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BFF5230 Global Financial Markets

Credit derivatives
Dr. Hassan Naqvi
Recap

 Structure of securitization
 Terminology: Originator, SPV,
 Credit enhancements
 Tranching
 Waterfall
 Benefits and costs of securitization
 ABS and MBS
 Prepayment risk
 CDO and CLO
 Covered bonds
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Outline

• Review basic credit derivative structures

– Total return swaps
– Credit Default Swaps
– Collateralised Debt Obligations

• Work through the SEC versus Goldman Sachs Abacus case

– Aim is to understand some of the complexity and the ethical issues involved
– What would you have done in the same situation?

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Credit Derivative Instruments

Derivatives where the payoff depends on the credit quality of a company or sovereign entity

Over-the-counter instruments classified as:

• Total Return Swaps

– one party pays a fixed set of payments in return for a variable stream indexed
to the total return (coupon plus value change) of the reference bond

• Credit Default Swaps (CDS)

– one party receives a fixed income stream in return for the promise to pay a
pre-arranged lump sum in the event of default of the reference bond
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Credit Derivative Instruments

 Collateralized Debt Obligations (CDOs)

– CLOs and CBOs

 Forwards and Options on CDS

– a forward or option written on a particular CDS on a particular entity

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Size of Credit Derivative Market
• At its 2007 Regional Member Conference in New York, the International Swaps and Derivatives Association
(ISDA) announced the results of its Mid-Year 2007 Market Survey of privately negotiated derivatives.

• According to the Survey, notional amount outstanding of credit derivatives grew by 32% in the first six
months of the year to $45.46 trillion from $34.42 trillion.

• In 1998 the market was USD 90 billion

• A clearinghouse established for trades of CDS between financial institutions as a result of the GFC

• Sept 2008 credit derivative market reported to be $62 trillion (The Times)

• For the 10 years leading to the GFC- the market grew rapidly.

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 MONASH
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Total Return Swap

Total Return Swap

 A swap involving an obligation to pay interest at a specified fixed or floating

rate for payments representing the total return on a specified amount.

 Allows FIs (Financial intermediaries) to maintain customer relationship and at

the same time to reduce credit risk

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Total Return Swap: Example 1 (Reducing credit risk)

 Suppose FI lends $100m to a firm in Brazil at fixed rate of 10%

 To hedge an increase in borrower’s credit risk FI enters into a total return

swap: agrees to pay a fixed rate (f = 12%) plus changes in market value of
Brazilian bonds.

 In return, FI receives a variable return (e.g. LIBOR rate)

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Total Return Swap: Example 1 (Reducing credit risk)

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Total Return Swap: Example 2 (Hedging investment risk)

Swap- Total Return on S&P500

on principal amount of $ 1 million

Counterparty A Counterparty B

(Seller) (buy)

LIBOR + 2%

Protects against default and change in credit rating

No physical exchange of asset. Counterparty B gains
synthetic replication of counterparty A asset.

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Total Return Swap: Example 2 (Hedging investment risk)

 Let us assume LIBOR is 3.5% and value of S&P 500 appreciates by 15%.
– Counterparty B pays counterparty A LIBOR + 2% = 5.5%
– Counterparty A pays value of appreciation 15% X $1,000,000

 Position Netted: Counterparty A pays Counterparty B (15% - 5.5%) X $1,000,000 m =

$95 000

VS.

 If value of S&P500 depreciates by 15% - Then Counterparty B should pay counter

party A for the fall in value plus the agreed variable rate:
– Counterparty B will pay counterparty A : (15%+ 5.5%) X $1,000,000= $205,000

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Total Return Swap: Example 3 (Financing tool for receiver)

 Can be used as financing tools by companies that want an investment in a

corporate bond
 Receiver wants to invest $100m in the reference bond
 Approaches the payer (usually a FI) and agree on a swap
 Payer invests $100m in the bond
 Receiver pays LIBOR plus spread. Similar to borrowing money.

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Total Return Swap: Example 3 (Financing tool for receiver)

 Payer retains ownership of the bond for the life of the swap
 Payer faces less credit risk compared to lending money directly to receiver.
 This is because payer holds ownership of bond as collateral

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 MONASH
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Credit Default Swaps

Credit Default Swap (CDS)

Buyer of the instrument acquires protection from the seller against a default by a particular
company or country (the reference entity). They are like an insurance contract.
– Example: Buyer pays a premium of 90 bps per year for $100 million of 5-year
protection against company X

Premium is known as the credit default spread. It is paid for life of contract or until default.

If there is a default (credit event), the buyer will be compensated.

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Credit Default Swap (CDS)

o Investors use CDS to hedge against cash investments or to speculate on the

direction of credit markets

o You do not have to hold the underlying asset to buy a credit default swap

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Credit Default Swap (CDS) on companies

 Think “insurance contracts against the cost of default of a company.”

 Suppose that you hold Ford bonds and are concerned about Ford’s default
risk. You could insure your bond holdings with a credit default swap  You
pay premiums over time (same as car insurance, different underlying risk).

 If Ford does not default, you lose the premiums.

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Credit Default Swap on companies

 If Ford does default, the credit default swap allows you to

– Either exchange the Ford bonds you hold, which are now worth little, for
the principal amount of the bonds,

– or alternatively, depending on the details of the contract, for a payment

equal to the principal amount of the bonds you hold minus their current
value at the time of default.

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Credit Default Swap on companies

 Your Ford bonds could lose value even if Ford does not default—for instance, if
Ford’s credit ratings falls without a default—but you only receive payment from a
credit default swap in the case of an actual default (and in the event of a debt
restructuring for some contracts).

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Differences between CDS and other insurance contracts

 You do not have to hold the bonds to buy a CDS on that bond, whereas with an
insurance contract, you typically have to have a direct economic exposure to obtain
insurance.

– Because you don’t have to hold bonds, the amount you insure with a credit
default swap is usually called the notional amount: If you buy a credit default
swap on Ford for a notional amount of $100 million, you have insurance on
$100 million of principal amount of Ford bonds.

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Differences between CDS and insurance contract

 Insurance contracts (mostly) are not traded;

 In contrast, CDSs do trade over the counter—that is, a market where

traders in different locations communicate and make deals by phone and
through electronic messages.

 Dealers trade with end users as well as with other dealers.

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Ford Example:
 The week ending on May 15, 2009 the DTCC had 5,387 credit default swap contracts
registered with it on Ford Motor Company, 1,583 on Ford Motor Credit Company, and 4,649
on Ford Motor Credit Company LLC.

 The total notional amount of credit default swaps on Ford Motor Company was for $36
billion.

 For comparison, on December 31, 2008, the automotive sector of Ford had total debt of
$25.8 billion.

It is not unusual for the total notional amount of credit default swaps written on a name to
exceed the total amount of debt issued by that name.
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CDS Structure

90 bps per year

Default Default
Protection Protection
Buyer, A Seller, B
Payoff if there is a default by
reference entity=100(1-R)

Reference
Asset
This could be loans
to customers

Recovery rate, R, is the ratio of the value of the bond issued by reference
entity immediately after default to the face value of the bond
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 CDS

A CDS contract includes:

o The identity of the reference loan (notional value, credit spread, maturity on a risky
loan issued by the obligor)

o The definition of a credit event

o The compensation that the protection seller will pay the protection buyer if a credit
event happens

o Specification of either physical settlement (delivery of agreed debt instruments) or

cash settlement
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CDS
For corporates cash settlement:

 Dealer poll conducted to establish value of reference obligation (e.g. x

percent of par)

 The protection buyer in a 5,000,000 USD CDS, upon the reference entity’s
filing for bankruptcy protection, would notify the protection seller. A dealer
poll would then be conducted and if, for instance, the value of the reference
obligation were estimated to be 20% (R) of par, the seller would pay the
buyer 4,000,000 USD.

See: http://www2.isda.org/asset-classes/credit-derivatives/2014-isda-credit-
derivatives-definitions/ for recent changes
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Other Details

• Payments are usually made quarterly or semiannually in arrears

• In the event of default there is a final accrual payment by the buyer

• In September 2005 significant backlogs in clearing resulted in the creation of

a central depository and agreed protocol, and in July 2008 a central clearing
house was created to make market operations more efficient

• In September 2008 Lehman Brothers was the first major dealer to file for
bankruptcy, triggering billions of dollars of losses by its counterparties and
by sellers of protection on its debt

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 Example:

• Suppose you have sold a 5 year Credit Default Swap with reference asset a $100 million
bond portfolio, for which the premium charged is 100 basis points per annum payable
semi-annually in arrears. The CDS is cash settled.

– How much do you receive each 6 months for the CDS?

– Describe exactly what happens if the bond portfolio defaults after 15 months and the
recovery rate on the bond portfolio is 50%. Calculate how much money you have
received in premiums. State how much you must pay out when the bond portfolio
defaults.

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Solution

• 0.01*100m*0.5= $500,000

• If the bond defaults after 15 months, you receive the accrued premium of half
of 500,000 or 250,000. So you have received two payments of 500,000 each
and you receive one payment of 250,000 at the 15 month mark. You must
then pay out a cash settlement to the holder of the CDS to compensate the
holder for the loss on the bond portfolio. So you must pay out $50m.

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Attractions of the CDS market

 Allows credit risks to be traded in the same way as market risks

 Can be used to transfer credit risks to a third party

 Can be used to diversify credit risks

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 Bank for International Settlements (BIS) statistics
http://www.bis.org/statistics/derstats.htm
• Lehman Collapse resulted $400 billion to become payable to the buyers of CDS protection referenced against the insolvent.
(after netting the net amount was lower).

• AIG - Required a $85 billion federal CDS Outstanding: notional amounts

loan because it had been excessively 70,000,000

selling CDS protection without hedging 60,000,000

against the possibility that the
50,000,000
reference entities might decline in
40,000,000
value, which exposed the insurance
giant to potential losses over $100 30,000,000

billion. 20,000,000

10,000,000

• Other Concerns- Collapse of Bear 0

Stearns which was sold to JP Morgan

Why this contraction?

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Recent regulatory changes
https://www.sec.gov/spotlight/dodd-frank/derivatives.shtml

• Title VII of Dodd-Frank Wall Street Reform and Consumer Protection Act addresses the gap
in U.S. financial regulation of OTC swaps by providing a comprehensive framework for the
regulation of the OTC swaps markets.
• SEC has regulatory authority over swaps based on a single security or loan or events
related to a single issuer or issuers of securities in a narrow-based security index
• CFTC has primary regulatory authority over all other swaps (e.g. energy, agricultural). Jointly
SEC and CFTC have authority over ‘mixed swaps’
• Rules regarding trade reporting, real-time public dissemination of trade information,
repositories registered with SEC, mandatory clearing, registration of dealers, clearing house
standards, record keeping for dealers and participants

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CDO
Collateralised Debt Obligation (CDO) (Seen last week)
A simple securitisation process where the underlying are bonds…

• A collateralized debt obligation (CDO) is a security that is backed by—or linked to—a
diversified pool of credits. The credits can be assets, such as bonds or loans, or simply
defaultable names, such as companies or countries.

• CDO issuance was based in the majority of cases on portfolios of corporate bonds and
leveraged loans.
• As the investor base expanded, emerging markets CDOs (EMCDOs) also appeared,
consisting of sovereign debt and emerging markets corporate debt.

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Asset Backed Security (Simplified)
Similar to slides of
Asset 1 Senior Tranche Securitisation
Asset 2 Principal: $75 million
Asset 3 Return = 6%

SPV Mezzanine Tranche


(special purpose Principal:$20 million
vehicle) Return = 10%

Asset n
Equity Tranche
Principal: Principal: $5 million A “waterfall” defines
the precise rules for
$100 million Return =30% allocating cash flows
to tranches

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 The Waterfall

Asset
Cash
Flows

Senior Tranche

Mezzanine Tranche

Equity Tranche

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Collateralised Debt Obligation (CDO)

The generic term CDO refers to those investment entities that are backed by a
portfolio of bonds or loans, or a combination of both.

– In the infancy of the market, CDOs backed primarily or exclusively by bonds

were referred to as collateralized bond obligations (CBOs), while those
issuances backed primarily or exclusively by loans were commonly referred
to as collateralized loan obligations (CLOs).

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CLO or CDO (collateralised loan (debt) obligation)

Source: Laurie S Goodman Journal of Derivatives; Spring 2002; 60 - 72

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Cash CDOs

• A CDO created from a bond portfolio is known as a cash CDO

• Cash flow CDOs are structured vehicles that issue different tranches of
liabilities and use the net proceeds to purchase the pool of assets.

• The cash flows generated by the assets are then used to pay back investors
generally in sequential order from the senior investors that hold the highest-
rated (typically 'AAA') securities, to the "equity investors" that bear the first-loss
risk and generally hold unrated securities.
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Cash CDOs

• To compensate for the risk associated with bearing the first-loss position, the
equity investors are generally paid most of the residual interest and may
achieve a high annual rate of return.

• The money invested by the noteholders is used by the SPV to purchase the
assets and cover the costs associated with executing the transaction. The
par value of the securities at maturity is used to pay the notional amounts of
the liabilities.

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 MONASH
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Collateralised Loans
Obligations (CLOs)
Just for fun…

No, but seriously…

“The way the deals are structured should be known by anyone familiar with how mortgage bonds work: a
company sells an asset, be it a fitness center, intellectual property, or a tug boat, to a shell company. The shell
then issues debt to investors, using the cash to repay the corporate parent for the asset, and servicing debt
with cash flows from the businesses it now owns. The assets are structured so that they're protected from a
bankruptcy of the corporate parent, at least in theory.” Source: Business Insider
CLO Features

• Bank removes assets from balance sheet but still retains management
responsibility for collecting payments and enforcing contracts - receives
management fee
• Trust holds assets and receives interest and principal payments passed through
bank
• Trust distributes to investors
• Note that there is a tiering of seniority. First losses are absorbed by the equity
holders until all equity is lost. Thus investment grade ratings are issued for senior
tier
• Investors and bank have agency conflict. Typically bank will be investor in equity
tranche to show ‘goodwill’

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CLOs
• The structure of CLOs is economically similar to CDOs.

• Each pools multiple loans to create synthetic, bond-like investments. Investors buy a
slice (or tranche) of the underlying interest and principal cash flows of the portfolio.

• A defined order of which investors get repaid first and which bear the most losses
allocates risk differentially.
– High-risk CLO equity pieces, which are unrated, are first in line for losses and last for
repayment.
– Less-risky subordinated or mezzanine pieces, typically rated anywhere between
BBB and B, rank ahead of equity.
– Low-risk senior pieces, typically rated A or better, rank first for payments and only
bear losses if the equity and subordinated pieces are completely wiped out.
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CLOs risks
 CLOs, like CDOs, are designed to increase the leverage on a portfolio of debt.

 Rather than mortgages, subprime or otherwise, they repackage corporate loans, primarily
leveraged loans, as well as consumer credit such as automobile loans.

 Current CLOs outstanding globally total around $700 billion, with annual new issues of over
$100 billion. That’s broadly comparable to subprime CDO volumes in 2008.

 Potentially high risk: The Financial Stability Board said in March 2019 that it will look into
them as well.

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CLOs risks
 Investors in better-rated tranches have greater protection than they would have in CDOs, as
higher levels of losses are required before they lose money.

 Nevertheless, many risks remain.

– The credit quality of the leveraged loans which underlie the bulk of CLOs is poor,
typically not investment-grade.
– Borrowers are highly leveraged.
– The loans increasingly have minimal investor protection, with over 70 percent lacking
any covenants that would allow monitoring of financial condition and early intervention
to manage problem borrowers.

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 MONASH
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CDOS more generally

ABS CDOs or Mezz CDOs (Simplified)
ABS
Subprime Mortgages Senior Tranche (75%)
AAA
The mezzanine tranche is
repackaged with other mezzanine
tranches, called
Mezz CDO

Senior Tranche (75%)

Mezzanine Tranche (20%) AAA
BBB
Mezzanine Tranche
(20%) BBB
Equity Tranche (5%)
Not Rated
Equity Tranche (5%)

How much of the original portfolio of subprime

mortgages is AAA?

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Losses to Mezzanine Tranche of ABS CDO

Losses on Losses on Losses on Losses on Losses on

Subprime Mezzanine Equity Tranche Mezzanine Senior
portfolios Tranche of ABS of mezz CDO Tranche of Tranche of
mezz CDO mezz CDO

10% 25% 100% 100% 0%

15% 50% 100% 100% 33.3%

20% 75% 100% 100% 66.7%

25% 100% 100% 100% 100%

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A More Realistic Structure
High Grade ABS CDO

Senior AAA 88%

Junior AAA 5%
AA
3%
A
2%
BBB
ABS 1%
AAA NR 1%
81%
AA 11%
Subprime
A 4% Mezz ABS CDO CDO of CDO
Mortgages
BBB 3% Senior AAA Senior AAA
62% 60%
BB, NR 1% Junior AAA Junior AAA
14% 27%
AA AA
8% 4%
A A
6% 3%
BBB BBB 3%
6%
NR 4% NR
2%

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Synthetic CDOs

• A synthetic CDO is similar to a traditional cash CDO.

• The primary difference between the two is that a synthetic CDO does not own the
underlying assets.

• Alternatively, synthetic CDOs gain credit exposure to a portfolio of fixed-income assets

through the use of credit default swaps. The risk of loss on synthetic CDOs is divided into
tranches just like traditional (cash) CDOs.

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Synthetic CDOs

Alternatively:
• Synthetic CDOs are structured vehicles that use credit derivatives to
achieve the same credit-risk transfer as cash flow CDOs, without physically
transferring the assets.

• The risk is typically transferred to the investors by the entity holding the
physical assets. The investors are the sellers of credit protection, since they
take the risk of loss should the asset default. The institution holding the
assets is the credit-protection buyer, since the risk of the loss was
transferred to the investors.

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Synthetic CDOs

Another way of looking at it:

 A long position in a corporate bond has the same risk as the seller (short
position) of CDS.
 Instead of buying bonds, the originator of a CDO can short CDS.
 A CDO created in this way is known as a synthetic CDO.
 Synthetic CDOs are also referred to as unfunded structures since the
tranche holders do not invest anything.
 They receive premiums and cover losses due to default.

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Case Study: The ABACUS 2007- AC1

Case Study: The ABACUS 2007- AC1
http://www.youtube.com/watch?v=891HpnJcPqw&feature=fvwrel

Fabrice Tourre is a former vice president at

Goldman Sachs.
On April 16, 2010, the Securities and
Exchange Commission said in a civil complaint
that Goldman and Fabrice Tourre, then vice
president, created and sold opaque
collateralized-debt obligations, or CDOs, that
hinged on the performance of subprime-
mortgage-backed securities.
A French graduate of Stanford who has worked at
Goldman Sachs since July 2001

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Case Study: The ABACUS 2007- AC1

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Mr Tourre hit the headlines over the candid private emails he had sent in 2007 to his
girlfriend, describing his fears about the housing market and the financial packages he
was creating.

One of the more memorable emails was sent on January 23, 2007. In it he shared his
apparently true feelings on the state of the US housing market: “More and more
leverage in the system. The whole building is about to collapse anytime now ... Only
potential survivor, the fabulous Fab ... standing in the middle of all these complex,
highly leveraged, exotic trades he created without necessarily understanding all of the
implication of those monstruosities [sic]!!!”

A month later, on February 26, the French-born banker produced another document, a
65-page “flip book” that contained details of a $1bn investment fund, designed to be
given to potential investors. The fund was a synthetic collateralised debt obligation
(CDO) – a parcel of sub-prime mortgages - called Abacus 2007-AC1.

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Case Study: The ABACUS 2007- AC1

 Known as a mezzanine CDO

 The parties involved in (setting up) the transaction
– Goldman Sachs is the originating bank
– Paulson and Co (hedge fund established in 1994)
– ABN Amro acted as an intermediary

 Some of the investors

– IKB Deutsche Industriebank AG
– IKB invested in $50m class A notes (AAA LIB+85) and $150m class A2 notes (AAA
LIB +110)
– IKB was subsequently bailed out by the German government
– ACA Management LLC (sold protection to investors)
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The structure
High
quality
collateral
Had role in Paulson & Co Repo
selecting hedge fund Govt
portfolio
cash
$15m ABACUS 2007
Reference
portfolio
Interest
& –$909m
AC1
super ABN Amro
principal
RMBS senior
50b
BBB rated (incl. Swap
p +85bp
ARMS) premium
Goldman Sachs
SPV
Interest
&
+110bp IKB
principal
originating bank
Funding
Credit
Sold
protection
protection
based on
reference
loan
portfolio equity ACA capital

Had role in selecting portfolio

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The case

 The deal closed on April 26 2007

 Goldman S were unable to sell off all the synthetic CDO, lost $90m and were paid
$15m by Paulson & Co
 By Oct 24 2007 83% of the RMBS in the ABACUS portfolio had been downgraded and
17% were on negative watch
 Paulson, known for his pessimistic outlook on the mortgage industry bet against the
ABACUS CDO and netted approx. $1 billion
 By Jan 2008 99% of the portfolio had been downgraded
 Investors in ABACUS liabilities are alleged to have lost more than $1b
 Goldmans and Fabrice Tourre are accused of civil fraud by the SEC, for failing to tell
ACA and other investors that Paulson and Co helped choose the portfolio

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The case

 ABN Amro intermediated the CDS (ABN-Goldman and ABN-ACA netting ABN 17 bp)
 ABN Amro was subsequently taken over by a consortium of banks including RBS
 RBS unwound ABN’s super senior position by paying Goldman Sachs & Co $804,909,090
 Most of this amount was subsequently paid to Paulson & Co
 Paulson & Co had a say on which loans went into the reference portfolio. It is said that “Paulson
kicked out all the Wells Fargo deals.” WHY?
 Goldman settled with the SEC in July 2010 for $550m, without admitting wrongdoing
 Tourre resigned in 2012
 Tourre was subsequently fined $650,000 (civil court) and told to hand back a $175,000 bonus for
defrauding investors (March 2014) http://www.bbc.com/news/business-26552995
 Goldman was blocked by the judge from paying the fine for him

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Ratings?

 Goldman is also alleged to have tried to pressure the credit rating agency
Moody's give its products a higher rating than they deserved.
 According to an article in ProPublica, "Goldman and other firms often
seemed to have pressured the agencies to give good ratings. E-mails
released last week by the Senate investigations subcommittee give a
glimpse of the back-and-forth (PDF). "I am getting serious pushback from
Goldman on a deal that they want to go to market with today," wrote one
Moody's employee in an internal e-mail message in April 2006. The Senate
subcommittee found that rating decisions were often subject to concerns
about losing market share to competitors. The agencies are, after all, paid by
the firms whose products they rate."

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Overview

 We have examined the structure of some simple credit derivatives

– Be able to reproduce in a diagram and explain the structure of
 A total return swap
 A CDS
 A CDO
 A CLO
 ABS CDO
 Synthetic CDO

 Who uses the credit derivative markets?

 What can go wrong when complex securities are designed?
 Understand the conflicts of interest in the ABACUS 2007- AC1 case
 Be able to discuss the ethical issues in the ABACUS 2007- AC1 case

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