ACTIVE LOAN PORTFOLIO MANAGEMENT

THROUGH THE USE OF CREDIT DERIVATIVES

Paul Van der Maas
The author is Managing Director, Head of Structured Credit Products Europe, with Bank of America.

Abstract The purpose of this article, which is based on a recent
presentation by Paul Van der Maas, is to give the reader a brief
overview of common credit derivatives, the size and scope of their
markets and their role in structured credit products. The case study
uses as a reference a current deal that Bank of America has
structured using credit derivatives.
Keywords Credit, Derivatives, Risk, Swaps, Value, Loans
What's your estimate of the size of the credit
derivatives market? ($ billion)
The data in Table I, taken from a study conducted by
the British Bankers Association, demonstrates that the
credit derivatives market has grown and is continuing to
grow at a far greater rate than estimated. The size of the
global credit derivative market was estimated to be $586
billion at year-end 1999 and was expected to reach $893
billion by year-end 2000.
Key drivers of this market include the recent
standardisation of ISDA documentation and regulatory
capital management which has seen an upsurge in
activity from the insurance and institutional investor
markets.
A noteworthy point is that London (representing the
vast majority of European activity) continues to be a very
significant player, with 46 per cent of the world's total.
Contributing factors to this include Euro currency
convergence alongside a migration of focus from market
risk to credit risk.
It is widely predicted that volumes will continue to
increase dramatically, most notably in Europe. An
increase in liquidity through new market participants has
aided and will continue to aid growth. A new Euro
denominated benchmark on corporate bonds has come
to the market, increasing the range of names traded.
Moreover, there has been an increased use of credit
derivatives by banks and corporates for managing credit
risk, e.g. concentration risk, which has improved
liquidity. This activity is facilitating an increased
# Paul Van der Maas
understanding of credit risk and investor willingness to
accept structured transactions.
What are credit derivatives?
The most frequently encountered credit derivatives are:
^ credit default swaps;
^ total return swaps.
These instruments will be examined in turn. An
overview of these credit derivatives will facilitate an
understanding of synthetic securitisation. Generally, at
least one of the above-mentioned credit derivatives is
used as a building-block in synthetic securitisation.
Credit default swap
A credit default swap (see Figure 1) is a bilateral
contract between two counter-parties, in which the
``protection buyer'' pays a periodic fee for protection ± a
contingent payment on the default (or any other
specified credit event) of a reference obligation, from the
``protection seller''.
How is protection triggered?
A reference obligation is nominated in the credit default
swap contract and, should a credit event occur on this
obligation, the protection seller may be asked to
compensate the protection buyer. The definition of
``credit event'' can vary between contracts and it is
therefore imperative that both parties to a transaction
agree and understand the scope of protection. Credit
events are one or more of bankruptcy, failure to pay,
obligation acceleration, repudiation/moratorium or
restructuring, as specified in the related confirmation[1].
A contingent payment can take two forms depending
on whether the transaction is cash settled or physically
settled. In cash settlement, the contingent payment is
calculated by taking the par price of the reference
obligation and subtracting from it its current post-credit
event market value. Physical settlement involves the
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Balance Sheet 9,1 2001, pp. 47-52, MCB University Press, 0965-7967
4 7
 Table I Ð The credit derivatives market Figure 2 Ð Total return swap
1998 1999 2000 2002
Year estimated Region ($) ($) ($) ($)
1999 Global 350 586 893 1,581
London 170 272 417 741
1998 Global 350 740
London 170 380
1996 London 40 100

Figure 1 Ð Credit default swap
protection seller taking delivery of the reference
obligation versus the payment of par. An advantage of
physical settlement is that potential disputes over the fair
market price of a post-credit event reference obligation
are avoided.
Trade rationale
^ Credit default swaps can be tailored to meet specific
investment needs. Investors can choose the
reference credit, term (typically one to five years), or
notional amount and currency.
^ Credit default swaps can be used to offload exposure
whilst maintaining client relationships. An
application of this would be a bank with a loan to a
client buying default protection on the exposure to
the client. This hedge need not necessarily be
disclosed to the client.
^ For investors with balance-sheet/funding
constraints, being a seller of protection (hence a
receiver of a periodic fee) can be used as an
unfunded investment.
^ Risk managers may use credit default swaps in order
to hedge their risk. By purchasing default
protection, they are decreasing their exposure to a
potentially risky credit and freeing credit lines.
Total return swap
A total return swap (see Figure 2) simulates the
purchase of an instrument such as a note or bond.
The total return receiver has economic exposure to a
reference obligation and receives value from interest
flows and capital appreciation. In the event of the asset
depreciating the total return receiver compensates the
payer. Payments under a total return swap are usually
cash settled.
Trade rationale
^ Total return payers can eliminate exposure to a
reference asset whilst retaining it. This can avoid
damaging client relationships.
^ Total return payers can achieve a synthetic short (if
asset not held), which can be difficult or impossible
to do in the cash market.
^ Total return receivers can achieve leverage and/or
diversification efficiently, since they take exposure
without having to fund.
^ Total return swaps provide investors with flexibility
± they can create transactions that meet their risk
and return needs, and account for these transactions
as off-balance-sheet.
Pricing
Several methodologies can be used when attempting to
price a credit derivative, each with their own advantages
and disadvantages.
Ratings-based default models
Ratings-based default models are a theoretical approach
to pricing and aim to model the expected loss resulting
from default. The inputs into the model are estimations
of the default probability and the recovery rate (i.e. the
value of a post-default asset). Default probability can be
estimated by using a security's credit rating and
modelled into the future. Recovery rates used can be
fixed or stochastic (involving or containing random
variables).
An advantage of this method is that it is not onerous
as regards data-requirements if the participant is willing
to use third-party providers such as KMV. However,
selecting a certain default probability and recovery rates
has an inherent risk. Moreover, this model is based on
historical data, which may not necessarily be a good
judge of the future.
Credit spread-based models
This method regards the underlying corporate bond's
credit spread over a virtually default-free asset with a
similar maturity as an estimate of pricing credit default
swaps. If the spread were 15bps over Libor then the
annual fee of a credit default swap would be 15bps. This
method has the great benefit that it is easy to estimate,

Balance Sheet 9,1 2001

4 8
but makes the false assumption that all of the spread is
attributable to credit risk.
Replication methods
Credit default swaps can be viewed as a synthetic
equivalent to an unfunded long position in an asset swap
(i.e. long a bond, with an interest rate swap attached
paying out fixed coupons and receiving Libor), since
credit risk exposure has been isolated.
Total return swaps can be viewed as synthetically
owning the underlying.
Replication methods used to evaluate the price of a
credit derivative involve the cost of entering a position
necessary to hedge the credit derivative contract. If we
consider trying to replicate a default swap in which we
sell protection, we have to:
^ purchase the bond;
^ swap out its fixed flows (assuming it is a fixed rate
bond) and receive LIBOR; and
^ finance the purchase through repoing that bond.
Although this method is theoretically sound, it may
sometimes prove impossible to fully hedge a credit
derivatives contract. In addition, the cost of transacting
the interest rate swap and the repo could prove
substantial.
Other issues determining the value of credit
derivatives
An institution should also examine internal issues such
as the cost of using its balance-sheet. Institutions that
face balance-sheet constraints would often find
unfunded positions advantageous, since, if the position
was held outright, the funding costs would erode part of
the credit spread earned. Correlation is another issue. If,
for example, a bank bought protection from a Korean
bank on Korean sovereign risk, would the Korean
protection provider be as effective as a protection
provider from another country? Theoretically, the
answer is no, since one would assume that there is a high
level of correlation between the Korean banking system
and the sovereign risk of that country, increasing the
probability of a joint default.
Applying credit derivatives in loan portfolio
management
Improved risk measurement systems have enabled banks
to isolate specific components of portfolio risks. The
credit derivative market has developed tools to
effectively manage these specific risks. Loan portfolio
management has driven a convergence among credit
derivative and asset securitisation market activity. This
convergence has led to an array of solutions for loan
portfolio risk management, as depicted in Figure 3.
Balance Sheet 9,1 2001
4 9
These solutions include freeing up credit lines for new
business, desired access to (a) specific exposure(s) for
targeted returns, freeing the balance-sheet and seeking
improvement on regulatory capital.
The examples which follow (credit linked note,
portfolio default swap and synthetic securitisation) will
demonstrate how using structures that contain credit
derivatives can aid in attaining the above-mentioned
solutions.
Credit-linked note
A credit-linked note (see Figure 4) typically embeds a
credit default swap (or even more than one) into a
security. An investor has a funded asset with two sets of
returns ± one from the asset itself and one transferred by
the credit derivative.
Credit-linked notes behave in a similar fashion to
bonds. In the example in Figure 4 an SPV (special
purpose vehicle) is set up which collates the premium
paid in the credit default swap and simultaneously
receives the return on the collateral assets (in this
example a high grade asset). The investor purchases the
CLN and receives an enhanced coupon, i.e. that of the
collateral plus the fee on the default swap, assuming that
no credit event occurs.
Trade rationale
^ The protection buyer can hedge the credit risk on
one of the loans in his/her loan portfolio.
^ Credit linked notes appeal to investors seeking an
enhanced yield.
^ For the buyer of protection the counter-party risk is
reduced, in that, should a credit event take place on
the reference credit, the issuer subtracts the value of
par minus the contingent payment from the
redemption of the supporting high grade collateral.
^ Since credit-linked notes behave like bonds, they
can be appealing to investors prohibited in
transacting credit default swaps.
Portfolio default swap: regulatory capital relief
transactions
Current BIS guidelines[2] on regulatory capital require
banks to set aside a disproportionately large amount of
regulatory capital for high-grade corporate credits. For
example, a BBB rated OECD bank has 20 per cent risk
weighting and yet an AAA corporate has 100 per cent
risk weighting.
The formula for calculating regulatory capital is:
[total amount of obligation 6
risk weighting6 8 per cent]
Challenge: to improve returns on regulatory capital
Let it be assumed that a bank has a portfolio of high-
grade corporate loans totalling $1 billion. Imagine that
 Figure 3 Ð Loan portfolio risk management solutions
Figure 4 Ð Credit-linked note
the management has decided to improve its return on
regulatory capital. A favourable solution would be one
which reduces the regulatory and economic capital
charge whilst releasing reserves, retaining substantial
economic benefit and retaining lending relationships.
Proposed solution transaction details
A seller of default protection is found for a second loss
tranche (i.e. losses that occur above a stipulated amount,
referred to as the first loss), for five years (see Figure 5).
Figure 5 Ð Improving returns on regulatory capital
Balance Sheet 9,1 2001
5 0
Trade rationale
^ The lending bank continues to own and service the
loan portfolio.
^ It reduces the regulatory capital charge for the
portfolio by $44.32 million (from $80 million to
$35.68 million) by reducing the second loss risk
weighting from 100 per cent to 20 per cent due to
hedge with an OECD protection seller. The first
loss, due to its nature, receives a one-for-one capital
treatment. Original portfolio capital charge:
$1 billion 6 8 per cent 6 100 per cent = $80
Exhibit 1

Balance Sheet 9,1 2001

5 1
 million. New portfolio capital charge: $980 million
6 8 per cent 6 20 per cent + $20 million 6 100
per cent = $35.68 million.
^ Improves economic capital: by reducing substantial
credit risks associated with the portfolio, significant
gains may be made on the return on economic
capital.
^ Substantial economic benefit of the loan portfolio is
retained, since the first loss captures the majority of
risk and return.
^ Corporate lending relationships are retained.
^ Reduced credit risk: since the protection provider
reimburses the bank for losses on the loan portfolio
above a minimum amount, substantial credit risk is
removed.
Synthetic securitisation
Credit derivatives have been introduced to structured
finance. Synthetic securitisation generally uses default
swaps to transfer risk of a reference portfolio of assets in
lieu of transforming receivables in a ``true sale''
securitisation. Typically, an SPV (special purpose
vehicle) is set up, with the aim of issuing credit-linked
notes and the proceeds of the issue are utilised to
purchase high-grade securities as supporting collateral
for the credit default swap.
Synthetic securitisation carries certain benefits of not
physically transferring assets as in true sale
securitisation. This can include simplified legal and tax
analysis. Existing client relationships need not be
damaged, since legal ownership of the underlying
portfolio is not transferred. Synthetic transactions also
have the advantage of the ability to introduce higher
returns due to leverage.
Synthetic securitisation can be used to provide many
solutions for investors and issuers. In the above example,
the portfolio credit default swap was utilised to achieve
regulatory capital relief. It is quite common for the
Balance Sheet 9,1 2001
5 2
protection seller in the above example to issue credit-
linked notes (referencing the second loss on the
portfolio). The issued CLNs transfer the second loss risk
to the noteholders. A noteworthy point is that the CLNs
need not be homogeneous and often differ.
The case study illustrates a live Bank of America
synthetic securitisation, with the aim to provide investors
with a BBB rated note with an enhanced yield (see
Exhibit 1).
Concluding comments
The purpose of this short article was to give a
rudimentary overview of credit derivatives and to
demonstrate their use in structured credit products by
way of some examples.
Credit derivatives markets are still relatively new and
the market is set to continue to grow rapidly in the next
few years. An increased focus and better credit derivative
valuation models will continue to exacerbate this
growth.
The existence of credit derivatives and their
increasing use in loan portfolio management is exciting.
The CDO market should improve the liquidity due to
the use of credit derivatives in synthetic securitisation.
Moreover structurers will seek to find new applications
for credit derivatives, which will help loan providers
dissect and identify the credit exposure they desire and
transfer unwanted exposure to another party.
The prospects for the further use of credit derivatives
and the increase in structures in which they will feature
deserve a watchful eye. BS
Notes
1. Further expansion on these terms can be obtained from ``Credit
Derivatives Definitions'' 1999 ISDA.
2. Further information on current and proposed BIS guidelines can
be found at http://www.bis.org