FRBSF Economic Letter
2005-34; December 2, 2005
Recent Policy Issues Regarding Credit Risk Transfer
Over the last decade, a variety of financial tools have
been developed for transferring credit risk between financial
institutions. Credit risk is defined as the risk that the
value of a corporate loan (or debt obligation more generally)
will decline due to a change in the borrower's ability
to make payments, whether that change is an actual default
or a change in the probability of default. Credit risk
transfer (CRT) mechanisms range from outright selling of
loans to credit derivatives that permit shifting credit
risk without necessarily referencing specific loans.
As new varieties of CRT mechanisms have developed, so
has the volume of CRT transactions, and this has increased
liquidity in the underlying bond and loan markets. In
conjunction
with this growth, the policy issues surrounding CRT transactions
have changed in important ways. For example, if a seller
of a credit derivative fails to fulfill its contractual
obligations, the purchaser of credit risk protection
could unexpectedly find itself exposed again to that risk.
In
addition, regulatory concerns regarding CRT arise from
the potential damage that might be caused by credit risk
concentrations within the financial system. This Economic
Letter provides a brief description of the common types
of CRT mechanisms and reviews the policy issues surrounding
their use, especially with respect to credit derivatives.
CRT mechanisms
In originating a commercial loan, the lender acquires
much information on the borrower's overall financial condition
and prospects of repayment. Two key issues for designing
CRT mechanisms emerge from this information-gathering process.
The first involves protecting the valuable, ongoing relationship
the lender has forged with the borrower; specifically,
the lender may want to be careful not to harm that relationship
by raising the possibility of reducing its commitment to
the borrower with a CRT transaction. The second involves
the information advantage that the original lender has
over potential counterparties to the CRT transaction; specifically,
counterparties may be concerned that the original lender
may conceal some relevant risks about the borrower. This
issue is known as "adverse selection."
Both issues arise in the simplest CRT mechanism, the
loan sale, in which a lender sells all of its obligations
and
future payments from a commercial loan to a third party.
Given the covenants in such loans, borrowers typically
must be informed of the sale, which could have an impact
on the business relationship. In addition, the adverse
selection problem is most clearly visible in this type
of transaction. In fact, Dahiya et al. (2003) found that
half of the public corporations whose loans were sold
from 1995 to 2000 filed for bankruptcy within three years.
Loan syndication, in contrast, addresses these two issues
directly. In a typical syndication, the lead bank (or
banks) and the borrower agree on the terms of the loan,
and the
lead bank then assembles a syndicate of lenders. Syndicates
can take several forms; for example, in a firm commitment
syndicate, the loan amount is set, and the lead bank's
share diminishes as more lenders join. Unlike loan
sales, syndication allows the lead bank both to reduce
its credit
exposure to a borrower without damaging its business
relationship and to avoid many adverse selection issues.
After the syndication
is completed, banks may sell their loan shares in the
secondary market, either by assignment, which requires
the consent
of the borrower since the purchaser becomes a direct
lender, or through participations in which the seller
retains the
relationship but passes the payments on to the purchaser.
Securitization is a third kind of CRT mechanism. Although
more widely used for retail lending (such as through
residential mortgage-backed securities), it is used
increasingly for
corporate lending. A traditional securitization involves
transferring a pool of loans or other debt obligations
to a third party, typically a corporate entity established
just to own the loan pool, which then issues securities
that are claims against the pool's interest and principal
payments. Various securities tranches with differing
degrees of risk are typically issued; for example,
the best rated
tranches would be very unlikely to experience payment
disruptions regardless of the underlying pool's credit
quality, while
lower rated or unrated tranches would be more likely
to be affected.
Investors in these securities, while not having a direct
lending relationship with the underlying borrowers,
are protected from the adverse selection problem through
a series of contractual obligations placed on the pool's
administrator and often through oversight provided
by
the
rating agencies. With respect to the borrowers, the
originating banks can, and often do, act as the servicer
of the loan
pool and hence can easily retain the lending relationship.
The fourth kind of CRT mechanism, and the most recently
developed, is credit derivatives, which are financial
instruments that transfer some or all of the credit
risk of an underlying
debt obligation or a borrower (or groups of obligations
or borrowers) from one party to another without necessarily
transferring the underlying asset; see Lopez (2001).
Since their introduction in the mid-1990s, the credit
derivatives
market has grown dramatically. According to estimates
by the British Banker's Association, the notional amount
of
credit derivatives outstanding grew from almost $600
billion in 1999 to approximately $5 trillion in 2004.
The two main types of credit derivatives are credit
default swaps (CDS) and collateralized debt obligations
(CDOs).
In a CDS transaction, the buyer of credit protection
makes regular payments in exchange for a contingent
payment in
case a defined credit event, such as bankruptcy of
the original borrower, occurs. While the contingent
payment
could be tied explicitly to the value of a specific
debt obligation after the credit event, it could also
be determined
independently; that is, the contingent payment could
be tied to the value of a specific loan in case a borrower
defaults, or it could be tied simply to whether the
borrower defaults. In this sense, CDS transactions
are more like
standard insurance contracts that protect the purchaser
from an adverse event. Some industry estimates suggest
that CDS transactions based on individual corporate
borrowers make up about 60% of total credit derivatives
volume.
Standard CDOs are structured much like debt securitizations:
the lender transfers credit exposures to a specialized
corporate entity that issues different tranches of
securities with differing degrees of risk. The credit
risk is then
borne by the purchasers of the securities. The riskiest
is the "equity" tranche. Investors in these securities
are said to be in a "first loss" position, since
their securities will be the first to lose value in case
of a credit event. Typically, they contractually agree
to absorb the first 3% to 7% of losses from the reference
portfolio. The originator of the CDO often retains some
of this tranche to signal confidence in the transaction
and to reduce concerns about adverse selection. The second
type of security typically consists of unrated debt securities,
whose payments are more directly linked to the underlying
loans. The third type consists of debt securities that
are commonly over-collateralized to achieve a high credit
rating and minimize repayment risk. These securities are
referred to as the senior or "super-senior" tranches
(i.e., senior to an AAA-rated tranche), because they incur
losses only if all tranches subordinate to them have been
exhausted. Contractual provisions give additional protection
to senior tranches. Mechanically, if defaults cause the
loan pool's value or interest proceeds to fall below certain
trigger levels, cashflows from the loan payments are diverted
to pay down the balances of senior tranches before more
junior tranches can receive payments. The contractual terms
governing the payout of interest and principal payments
on the CDO's reference portfolio are known as the payments "waterfall."
An important recent development in the credit derivatives
market is the growing use of "synthetic" CDOs,
in which the pooled assets are a collection of CDS
transactions that the specialized corporate entity
has entered into with
one or more lenders. While certainly more complicated than a standard securitization,
the underlying economic and financial fundamentals remain the same. According
to a report by the Counterparty Risk Management Policy Group (CRMPG 2005),
synthetic CDOs and related credit derivatives currently
account for about 15% of the total
market volume.
Credit derivatives need not impact the relationship between
a borrower and a lender, since they may be structured so
that the borrower is neither a
party to the transaction nor aware of it. In fact, a loan need not be removed
from
the lender's balance sheet. In terms of adverse selection, issues remain,
but credit derivatives address certain aspects, such as imposing requirements
on
the pool of borrowers in the reference portfolio and requiring the originator
to retain some of the "first loss" position.
Supervisory
issues
The more traditional forms of CRT, such as loan sales
and syndication, have been around for some time, and many
issues are already addressed by supervisory rules and experience.
For example, the Federal Reserve System's Supervisory and
Regulatory Letter 01-12 lays out explicit guidelines for
accounting for loans held for sale. Securitization of residential
and commercial real estate loans is also well established
and widely monitored by public rating agencies.
However, the relatively new and rapidly expanding market
for credit derivatives does give rise to some pressing
supervisory policy issues. One such issue is whether
a credit derivatives transaction establishes a complete
credit
risk transfer. Several factors could undermine these
CRT transactions and negate their intended purpose. For
example,
since the seller of protection might fail to meet its
obligations, the buyer must be careful to manage this counterparty
risk.
In addition, various legal issues, such as whether counterparties
actually have the legal authority to enter into a transaction,
could undermine a transaction. To address this concern,
the Joint Forum (2005) report strongly calls for enhanced
counterparty risk management, increased standardization
of credit derivatives documentation, and diligent legal
analysis of individual transactions.
Another key supervisory issue is the risks related to
delays in processing the needed documentation. This
issue was
on the agenda at a recent meeting of leading participants
in the credit derivatives market hosted by the Federal
Reserve Bank of New York to discuss market practices
with regard to assignments of trades and operational
issues
associated with confirmation backlogs. Industry participants
have taken several steps to address these concerns
(see CRMPG 2005).
Regulatory
concerns
Regardless of the supervisory challenges regarding CRT
mechanisms, supervisors generally are able to monitor whether
undue concentrations of credit risk are building within
supervised institutions. The larger regulatory question
is how to detect and respond to such concentrations of
risk developing in the financial system as a whole. The
Joint Forum (2005) report did not find evidence of such "hidden
concentrations" of credit risk in specific sectors
of the financial system. However, to address this concern
more generally, the report made several recommendations
for improving the quality of public disclosures by market
participants regarding their CRT transactions and the corresponding
aggregate distribution of credit risks. While disclosures
need to respect the legal frameworks within which individual
financial institutions present their risk profiles, market
participants should provide clear qualitative descriptions
of the nature of their CRT activities. For example, such
descriptions could provide summary information and breakdowns
of credit exposures and CRT transactions by instrument
type, borrower credit quality, industry, or geographic
location.
Conclusion
The underlying economic fundamentals of credit risk transfer
are clearly strong and should lead to an increased volume
of transactions. Given the dual concerns of preserving
lending relationships with borrowers and avoiding adverse
selection issues, credit derivatives seem to be a promising
avenue for development. While supervisory and regulatory
concerns will always be present, prudent oversight of this
market should be sufficient to avoid disruptions to the
wider financial system.
Jose A. Lopez
Senior Economist
References
Board of Governors of the Federal Reserve System. 1999. "Interagency
Guidance on Loans Held for Sale." Supervisory and
Regulatory Letter 01-12.
Counterparty Risk Management Policy Group II. 2005. "Toward
Greater Financial Stability: A Private Sector Perspective." Manuscript.
Dahiya, S., M. Puri, and A. Saunders. 2003. "Bank
Borrowers and Loan Sales: New Evidence on the Uniqueness
of Bank Loans." Journal of Business 76, pp. 563-582.
Federal Reserve Bank of New York. 2005. "Statement
Regarding Meeting on Credit Derivatives." Press
release, September 15.
Lopez, J.A. 2001. "Financial
Instruments for Mitigating Credit Risk." FRBSF Economic Letter 2001-34
(November 23).
The Joint Forum. 2005. "Credit Risk Transfer." Manuscript.
Bank for International Settlements.
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do not necessarily reflect the views of the management
of the Federal Reserve Bank of San Francisco or of the
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