LEVEL: BEGINNER
Exposure within the capital markets has historically been focused on market risk and the fluctuations of financial instruments. The 2008 financial crisis brought to light how important credit risk exposure can be and how an economy can move to the verge of bankruptcy if this type of exposure gets out of hand.
While banks and financial institutions have faced difficulties during the past few years in the aftermath of the US financial crisis, the major cause of serious problems continues to be directly related to credit issues and the inability for companies to manage their credit exposure.
The issues in the credit space are not confined to lenders. Credit ratings agencies such as S&P and Moody’s as proved that they were not immune to overvaluing actual credit. The ability of a company or individual to pay their debt has even moved up to the sovereign level which is evident in the current EU debt crisis.
Defining Credit Risk
Credit risk is the exposure of counterparty to another based on the notion that each party will meet their obligations. Credit risk management is a process that is geared toward enhancing a portfolio by maintaining credit risk exposure within acceptable parameters.
Investors need to manage the credit risk inherent in the entire portfolio as well as the risk in individual credits or transactions. Investors should also consider the relationships between credit risk and other risks. The effective management of credit risk is a critical component of a comprehensive approach to risk management and essential to the long-term success of any portfolio or organization.
For most financial institutions, loans are the largest and most obvious source of credit risk. Other sources of credit risk exist throughout the activities of a bank, including a trading portfolio.
In the hedge fund space, credit risk is based on counterparty risks were the focus is on the credit worthiness of the company on the other side of any transaction.
Since exposure to credit risk continues to be the leading source of problems in banks world-wide, banks and hedge funds have spent countless hours designing transactions that will protect them from a credit meltdown.
Institutions have the need to identify measure, monitor and control credit risk as well as to determine that they hold adequate capital against these risks and that they are adequately compensated for risks incurred.
Managing Credit Risk
Over the past decade, credit risk management tools have developed that allow investment managers the capabilities of hedging their credit risk management. The most noteworthy is the credit default swap or CDS. This is an agreement were the seller of the CDS will compensate the buyer in the event of a loan or transaction default. The buyer of the CDS makes a series of premium payments to the seller and, in exchange, receives a payoff if the payments are deflated. CDS can be thought of a default insurance or the shorting of a bond.
In the event of default the buyer of the CDS receives compensation and the seller of the CDS takes possession of the defaulted loan. This is considered a physical settlement. A naked CDS is when an investor purely speculates on the direction of the CDS in which the counterparties have no direct interest in a credit event.
Activity in CDS instruments increased in 2003 and peaked by the end of 2007. Outstanding notional value of CDS was over 60 trillion at its peak. Most CDSs are documented using an ISDA International Swaps and Derivatives Association (ISDA) template, although some are tailored to meet specific needs.
CDSs have many variations which include basic, single-name swaps, or a basket default swaps. Credit default swaps and other derivatives are leveraged vehicles and therefore can be volatile and incur the risk of ruin. During the financial crisis large financial institutions wrote billions of dollars worth of CDS, and were overwhelmed by the unrealized and realized losses, as the market shifted in an adverse manner.
When used properly, credit default swaps can play a significant role in managing credit risk. Prior to the financial crisis, many institutions did not consider the extent of their credit risk when they transacted market risk positions. For example, former money center banks would allow clean credit loans on over the counter transactions on capital market directional derivates. So if a bank transacted a interest rate swap with a corporate counterparty, they would not require margin collateral and did not hedge against the potential for the counterparty to default on a payment for the transaction.
Today, the same companies will purchase credit default swaps that protect against a position where the counter party to an OTC transaction owes you money. That notional value of the transaction has potential credit risk and needs to be hedge to some extent.
Another way an investor can hedge counterparty risk is to short a company’s corporate bonds. Similar to stocks, bonds can be shorted, but this requires the ability to borrow the bond, which is not always available.
Exchanges
Credit risk can be initiated by purchasing or selling a credit default swap as a way to speculate on the credit worthiness of a corporation, or by purchasing a bond or stock. As discussed early most transactions that are traded in the over the counter market generate credit risk.
In an effort to eliminate credit risk while transacting derivatives, investors have migrated to clearing exchanges. These exchanges, such as the Chicago Mercantile Exchange, create a process in which counterparties face off against the exchange and not each other. The exchange requires daily margining to keep market participants whole, and will liquidate a position if margin falls below required levels.
Credit default swaps are now cleared through the Chicago mercantile exchange. Investors now can add an extra layer of security to their credit risk by hedging single name exposure by purchasing CDS and using the CME as a clearing house. The credit risk is then transferred to the CME instead of the counterparty.
The presence of a central counterparty like CME Clearing is an important customer advantage compared to over-the-counter markets. CME Clearing’s status as the central counterparty allows it to deliver operational and financial efficiencies to market participants, while reducing the risk inherent in trading activities.
Credit risk is an important component of any portfolio. The recent financial crisis involved huge amounts of credit exposure that was not account for, which created a domino effect toppling many of the large US financial institutions. These are a key element for any portfolio or risk manager.