FRBSF Economic Letter
2001-34; November 23, 2001
Financial Instruments for Mitigating Credit Risk
Financial derivatives have greatly enhanced the range of tools available
for managing financial risks. Currently, derivatives are widely used to
mitigate and reallocate the financial risk related to changes in interest
rates, exchange rates, stock prices, and commodity prices. A recent addition
to the risk-management toolbox is the credit-related derivative and its
variants. These financial instruments are used to manage a lender's credit
risk, which is the risk that a borrower will default on a debt obligation.
The emergence of these credit-mitigating financial instruments has been
particularly useful to financial institutions, such as commercial banks,
that extend credit as part of their main business operations.
This Economic Letter describes the main types of credit-mitigating
financial instruments and the marketplace for them, as well as some issues
that will affect this market's future development.
Types of credit-mitigating financial instruments
Credit risk is defined as the risk that the value of a loan (or more
generally, a stream of debt payments) will decrease due to a change in
the borrower's ability to make payments, whether that change is an actual
default or a change in the borrower's probability of default. Credit-mitigating
financial instruments permit the owners of these reference credits to
transfer this risk to another party, typically known as a guarantor. The
function of these instruments is different for the buyers and guarantors.
For the buyers, the primary goal is to reduce their exposure and potential
losses with respect to a specific borrower or class of borrowers. For
the guarantors, the primary goal is to increase their exposure and collect
the fees associated with doing so. In both cases, these instruments can
help diversify a lending portfolio by reducing its credit risk concentrations.
Credit-mitigating financial instruments fall into two general categories—credit
derivatives and collateralized debt obligations (CDOs). Credit derivatives
permit lenders to insure against changes in a borrower's credit quality
without removing the reference credit from their balance sheets. Recall
that a derivative security is a financial instrument whose value is contingent
on the performance of another security, in this case, the reference credit.
The two main types of credit derivatives are total-rate-of-return (TROR)
swaps and credit-default (CD) swaps. Although these instruments are typically
discussed in terms of a single loan from a single borrower, they can be
and often are applied to pools of loans from different borrowers.
For TROR swaps, the owner of the reference credit passes on the credit's
total return (i.e., interest payments and asset appreciation) to the guarantor
in exchange for a stream of floating-rate payments, typically the LIBOR
interest rate plus some basis points, and a promise of reimbursement for
any asset depreciation. The swap has a periodic mechanism for determining
the changes in the credit's market value and for making the specified
payments. In the case of default, the guarantor would compensate the lender
for the almost complete loss of the credit's value.
CD swaps are more like standard insurance contracts. In a CD swap, the
owner of the reference credit makes regular floating-rate payments in
exchange for a contingent payment based on a defined credit event, such
as bankruptcy or a credit-rating downgrade. The contingent payment could
be tied explicitly to the value of the reference credit after the credit
event, but it could also be determined independently.
In addition to bilateral CD swaps, an alternative structure, known as
a credit-linked notes facility, permits credit risk to be spread across
a larger number of guarantors. In this structure, a separate company,
known as a special purpose financing vehicle (SPV), is established, often
by the owner of the reference credit, and it issues debt securities whose
payments are linked to the credit quality of a reference credit. Investors
purchase these securities, and those funds are used by the SPV to purchase
high-quality bonds. The SPV then enters into a CD swap with the owner
of the reference credit. If a contingent payment is made to the owner
due to a credit event, then the payments to the SPV's debt holders are
reduced accordingly. If such a payment is not made, the debt holders receive
both the payments from the SPV's purchased bonds and the owner's regular
A CDO requires the owner of the reference credit to remove it from its
balance sheet, as in the creation of mortgage-backed securities. CDOs
are based almost exclusively on pools of credits, and the types of credits
used as reference assets have expanded beyond investment-grade corporate
loans to include junk bonds and equipment leases. In a typical CDO transaction,
the reference credits are sold to an SPV, which then issues a variety
of securities with differing degrees of repayment risk. Typically, the
SPV will issue three tiers of securities. The first tier consists of debt
securities that are over-collateralized to achieve a high credit rating
and minimize repayment risk. The second tier consists of debt securities
that are typically unrated and whose payments are directly linked to the
underlying reference credits. The third tier is the residual equity interest
in the reference credits, which retains most of the credit risk. Investors
in these securities are said to be in a "first-loss" position,
since the securities will be the first to lose value in case of a credit
event. The originator of the CDO typically retains some of these third
tier securities as a sign of confidence in the transaction.
An interesting development in this market is the "synthetic"
CDO. In these transactions, an SPV again issues a variety of securities
whose payments are linked to the credit quality of reference assets. However,
the reference assets are a collection of CD swaps that the SPV has entered
into with one or more lenders, not a pool of credits. As with credit-linked
notes, the proceeds from selling the synthetic CDO securities are invested
in high-quality bonds, and the SPV stands ready to make payments to the
owners of the reference credits as specified in the CD swap contracts.
The market for credit-mitigating financial
Since credit-mitigating financial instruments are not traded on a securities
exchange, the size of the market is difficult to measure accurately. The
most reliable measures of market activity are from surveys, such as the
1999 British Bankers Association (BBA) survey (http://www.bba.org.uk/html/1601.html).
It found the global size of the market to be about $600 billion in notional
outstanding contracts, which is relatively small compared to the over-the-counter
interest rate derivative market estimated at around $64 trillion in 1999.
More recent surveys estimate the market for credit-mitigating financial
instruments to have grown to over $800 billion in 2000.
The 1999 BBA survey found that about 40% of the transactions in this
market were CD swaps on single credits, while about 20% were CDOs and
other instruments tied to pools of credits. The CDO sector appears to
be the fastest growing. Moody's Investors Services estimated new CDO issuance
in 2000 to be more than $120 billion, as opposed to about $90 billion
The BBA survey also found that the majority of market participants were
commercial banks, making up about 65% of the buyers of these instruments
and about 50% of the guarantors. An important reason for the significant
role of commercial banks in this market is that originating loans is one
of their key businesses. Thus, their need for credit protection would
motivate their purchases, and since they have expertise in determining
and monitoring the borrower's credit quality, they should also be able
to sell credit protection and manage their exposures. The next largest
class of market participants includes insurance companies and securities
firms, with 10% and 20% share of the buyer market, and about 25% and 15%
of the guarantor market, respectively.
Like any developing financial market, the market for credit-mitigating
financial instruments must address several important issues to ensure
its smooth functioning and potential growth. Two key concerns are discussed
The first concern is the definitions of credit events used in the contract
language of the instruments. This concern first arose in 1998 when Russia
defaulted on its sovereign debt. Several lawsuits were initiated due to
ambiguities in the instruments' legal language about whether and how the
credit protection was to be provided. To reduce such uncertainties in
the future, the International Swap Dealers Association (ISDA), a trade
association representing participants in the over-the-counter derivatives
industry, published a set of credit event definitions in 1999 that help
provide a common language for documenting credit derivative transactions.
Still, several documentation issues remain. One is successor language,
that is, handling credit protection when a reference credit's company
splits into several companies. Given the generally idiosyncratic nature
of such events, it is difficult to write general contract language that
effectively keeps track of where the original firm's principal assets
have gone. A potentially more significant issue arises with debt restructuring
and whether it should constitute a credit event that triggers the credit
protection. The 1999 ISDA definitions included debt restructuring as a
trigger event, but subsequent restructurings showed that this choice entailed
significant moral hazard. If a bank has purchased protection that would
be provided in the case of debt restructuring, then the bank has an incentive
to encourage such a restructuring in its dealings with the reference credit's
company. In fact, several major market participants have begun quoting
separate prices for CD swaps that do and do not include debt restructuring
in the contract language. ISDA issued some supplemental guidelines in
May of 2001 to begin addressing such concerns.
The second concern is that the market for these financial instruments
has not yet been tested in a recession, despite several individual credit
events over the past few years. The dearth of data on the dynamics of
credit ratings and defaults over the business cycle has limited historical
studies of how the market might perform. It is not yet clear how the market
will do in the current environment, with the weakening global economy
and the increased corporate defaults and restructuring in the U.S. A particular
concern is that even though these instruments can be used to reduce credit
risk, they can also lead to risk concentrations. Recent losses by the
American Express Corporation in the CDO market were limited to that firm,
but similar losses could spread across financial firms and raise systemic
concerns for financial regulators.
Credit risk is present in every financial transaction that includes credit
extension, such as purchasing debt securities, making loans, or establishing
trade financing. The development of financial instruments for mitigating
and transferring credit risk has begun and has much promise. However,
many challenges remain. Important concerns such as documentation and liquidity
must be addressed in the near future. Furthermore, the issues of contract
transparency and systemic risk must also be addressed to reduce regulators'
concerns about the widespread use of credit-mitigating financial instruments.
Jose A. Lopez