Chapter 31 – Credit Default Contracts

1. Chapter 31 – Credit Default Contracts BA 543 Financial Markets and Institutions

2. Chapter 31 – Credit Default Contracts • Transfer of Credit Risk (Default Risk) • Failed payments • Credit spread • Rating Downgrades • Sell off the loan • Typical in mortgage market where the originator of the loan does not keep the loan in their portfolio of investments • New ways • Credit derivatives • Collateralized Debt Obligations

3. Chapter 31 – Credit Default Contracts • Credit Derivatives • Credit Default Swap is the most common of the credit derivatives • Single named – one reference entity (issuer of the original credit instrument) • Basket – multiple reference entities (multiple issuers of original credit instruments) • Default Index – multiple reference entities but a standardized list of entities (index of issuers is constant) • Tenor is the length of the contract • Payment can be physical or cash • Payment of premium can be quarterly (standard)

4. Chapter 31 – Credit Default Contracts • Example Single Named Credit Default Swap • The underlying bond – Ford Motor Company $20 million thirty-year semi-annual bond at 8% coupon rate (semi-annual payments: $800,000) • Protection buyer (buys insurance on payments) at 100 basis points on quarterly basis ($20,000,000 x 0.01 x 91/360) $50,555 • Premiums paid every quarter (based on actual days in quarter) until “credit event” • At Credit event: Cheapest to deliver bond of original issuer is made to the protection seller for cash payment of principal to protection buyer

5. Chapter 31 – Credit Default Contracts • Collateralized Debt Obligations • Collateral manager buys “underlying” portfolio of bonds or mortgages • Constructs a set of obligations (sells CDO) • Senior Tranche • Mezzanine • Subordinate/Equity where this is a residual claim • Enters into interest rate swap agreement to arbitrage the interest rates in the underlying portfolio and the obligation portfolio • Needs an equity stakeholder…

6. Chapter 31 – Credit Default Contracts • Issues with CDOs • Defaults on bonds or mortgages in the underlying portfolio • These are the cash flows needed to pay CDOs • Prepayments • These can hurt the swap agreements on higher notional amounts • Principal repayment • Senior and Mezzanine must get their principal back and so this must be part of the structure and may be misaligned with the underlying portfolio maturities

7. Chapter 31 – Credit Default Contracts • Synthetic CDO • Replaces risky underlying portfolio with low risk portfolio and sells credit default contract for premiums • Cash flow of premiums and underlying portfolio sufficient to satisfy cash outflow to obligation portfolio • Mitigates problems with notification of selling of loans/bonds in the underlying asset to a collateral manager

8. Chapter 31 – Credit Default Contracts • Issues with the Credit Default Contracts • Clean Risk Transfer • Ability of the counter-party to meet obligations at a credit event • Failure to Understand Risk • Participants don’t fully understand the contractual obligations (Gibson Greetings and Proctor & Gamble) or are not properly hedged, increasing risk • Risk Concentration in areas unable to generate credit • Adverse selection – too many mortgages