Credit Derivatives
Credit derivatives are contracts that transfer the risk of a borrower's default from one party to another without transferring the loan itself. The buyer of protection pays a periodic premium; the seller pays out if a defined credit event — default, bankruptcy, restructuring — occurs. They are the instrument behind synthetic securitisation, and the way a bank keeps a customer relationship while selling its risk.
- Also known as
- Credit default swap, CDS, Credit protection
- Used at
- bank balance-sheet management, capital relief transactions, hedging of loan and bond exposure, and as a traded market in its own right
- Binding
- yes — standard ISDA documentation defines the credit events, the reference obligation and the settlement method
- Typical forms
- the single-name credit default swap, index CDS on a basket of names, and the credit-linked note or financial guarantee used in synthetic securitisations
- Typical premium
- quoted in basis points a year on the protected amount — tens for an investment-grade name, hundreds for a stressed one
- Parties
- the protection buyer (usually a bank), the protection seller (an insurer, a fund, another bank) and the reference entity, which is not a party at all
How credit derivatives work in practice
The simplest form is the credit default swap. A bank holds €50m of a company's loans and wants less exposure to it but does not want to sell the loans — the customer would notice, and the relationship earns fees. It buys protection: it pays, say, 150 basis points a year (€750,000) to a fund, and if the company defaults the fund pays the bank the loss on €50m, either by taking the defaulted debt at par or by paying the difference between par and the recovery value. The bank has kept the customer and shed the risk; the fund has earned a premium for taking it.
The same contract scaled to a portfolio is a synthetic securitisation. Instead of one name, the reference is a pool of loans; instead of one protection seller, the risk is cut into tranches and the junior tranche — the first losses — is sold to investors who want the yield. The bank's regulatory capital on the pool falls because the risk it retains is now senior, and the regulator's rules for significant risk transfer decide how much.
The risk that remains is the counterparty. Protection is only as good as the seller's ability to pay when the credit event happens — the lesson of 2008, when protection bought from AIG was worth what AIG was worth. So protection sellers now post collateral, and most bank transactions are funded: the investor pays cash up front, held against the losses it has agreed to bear.
Example
A bank has €2bn of SME loans on which it expects losses of 0.4% a year, €8m. It buys protection on the first 7% of losses — a €140m tranche — from a credit fund, which funds the tranche in cash and receives a 10% coupon: €14m a year. The fund's expected net return is €14m less the €8m of expected losses, €6m, plus the interest on its cash — a return it will accept because the tranche is well above the losses it expects. For the bank, the risk it keeps is now senior: risk-weighted assets on the pool fall from €1.5bn to about €400m, freeing some €130m of capital at a 12% ratio. That capital cost the bank's shareholders 12–14% a year; the protection costs 10.8% of it. The regulator's significant-risk-transfer review decides whether the relief stands.
Common mistakes
- Buying protection whose credit-event definition does not cover the way the borrower actually fails — a restructuring that is not a default. - Ignoring the protection seller's credit: unfunded protection from a weak seller is a second exposure, not a hedge. - Reading a CDS spread as the market's probability of default without the recovery assumption behind it. - Treating capital relief as permanent when the regulator's significant-risk-transfer test can be failed on review. - In diligence on a lender, missing that part of the book's risk has been sold and part of its yield with it.