Credit Risk: From Transaction to Portfolio Management

Figure 3.5 shows the TROR transacted between the bank and the

institution. This arrangement is financially the same as being ‘long’ the

asset in the individual cases. However a significant advantage is now

conferred, providing the asset and the BB institution have a low default

correlation.

Finally Figure 3.6 illustrates the ‘synthetic’ asset for each counter-

party. The institution has an unfunded asset as in Figure 3.4, but the

periodic financing is five basis points cheaper. While the bank has a high-

quality credit on its books; with a higher rating than the original asset.

3.6 Securitization overview

In this section we wish to introduce an important application of credit

derivatives within the context of securitization, we are furthermore going

to use the investment management business as an example. In order to

achieve this some background is required on securitization in general.

Credit derivatives 149

BB Institution AA Bank

TROR

TROR

L  5 bps

L  30 bps

BBB asset

Funding

L  5 bps

Figure 3.5 The bank enters a TROR.

Asset

TROR

BBB asset

L  70 bps

Funding

L  30 bps

BB Institution

AA Bank

Synthetic asset

35 bps

Figure 3.6 The net financing arrangement within the TROR.

The phrase CDO is a generic expression applied to any securitization

backed by a pool of debt, usually bonds and/or loans. There are two

main categories, the cash flow and the arbitrage.

1

The distinction is

made on the basis of collateral backing and motivation. CDO issuance

constitutes a major activity within continental Europe, indeed compara-

ble to other varieties of ABS. The term arbitrage arises because a vehicle

is established in order to benefit from the funding gap which may tem-

porarily exist between the assets, typically high-yield bonds and the

liabilities, typically investment grade bonds. This has to be positive for

the viability of the vehicle.

The cash flow CDO is employed by banks to remove assets from their

balance sheet. The backing consists of loans no longer profitable because

of regulatory reasons. The arbitrage CDO is issued by a portfolio manager

purchasing backing in the secondary market. The resulting structure

is typically sold to institutional investors. There are many advantages

to the manager including the ability to grow assets under management.

Both CDOs have similar structures consisting of asset backing, the

creation of a bankruptcy remote vehicle (SPV) and the structuring of the

liabilities appealing to the net end investor. When the backing is mainly

bonds the CDO is referred to as a CBO, with loans the term CLO is used.

These arrangements are addressed in Section 7 within the chapter on

securitization. We also give examples of the synthetic CLO, where credit

derivatives are employed by banks wishing to seek regulatory relief. In

this section we wish to focus on the use of credit derivatives within the

investment management community.

An important development in the market has been the inception of

the investment grade CDO. This represents a new type of mandate for

the investment manager. The phraseology is misleading because the

collateral is a combination of assets including investment grade bonds

or loans. The benefits are considerable, and in common with the trad-

itional arbitrage variety include the opportunity to grow assets and

consequently the fee base but further to leverage the existing expertise.

There are three alternatives: traditional ‘cash flow’ CDO’s using invest-

ment grade bonds as the collateral; a fully synthetic market value CDO

which instead of having a tangible instrument backing the indenture

rely on the cash flows from credit derivatives and finally a market value

hybrid consists of a combination of credit derivatives and cash bonds

150 Credit risk: from transaction to portfolio management

1

The arbitrage CDO is further divided into the cash flow and market value categories.

The basis of distinction is that cash flows are used to pay principal in the former while

receipts from sales on the collateral provide the principal repayments in the latter. This

implies that the manager can freely trade the backing in the market.