"There is a common misconception that banks are using credit derivatives because they are worried about the borrower; in fact it's completely the opposite. Most banks would rather liquidate the cash position than buy a default swap in that situation." Hermann Watzinger, vice president, credit derivatives at Citibank in London, is keen to dispel the image of the credit derivatives market as a way for banks to dump the toxic legacy of poor lending decisions onto unsuspecting institutional investors. "The most important use will be in loan portfolio management and we already use credit derivatives very extensively as an end-user in our own portfolio. We have done deals from $10 million to $1.1 billion."
Citibank, in common with other commercial banks, says that it would not lay off risks on a credit that it thought might default. Instead it would liquidate the position or hand the exposure to a specialist work-out team within the bank. Another banker agrees: "We don't want to sell a default swap and then collect on the default. That would be bad for our clients and no one wants to test that in court. And we wouldn't buy default protection on risky places either we use emerging-markets trades to manage country limits."
Most credit-derivative transactions are driven by capital considerations and have their roots in the beginnings of the credit revolution. This began quietly in two activities of the large commercial and investment banking groups. In the lending divisions, losses caused by recession or by external crises forced banks to provision - to mark their loans to market. The economic cycle dictated the timing. Thus in such places as the US, UK, Italy, France and Scandinavia this happened in the late 1980s. Elsewhere, for example in Switzerland, it is still happening. Such large after-the-fact provisioning affected banks in a number of ways that are now driving the development of new means to manage credit risk.
It forced the banks to recognize that they should find better ways to measure and manage credit risk. It damaged earnings to such an extent that it made banks search for a provisioning policy correlated with the predicted losses from default, to avoid earnings volatility. And it gave them a reason to sell loans which in turn made illiquidity in the credit markets an issue. Better provisioning methods - one promise of the new credit risk management models - are also being forced on institutions by more transparent accounting standards. Transparent accounting reduces banks' ability to use general loan-loss provisions to build hidden reserves and so distort reported earnings figures.
"For banks to look at credit risk afresh they have to realize they are uncomfortable with some of the risks in their portfolio. That will force them to assess them to find out what risks they are comfortable with. And that will force them to manage them. When they realize they have too much risk they will sell it and then, to defray the cost of selling, they will buy. That is what will kick-start the credit derivatives markets," says Paul Hattori, head of global credit derivatives at Dresdner Kleinwort Benson in London.
Credit risk was also at the forefront of people's minds in the derivatives group. As banks' derivatives books grew, traders began to ask credit officers how they calculated the capital charges they set against trades. Realizing that this charge significantly affected the performance of their businesses, and so their bonuses, derivatives chiefs set their quantitative analysts the task of putting credit risk evaluation on a scientific footing. Using the methods they were already adopting to analyze market risk, these quants challenged the credit departments to justify their capital charges.
They also constructed the first credit derivatives - default swaps - and embedded them in bonds to create credit-linked notes. The buyers of these notes assumed the default risk of specific counterparties, thus freeing the sellers' swap lines and allowing the derivatives departments to originate new business.
These trends coincided with renewed criticism of the Bank for International Settlements' risk-weighted bank capital requirements, spurred by increasing use of the risk-adjusted return on capital (Raroc) measure both in analyzing performance and in pricing credit. Raroc models measure the amount of economic capital needed to support business lines and help banks more accurately correlate risks and returns in those businesses.
Credit derivatives have benefited from these developments because they are an extremely efficient way to release regulatory capital. Banks use default swaps and total-return swaps to lay off exposures that do not meet their return criteria and use the freed capital to invest in transactions that do. The buyers typically are looking for leveraged or off-balance-sheet exposure, require synthetic assets or are unable to buy the assets they require in the cash market because their funding costs are too high. Credit derivatives are not yet being used much to manage credit risk systematically, though next year bankers expect a boom in the use of these instruments to diversify and reduce concentration risks.
Default swaps are also often structured with maturities different from that of the underlying exposure. This creates synthetic investments that are not available in the cash markets. This can make the swap more desirable than a cash investment and drive down the price.
Hedgers also have to take into account the correlation between the swap counterparty and the hedged exposure. If there is a positive correlation, then default by the underlying borrower may imply that the swap counterparty's ability to deliver the notional value of the reference security is impaired.
"If there is a high correlation between the provider of protection and the entity on which the protection is written, then there can be a problem," says Andrew Austin, head of credit derivatives at Nomura International in London. "If Bank A gives me protection against the default of Bank B and both banks are in the same country, I run the risk that whatever event has made Bank B default is also highly likely to have an effect on Bank A which may then be unable to fulfil its side of the swap."
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