Structured Credit Products E-Book

Moorad Choudhry

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Editions
• Sprache: Englisch

Seitenzahl: 817

Veröffentlichungsjahr: 2011

Beschreibung

Updated coverage of structured credit products with in-depth coverage of the latest developments Structured credit products are one of today's fastest growing investment and risk management mechanisms, and a focus of innovation and creativity in the capital markets. The building blocks of these products are credit derivatives, which are among the most widely used products in finance. This book offers a succinct and focused description of the main credit derivative instruments, as well as the more complex products such as synthetic collateralized debt obligations. This new edition features updated case studies from Europe and Asia, the latest developments in synthetic structures, the impact of the subprime meltdown, along with models and teaching aids. Moorad Choudhry returns with this excellent update of the credit derivatives market. The second edition of his classic work is, like the subject matter itself, at the forefront of the financial industry. It deserves a wide readership. --Dr Didier Joannas Regional Director, Thomson Reuters, Hong Kong This is the perfect companion for both experienced and entry level professionals working in the structured credit fraternity. It is an erudite, insightful and enjoyable read that successfully demystifies one of the most topical subject areas in banking today, while also providing important practical examples that link the theory to the job itself. --Dr James Berriman Global Pricing Unit, Royal Bank of Scotland Moorad Choudhry has earned a deserved reputation from both academics and practitioners as one of the leading practical yet rigorous authors of finance books. In this Second Edition, his practical knowledge of credit derivatives keeps the audience engaged with straightforward explanations of complicated structures, and an accessible level of mathematical sophistication necessary to understand structured credit products. The author offers complete, rigorous analysis while avoiding overuse of mathematical formulas and carefully balanced practical and theoretical aspects of the subject. I strongly recommend this book for those wishing to gain an intuitive understanding of structured credit products, from practitioners to students of finance! --Mohamoud Barre Dualeh Senior Product Developer, Abu Dhabi Commercial Bank, UAE This is THE book for credit derivative trading. From first steps to advanced trading strategies, this is invaluable. Well written and insightful, perfect for ad hoc reference or reading cover to cover. --Andrew Benson ETF Market Making, KBC Peel Hunt, London Professor Choudhry has inspired me to really get into credit derivatives. It's great to be lectured by someone with such energy and practical hands-on experience, as well as the ability to get stuck into the details. --George Whicheloe Equity-Linked Technology, Merrill Lynch, London Moorad Choudhry is Head of Treasury at Europe Arab Bank plc in London. He is a Visiting Professor at the Department of Economics at London Metropolitan University.

Leseprobe

Contents

Foreword: Professor Darrell Duffie, Stanford University

Preface

Acknowledgements

About the Author

Prologue: The 2007–2008 Credit and Liquidity Crunch: Impact on Structured Credit Markets

Part I: Credit Risk and Credit Derivative Instruments

Chapter 1: Credit Risk

Corporate Default

Credit Risk

Credit Ratings

Formal Credit Ratings

Ratings Changes Over Time

Value-At-Risk (VAR)

Explaining Value-At-Risk

Variance–Covariance Value-At-Risk

Credit Value-At-Risk

Creditmetrics™

Reference

Chapter 2: Credit Derivatives I: Unfunded Instruments

Market Volumes

Credit Risk and Credit Derivatives

Credit Derivative Instruments

Credit Default Swaps

Technical Features of CDS

Basket Default Swaps

Quanto Default Swaps

Structured Finance Security CDS

Asset Swaps

Total Return Swaps

Credit Options and Credit Spread Options

The CDS Itraxx Index

Bloomberg Screens

Settlement

Issues With The Settlement Mechanism

Risks In Credit Default Swaps

Impact of The 2007–08 Credit Crunch: New CDS Contracts and The CDS ‘Big Bang’

Quick Cds Calculator

CDS Index Screens

Appendix 2.1 ISDA 2003 Credit Derivative Definitions

Appendix 2.2 CDS Term Sheet

Appendix 2.3 Total Return Swap and Repo

Appendix 2.4 Basel Regulatory Capital Treatment and Credit Derivatives

Appendix 2.5 Market-Implied Timing of Default From CDS Prices

Reference

Chapter 3: Credit Derivatives II: Funded Instruments

Credit-Linked Notes

Clns and Structured Products

Principal Protected Structures

Funded Total Return Swap

The Portfolio CLN

Static Portfolio CLN

Chapter 4: Credit Analysis and Relative Value Measurement

Credit Analysis

Financial Analysis

Industry-Specific Analysis

Relative Value Analysis: Bond Spreads

Reference

Chapter 5: Credit Derivatives III: Applications

Managing Credit Risk

Basic Use of Credit Derivatives By Banks

Applications of TRSS

The TRS as Off-Balance Sheet Funding Tool

Applications For Portfolio Managers

Credit Derivatives and Relative Value Trading

Bond Valuation From CDS Prices: Bloomberg Screen VCDS

Chapter 6: Credit Derivatives Pricing and Valuation

Introduction

Pricing Models

Credit Spread Modelling

Credit Spread Products

Total Return Swap (TRS) Pricing

Credit Curves

Appendix 6.1 Default Probabilities

Reference

Chapter 7: Credit Default Swap Pricing

Theoretical Pricing Approach

Market Pricing Approach

Risk-Neutral Default Probability

Credit Derivatives Pricing in Volatile Environments: ‘Upfront + Constant Spread’

The Basis of Default Probabilities

Description of Bloomberg Screen CDSW

Appendix 7.1 The Marketa Pproach To CDS Pricing

References

Chapter 8: The Asset Swap—Credit Default Swap Basis I: The Asset Swap Pricing of Credit Default Swaps

Introduction

Asset Swap Pricing

Illustration Using Bloomberg

Reference

Chapter 9: The Credit Default Swap Basis II: Analysing the Relationship Between Cash and Synthetic markets

The Asset Swap Price

The CDS Basis

Factors Driving The Basis

The Dynamics of The CDS Basis

Analysing The Spread Measure

Analysing The Basis

Adjusted Basis Calculation

The Itraxx Index Basis

Market Picture Post-Credit Crunch

Conclusion

Reference

Chapter 10: Trading the Credit Default Swap Basis: Illustrating Positive and Negative Basis Arbitrage Trades

Relative Value and Trading The Basis

Factors Influencing The Basis Package

Trade Examples

A Credit Default Swap Relative Value Trade in Eu Aaa-Rated Sovereign Names

Conclusion

References

Chapter 11: Syndicated Loans, Loan-Only Credit Default Swaps and CDS Legal Documentation

Introduction

Leveraged Loans and High-Yield Bonds Compared

Standard Documentation For Single-Name LCDS and CDS

References

Part II: Structured Credit Products and Synthetic Securitisation

Chapter 12: An Introduction to Securitisation

The Concept of Securitisation

Reasons For Undertaking Securitisation

The Process of Securitisation

Illustrating The Process of Securitisation

ABS Structures: A Primer on Performance Metrics and Test Measures

Securitisation Post-Credit Crunch

Securitisation: Impact of The 2007–2008 Financial Crisis

Conclusion

Reference

Chapter 13: Synthetic Collateralised Debt Obligations

Securitisation and The Collateralised Debt Obligation

The Synthetic CDO

Assessing The Genesis of The Synthetic CDO

Synthetic CDO Deal Structures

The Managed Synthetic CDO

The Single-Tranche Synthetic CDO

Hypothetical Pricing Example

Case Studies

Liquidity, Defaults and Credit Rating: Interrelated Beasts During The Market Crisis of 2007

Appendix 13.1 Hypothetical Deal Term Sheet

Appendix 13.2 The Moody’s Diversity Score

References

Chapter 14: CDO Valuation and Cash Flow Waterfall Models

Overview

Valuation Approaches

Valuation Using Default Probability and Correlation

Pricing Methodology For Synthetic CDO Notes

Parameter Sensitivities of Synthetic CDO Tranches

CDO Note Pricing: Summary

Hypothetical Case Study: Cash Flow Approach

Cash Flow Waterfall Model: Static Synthetic CDO

Chapter 15: Synthetic Conduits and Credit Derivative Funding Structures

Commercial Paper Conduits

Asset-Backed Commercial Paper

Evolution of ABCP Programmes

ABC Fund Limited

Synthetic Repackaging Structures

Example Deal Structure

Synthetic Funding Structures

CDS-Linked TRS Term Funding Structure

Part III: CD-R

Chapter 16: Files on the Accompanying CD-R

CDO-Note: Synthetic CDO Note Pricing Model

CDS Pricing Spreadsheet

Diversity Score Spreadsheets

Fitch Rating Agency Reports

Static Synthetic CDO Cash Flow Waterfall Model

Teaching Aids: Powerpoint Slides

Contributing authors

Afterword: Econometrics, Finance and Football . . .

Glossary

Index

© Moorad Choudhry 2004, 2010

First edition published 2004

Second edition published 2010

The views, thoughts and opinions expressed in this book are those of the author in his individual private capacity and should not in any way be attributed to Europe Arab Bank plc or Arab Bank Group, or to Moorad Choudhry as a representative, officer, or employee of Europe Arab Bank plc or Arab Bank Group.

While every effort has been made to ensure accuracy, no responsibility for loss occasioned to any person acting or refraining from action as a result of reading any material in this book can be accepted by the author, publisher or any named person or corporate entity.

The following disclaimer also applies to the CD-R: the authors make no express or implied warranties relating to any model, including but not limited to warranties of suitability of the model for a particular purpose or as to the results obtained from the model. The software is the intellectual property of the authors.

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Library of Congress Cataloging-in-Publication Data

ISBN 978-0-470-82413-9

For Lindsay

It was worth the wait . . .

Foreword

Now, more than ever, credit-market professionals rely on sound guidance through the changing world of structured credit products. Moorad Choudhry once again delivers, with a completely updated treatment of the topic, and the same high level of clarity and comprehensiveness.

The timing is perfect. The market has been put back on its heels with the shocking default losses of the past year. It is time to re-think the design, risk measurement, risk management, rating and pricing of these products. The premise of the market, particularly with respect to collateralised debt obligations (CDOs), is that most of the default risk would be distributed outside of the banking system, leaving banks and other originators holding only slivers of equity risk, just enough to provide them with an incentive to protect senior tranches from significant losses. In concept, the highly rated senior tranches would be almost immune to loss, and would be held by institutional investors outside of the banking system, where losses that did occur would be less likely to cause systemic risk. Instead, the senior tranches were, in several alarming cases, held in massive quantities by systemically important banks or dealers, who suffered immense write-downs on these exposures.

What went wrong? It will be some time before we have a complete picture. Was it just bad luck that mortgage-related CDOs suffered such significant losses through an anomalously widespread and deep decline in home prices? Or, as some initial research indicates, did the availability of structured credit products and perhaps a lack of understanding of them lead to an appetite for senior CDOs that gave an unwarranted boost to the housing boom? Why were banks warehousing so much of the senior tranches? Was it poor risk management, incentive-based compensation schemes gone wrong, undue reliance on incorrect ratings or all of the above? Much work remains to be done to answer these questions.

The spill-over effects for corporate-debt structured credit products have been well noted. For example, consider the pricing of protection offered on the CDX.NA.IG 5-year tranches, covering losses on the CDX index of 125 North American investment-grade firms. From February 2007 to February 2008, the market value of protection against losses above 15% of the total notional underlying amount of debt increased by a factor of roughly 50, a truly amazing increase over a period in which corporate default risk had not really changed that much, and was projected to go up only moderately, according to forecasts by the rating agencies and by Ed Altman. The total market value of protection on all losses on the index names went up by a factor of about 5, perhaps reflecting the tightness of credit generally. The fraction of the total market value of all losses that was allocated to those bearing losses above 15% of notional went up by a factor of 10 according to Morgan-Stanley data, and this is largely unexplained. These super-senior sellers of protection were collecting over 42% of the entire valuation offered to all sellers of protection on this index! Even during the worst five years of losses to investment grade debt ever experienced, during the Great Depression period of 1932–1937, total losses were significantly below 15%, according to Moody’s data. It is almost unthinkable that those selling protection on CDX.NA.IG.5yr losses above 15% would ever be called upon to pay anything. I speculate that those potential sellers of protection who had significant amounts of ‘real money’ (these certainly did not include the major dealers) had been so alarmed by the AAA-mortgage CDO losses that they did not want exposure to other AAA-quality CDO-like exposure of any kind until they understood what had happened. The market was offering similarly ‘over-rich’ pricing for commercial real estate senior structured credit products.

For now, almost the entire CDO market has been poisoned by the experience of the past year. Issuance is down dramatically, and institutional investors will be on their guard for some time. Securitisation is too valuable a risk-transfer methodology to leave behind. It will need to be done better, and over time it will recover, I suspect.

I have also been concerned about weaknesses in the market infrastructure. Credit derivatives are traded almost entirely in the over-the-counter (OTC) market, where a dealer normally acts as a seller to buyers of default protection, and as a buyer to sellers of default protection. In order to balance their positions, dealers often take positions with other dealers. In addition, hedge funds often expose one dealer to another when they reassign their positions in an existing contract. As a result, dealers find themselves significantly exposed to the event of default by some other dealers, normally a very remote but potentially dangerous possibility.

Had Bear Stearns collapsed before the 2005 initiative of the Fed led to reduced documentation backlogs, and had quick action by the Fed and J.P. Morgan not occurred, the unwinding of Bear Stearns’ derivatives portfolio could have been extremely dangerous. In the absence of clear and up-to-date records of current derivatives positions, dealers would have been uncertain of their own and other dealers’ exposures, and could have responded by a dramatic withdrawal of financing to each other, which could have indeed caused other dealers to fail, with potentially disastrous economic consequences.

In addition to a lack of good records, the market has suffered from an unnecessary build-up of exposure of dealers to each other. For a simple illustrative example, suppose that Goldman Sachs has exposure to Merrill Lynch through a $1 billion credit derivatives position, while Merrill Lynch has the same $1 billion exposure to J.P. Morgan, and J.P. Morgan has the same exposure to Goldman. If all three dealers in this circle of exposures were to reassign their contractual positions to a central clearing counterparty, then each dealer’s positions would net to zero. None of them would be exposed through these positions, nor would the central clearing counterparty. In practice, however, the growth of the credit derivatives market has been accompanied by an exceptional increase in the exposures of dealers to each other that could have been significantly avoided by central clearing.

Through a new electronic confirmation platform known as Deriv/SERV, I believe that the trade documentation problem has now been largely addressed, although even more progress should be made in that direction. Central clearing counterparties such as The Clearing Corporation are likely to come on line in the credit derivatives market within a year, and will reduce dealers’ exposures to each other significantly for standardised credit derivatives, which constitute the bulk of dealer exposures.

The market is achieving a more robust infrastructure through these and other procedural improvements, such as improved protocols for auction-based cash settlement of contracts at credit events, and for ‘novation’, meaning the assignment of a customer’s position to a new dealer. Further improvements in the OTC market architecture are planned. These infrastructure improvements have come to the OTC derivatives market rather late. Many of their benefits have been available all along with exchange-based trading, which is perhaps a better venue for the trading of highly standardised credit derivatives. The OTC market will continue to be the engine of innovation and customisation to client needs for risk transfer.

As professionals improve their security design, valuation models, risk management practices and operational infrastructure, the market for structured credit products will most likely improve over the coming years, and more importantly it will rest on a firmer foundation for future growth.

Darrell Duffie

Dean Witter Distinguished Professor of Finance Graduate School of Business, Stanford University

July 2008

Preface

Never say never again . . . as James Bond once suggested, and an apt reference to make at the start of this, the Preface to the second edition of my book on credit derivatives, being published six years after the first one. I’d insisted that my book Bank Asset and Liability Management was definitely my last ever and that wild horses couldn’t drag me to write another. And yet here we are, a mere three years after the publication of that magnum opus, with me at my study desk in the middle of the night, penning arcane but hopefully accessible words on finance once more . . .

The 2007 credit and liquidity crunch was still being felt in 2008 and 2009 as the financial crisis helped tip global economies into recession. So there’s still much to talk about, not least the impact on credit derivatives and structured credit products, and I do hope that readers find the new material here to be of value.

We start with the premise that credit derivatives are ‘a good thing’. If you’re looking for someone to agree that they are ‘financial weapons of mass destruction’, or somehow ‘dangerous’, then look elsewhere because that person isn’t me. I didn’t start my career in credit derivatives (indeed, the market didn’t exist when I joined the London Stock Exchange in 1989), but I did start in finance and banking. Banks make the world go round. We can’t do without them: no one, whether government, corporate or individual, can function efficiently without credit. And, within banking, any tool that makes both investment and risk transfer easier to undertake is ‘a good thing’. We’ve all read about sub-prime fallout, toxic assets, CDOs and the backlog in credit derivatives documentation (as if people wouldn’t have lost money in 2007 and 2008 if credit derivatives or CDOs didn’t exist!). You won’t read about how bad structured credit products are in this book, because this is a textbook and not a polemic on finance. You will read, among other things, how risk exposure analysis of structured credit products should be undertaken. The first mantra of any investor should always be to know one’s risk. And this can be found here. However, we still think credit derivatives are a good thing. Banks have been around for a very long time and will continue to be around for a very long time; not because they are somehow saintly or the ultimate expression of human development, but because without them we couldn’t function in a modern productive way.

There is much to analyse and write about the 2007–2008 global financial crisis: its causes, its impact and the lessons to be learned for the future. But not in a textbook on credit derivatives. Specifically of relevance to this book are the calls for a centralised clearing house for the OTC credit derivatives market. But at the time of writing these remain regulators’ proposals, so we can’t deliver any detail here. Certainly, a centralised clearing house, along the lines of the London Clearing House model, via which CDS could be traded in a similar fashion to that of Tri-Party repo, would eliminate counterparty risk and contribute to a more stable market. Hopefully something along these lines will be closer to reality by the time you read this.

So there, polemic over! Let’s get on with the technical analysis . . .

LAYOUT OF THE BOOK

This book is organised into three parts. These comprise:

Part I: credit risk and credit derivative instruments;Part II: structured credit products and synthetic securitisation;Part III: description of the files on the accompanying CD-ROM.

The Prologue discusses the events of 2007–2008 and their impact on the structured finance market. To preserve the technical aspect of this textbook intact, we place this discussion before Part I. In Part I we discuss credit derivative instruments, their structure, application and pricing. In terms of organisation, we look first at unfunded credit derivatives in Chapter 2 and then later at funded credit derivatives. Following our discussion of pricing, we look in detail at the interplay between the cash (bond) and synthetic (credit derivative) markets in corporate credit, exemplified by the basis, in three chapters. Our look at CDS applications also includes a review of credit rating approaches and relative value analysis, as this is relevant to basis trading.

We introduce Part II with a primer on securitisation. Following that we discuss in detail the synthetic CDO and also synthetic (that is, credit derivative-based) structured funding vehicles. We illustrate each stage in product development with case studies of real-world deals. We also provide an analysis of CDO note pricing. At relevant points there is further review of the impact on the markets of the credit crunch. At certain stages we have some great input from other contributors, and I would like to take the opportunity now to thank my co-authors for their value added to this project: my appreciation to Abukar Ali, Suleman Baig, James Croke, Jaffar Hussain, Zhuoshi Liu, Richard Pereira, Sharad Samy, Daniel Sempere-Roldan, Timo Schläfer and Marliese Uhrig-Homburg.

All original material has been updated and in some cases removed if no longer relevant. Brand new material in this second edition includes:

a look at credit analysis and credit relative value measurement;a stand-alone chapter on negative basis arbitrage trading, for which there was renewed opportunity for investors after the financial crash;an update on the CDS basis, including a look at the adjusted basis and pricing the basis;a description and examination of the basis of default probabilities;further details on index CDS including the iTraxx contract;a new chapter on, and very detailed look at, loan-only CDS;descriptions of the latest funding techniques following the liquidity crisis, and a discussion of the in-house securitisations that banks are undertaking for use in central bank funding facilities;a single-name CDS pricing model and a CDO tranche pricing model, with Microsoft Excel front end, included on the CD-R.

We hope that readers find the contents to be of value. As ever, comments are welcomed, please contact me via the publishers.

THE CD-ROM

Files on the accompanying CD-ROM are described in detail in Chapter 16, and as well as the pricing models mentioned above there are files of diversity score models, sample Fitch ratings reports for synthetic CDO deals (reproduced with permission), a CDO waterfall model, and teaching aids in the form of a set of PowerPoint slides. The slides cover the bulk of any intermediate- to advanced-level course on credit derivatives and structured credit, and may be of value to course trainers and lecturers.

Acknowledgements

Special thanks to Professor Darrell Duffie for the excellent foreword, following his foreword in the first edition. It is a great honour to have his input and observations.

Thanks to Warren Collocott at Fitch Ratings in London for his assistance towards my understanding of Fitch’s revised ratings methodology on CDOs and synthetic CDOs, this was much appreciated. Thanks also to Dan Cunningham at KBC Bank in London for helping me out after I’d mis-booked the CHF roll the day before, and for being such a handsome devil.

Thanks to Paul Kerlogue at Moody’s, Peter Jones at Bloomberg for help with some of the screens, Hal Davis at JoSF for his support, and big thank you to Vincent Morris at EAB for assistance with the proofing – much appreciated! And big thanks to Janis Soo and Joel Balbin at Wiley Asia, you guys are awesome.

To the Raynes Park Footy Boys, thanks again for your help, support and friendship.

Moorad Choudhry

Surrey, England

30 July 2009

About the Author

Moorad Choudhry is Head of Treasury at Europe Arab Bank plc in London. He previously worked at KBC Financial Products, JPMorgan Chase Bank, Hambros Bank Limited, ABN Amro Hoare Govett Limited and the London Stock Exchange.

Moorad was born in Bangladesh and educated at Kingston Grammar School and Claremont Fan Court School in Surrey, England, then at University of Westminster and University of Reading. He obtained his MBA from Henley Management College and his PhD from Birkbeck, University of London. He is Visiting Professor at the Department of Economics, London Metropolitan University; Senior Research Fellow at the ICMA Centre, University of Reading; a Fellow of the Global Association of Risk Professionals; a Fellow of the ifs-School of Finance; and a Fellow of the Securities and Investment Institute. He is on the Editorial Board of the Journal of Structured Finance, the Securities and Investment Review and Qualitative Research in Financial Markets, and on the Editorial Advisory Board of the American Securitization Forum.

PROLOGUE

The 2007–2008 Credit and Liquidity Crunch: Impact on Structured Credit Markets

We shall begin the second edition of this book with an assessment, and observations, on the 2007–2008 financial crisis and its impact on structured credit markets. This is in two parts: first, we discuss the origins and impact of the crisis, and then we look at specific market events. Before we do this, though, we outline the rationale for credit derivatives and bank credit risk transfer.

BANKS AND CREDIT RISK TRANSFER

Banking institutions have always sought ways of transferring the credit (default) loss risk of their loan portfolios, for two reasons: (i) to remove the risk of expected losses from their balance sheet, due to an expected increase in incidence of loan default; and (ii) to free up capital, which can then be used to support further asset growth (increased lending). The first method of reducing credit risk is selling loans outright. This simply removes the asset from the balance sheet, and is in effect a termination of the transaction. Alternatives to this approach include the following:

spreading the risk via a syndicated loan, in partnership with other banks;securitising the loan, thus removing the asset off the balance sheet and, depending on how the transaction is structured and sold, transferring the credit risk associated with the loan;covering the risk of default loss with a credit default swap (CDS) or an index credit default swap;transferring the risk of the asset to a speciality finance company.

In principle, the ability to transfer credit risk is an advantage to the financial market as a whole, as it means risks can be held more or less evenly across the system. In practice this may not happen, and risk can end up being concentrated in particular sectors or among particular groups of investors. But such a result is not to detract from the inherent positive impact of credit risk transfer. In other words, an ability to transfer credit risk in straightforward fashion is in principle a worthwhile and valuable thing.

Credit risk transfer enables banks to manage bank capital more efficiently, and also to diversify their risk exposures. In theory this means they can reduce their overall credit risk exposure.1 The risk is transferred—not eliminated—to other banks and other sectors such as institutional investors, hedge funds, corporations and local authorities. More efficient allocation of capital should, in theory, lead to a lower cost of credit, which is a positive development for the economy as a whole. Put against this is the negative notion that securitisation and the use of CDS results in the poorest quality assets always being retained on bank balance sheets, because such assets are illiquid and not attractive to other investors; this concentrates risk. In addition, loan risk may be transferred to investors who are less familiar with the end-obligor, and so less able to monitor the borrower’s performance and notice any deterioration in credit quality. Where banks originate debt that they then instantly transfer, they may be pay less attention to borrower quality and repayment ability: this reduction in lending standards was one of the contributing factors to the US sub-prime mortgage market default.

In essence, though these are ‘micro-level’ arguments against risk transfer, we will proceed with the premise that credit risk transfer is on balance a beneficial activity.

Risk transfer is a logical element in bank risk management. The benefits of credit risk transfer are (i) reduction of capital costs that were associated with the full risk-exposure loan asset and (ii) diversification of risk. Risk transfer via securitisation produces other potential benefits, in the form of new investment product for bank and non-bank investors that is a liquid financial instrument, which may not have been the case for the securitised asset.

Risk transfer via credit default swap (CDS) enables the bank to maintain the loan and thus the client relationship, while benefiting from a capital cost reduction. That the CDS can be executed with an identical maturity to the loan is one of the prime advantages of the CDS instrument.

Given that there are various drivers behind why a bank may select to transfer the credit risk of an asset on its balance sheet using a credit derivative, by extension one can see that the same advantages apply if a bank wishes to transfer entire books of risk via a basket credit derivative, which can be either a cash collateralised debt obligation (CDO) or synthetic CDO. From the other side, investor demand for the product that arises from a CDO deal is also a driver of the transaction. Therefore a bank can tailor the construction of a CDO it wishes to originate to meet the risk-reward profile of the investor. This gives rise to a certain element of moral hazard, because the bank may wish to place its poorest quality assets in the CDO. At the same time, to help sell the CDO notes the bank may still retain the ‘first-loss’ piece of the CDO itself, which provides investor comfort and ensures that the bank still has an interest in the credit performance of the underlying collateral in the CDO. In the wake of the credit crunch in 2007–2008 and ongoing 2009 recession, banks that originated CDOs and sold the entire issue of notes to clients have been accused of less than good ethical practice.