rasheed Saleuddin is director, structured credit and alternatives marketing, ABN AMRO.
