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Credit Derivatives—Five Years Out

Everybody in the credit derivatives business is busy predicting that credit derivatives will change the face of finance, but let's get a little more specific, please. We asked several derivatives honchos to close their eyes and imagine what might happen five years from now, if credit derivatives really catch on.
How will banks manage the credit risk of their loan portfolios? How will the products change the way institutional investors invest in the bond market? How will international regulators view the capital adequacy of banks? What effects will they have on other areas of the financial world? Although some were more adept at this kind of speculation than others, they all predicted big changes ahead.


Blythe Masters
head of credit derivatives,
JP Morgan

Five years hence, commentators will look back to the birth of the credit derivatives market as a watershed development for bank credit risk management practice. Credit derivatives will fundamentally change the way banks price, manage, transact, originate, distribute and account for credit risk.

Global credit markets today display discrepancies in the pricing of the same credit risk across different asset classes, maturities, rating cohorts, time zones, currencies and so on. These discrepancies persist because arbitrageurs have traditionally been unable to purchase cheap obligations against shorting expensive ones in order to extract arbitrage profits. As credit derivative liquidity improves, banks, borrowers and other credit players will exploit such opportunities, just as the evolution of interest rate derivatives prompted arbitrage activity in the 1980s. The natural consequence of this, of course, is that credit pricing discrepancies will gradually disappear as credit markets become more efficient.

Banks will also adopt a more proactive approach to trading and managing credit exposures, with a corresponding decline in the typical holding period for loans. It will become more common to observe banks taking exposure to borrowers with whom they have no meaningful relationships and shedding risk to make room for further business with those with whom they do have relationships. Such transactions will occur both on a one-off basis and increasingly through large bilateral portfolio swaps, which in a sense are simply a less radical and more effective solution than a bank merger to the problem of a poorly diversified customer base.

Banks will increasingly have the ability to choose whether to act as passive held-to-maturity investors, or as proactive, return-on-capital-driven originators, traders, servicers, repackagers and distributors of the loan product. Ironically, this process will resemble the distribution techniques employed by institutions that have been disintermediating banks in the capital markets for years. It also seems inevitable that greater transaction frequency and the availability of more objective pricing will prompt a movement toward the marking-to-market of loan portfolios.

Credit derivatives will also bring about greater efficiency of pricing and greater liquidity of all credit risks. Institutions benefiting from this development will include a broad range of financial institutions, institutional investors and also corporates, in their capacity both as borrowers and as takers of trade credit and receivable exposures.

Just as the rapidly growing asset-backed securitization market is bringing investors new sources of credit assets, the credit derivatives market will strip out and repackage credit exposures from the vastly greater pool of risks that do not naturally lend themselves to securitization, either because the risks are unfunded (off balance sheet), or because they are not intrinsically transferable. By enhancing liquidity, credit derivatives achieve the financial equivalent of a free lunch, whereby both buyers and sellers of risk benefit from the associated efficiency gains.

David Crammond
president, Intercapital

The next five years will see the development of greater risk warehousing and of extensive redistribution networks for credit products. The use of credit baskets through derivatives used to package risks will allow for microsyndication of credit exposure in the secondary market. Credit risk management will become further centralized and market-price-oriented within each bank. I also anticipate that execution will increasingly take place away from trading floors for macrotrades driven by loan portfolio hedging.

Institutional investors will have completely broken-out credit as a separate and distinct asset class, trading and managing it actively through derivatives as they do currency and interest rate risks presently. Relative-value trading will have become a major component of credit derivatives trading, with the market reaching high levels of volume and transparency with resulting tightening in bid/offer spreads. I expect portfolios to be composed of layered credit risk based on a foundation of high grade/treasury products overlaid with yield-oriented credit swaps.

International regulators will be challenged by the migration of credit risk and credit liquidity away from banks. This will result in increasing difficulty in controlling systemic risk resulting from credit events. As a result, there will be a need for increasing cooperation between bank, insurance and securities regulators globally. The contingent nature of an increasing amount of exposure and competition from nonbank sources will, I believe, result in pressure to reduce bank capital adequacy.

Expect to see more insurers active in this marketplace. Credit derivatives are quickly making inroads into the "premium” business in the areas of credit enhancement and political risk cover. Central banks and monetary agencies will likely be active, selectively utilizing credit swaps in a manner similar to their use of interest rate products today to manage reserve investment risks, decrease bank line exposures, and to provide short-term relief as a "synthetic lender of last resort.” With EMU behind us in five years there will have existed massive credit arbitrages based on underlying inherent credit strength that will not disappear as a result of a single currency.

John Crystal
managing director, global head of credit derivatives structuring,
Credit Suisse Financial Products

Predicting the future of credit derivatives is difficult. First, most users cannot even agree on a common definition of the product. Second, the product and its applications are evolving quite rapidly, and any single product is likely to be quite wide of the mark. History is littered with famously bad predictions of rapidly changing technology. My favorite is attributed to H.M. Warner, who, in 1927, allegedly asked "Who the hell wants to hear actors talk?” Throwing caution to the wind, however, I will venture a few predictions and hope, when proved wrong, to adapt as well as Mr. Warner.

The present gives us a guide for the future. Credit risk is the largest risk in the financial system. It also permeates much of the business world and is an inextricable component of most planning exercises and business transactions. It is largely unmanaged. It is illiquid. It is situation-specific rather than standardized. It is often inaccessible. Finally, it is notoriously difficult to fit within the paradigms of modern portfolio management or efficient frontiers.

Credit derivatives have already fundamentally altered the credit markets. They expand the range of positions to include long, flat, short, asymmetric and option-like. Not surprisingly, swap dealers have quickly adopted this technology, and almost all major swap dealers use credit derivatives to manage the illiquid exposures in their swap books. Credit derivatives have unlocked markets. In the public arena, nondollar investors often use credit derivatives to create synthetic emerging markets exposure from dollar-denominated Brady bonds. The derivative shortens the maturity and changes the currency of the relatively cheap dollar bonds. The list is much longer.

Looking to the future, I believe market growth will follow the development of the interest rate swap market, and could possibly match its activity. Crucially important, though, is value creation. To date, most structures offer investors returns superior to those available in the cash markets. Risk flows from dealers and banks to the fixed-income investor community. Continued development will require two-way business flow.

The credit derivatives business will likely explode when banks develop the tools to manage credit using portfolio theory, much as the interest rate swap market swelled when banks developed good asset/liability management models. They will mark credit to market and focus on basis risk, relative value and holding-period returns rather than taking a buy-and-hold approach. The lending business will look a lot more like the bond business. Credit will be explicitly and continuously priced. Both the bond markets and credit markets in general will be more liquid. Structures will be standardized, much as they have become in interest rate swaps. Dealers will run large books rather than bespoke-tailoring each transaction. Most important, capital regulations will reflect the shift from large, illiquid, long-maturity credit exposures to liquid risks and basis risk. It will be a new world, and a welcome change.

Joyce Frost
vice president, credit derivatives,
Chase

The nascent credit derivatives market will continue to grow exponentially for the foreseeable future, driven by a knowledgeable user base, an accommodating regulatory environment and, most important, a compelling cache of investment, corporate finance and risk management applications. The market today is similar in its development to the interest rate and currency derivative markets of the early 1980s. However, while it took nearly 10 years to fully incorporate such products into the final management process of most large, sophisticated financial institutions and corporations, the integration of credit derivatives will be much quicker. Such expedited use will be attributed to the widespread familiarity with derivative products in general as financial management tools, the compelling characteristics of the products themselves, and a potential downturn in the credit cycle that will make effective risk management more important than ever.

The largest users of credit derivatives in five years will continue to be commercial banks, who will use such products primarily for risk management purposes. Currently, only a handful of banks have truly integrated credit derivatives within their overall financial management strategies, although many more have used them to address one-off exposures. In the years ahead, as the use of these products becomes widespread in the marketplace, we will see the development of more index products, including regional and industry-related credit indices, to manage credit exposures more effectively on a portfolio basis.

However, in addition to commercial banks, a host of other institutional investors, including insurance companies, investment banks, mutual and pension funds, corporates, money managers and hedge funds, will become active participants in the market as well. Currently established plain vanilla products such as total return and default swaps will be joined by options on credit spreads as the most widely accepted credit-derivative products. Screen quotes for all such products from any number of market-makers will be readily accessible to users. Moreover, the further development of structured products will enable sophisticated investors to unbundle more finely or consolidate and compound credit risks as needed.

Overall, the increased use of credit derivatives will add more efficiency and liquidity to the marketplace, reallocating credit exposures more optimally to those investors best equipped to manage them and leading to a fundamental decline in system-wide risk and credit spreads. As credit derivatives continue to knock down barriers to investment and risk management, thereby broadening the investor base for credit exposure and further empowering users to manage such exposures more efficiently, credit spreads in general will decline. Furthermore, systemic risk itself will decline as credit derivatives unbundle credit risk management from relationship management and other qualitative and quantitative market factors, leading to a more optimal distribution of risk across all participants.

Shaun Rai
acting head of credit derivatives,
CIBC Wood Gundy

At CIBC Wood Gundy, we expect the credit derivatives market to grow from an estimated $75 billion to $150 billion total notional outstanding today to more than $1 trillion within the next five years. There are three fundamental reasons why we expect this growth will occur.

First, the underlying markets for credit risk in its many forms are, in aggregate terms, extremely large. This provides broad scope for the application of credit derivatives. Second, these markets are still highly segmented by geography, product and term, providing extensive opportunities to use credit derivatives to extract value from differences in pricing, credit perceptions and risk aversion among different types of investors.

Third, financial institutions are focusing more resources on developing sophisticated credit risk management tools that will enable them to identify risks and opportunities resident in their credit portfolios. Credit derivatives will be used extensively to respond efficiently to these risks and opportunities. In particular, we think enhanced portfolio analysis will reveal under-diversification at most institutions. The consequent desire to diversify will create extensive opportunities for win-win transactions between institutions improving diversification by exchanging credit risks via credit derivatives.

The rapid growth of credit derivatives, in turn, will have a significant impact on the credit markets and the institutions that are involved in them. First, credit derivatives will accelerate the integration of credit risk and market risk management as "derivatives technology” is applied to the credit arena. Second, the credit markets will become more efficient as credit derivatives are used to derive benefits from the existing inefficiencies associated with discontinuous, fragmented markets and improve generally the diversification of credit portfolios. In turn, increased efficiency will tend to reduce the cost of credit for borrowers around the world. Third, credit risk will migrate from the best originators of risk to the best (that is, lowest cost and most diversified) holders of credit risk, much the way residential mortgage portfolios have migrated from local savings and loans to institutional investors. This could have a profound impact on banks, which tend to be higher-cost, underdiversified holders of credit risk.

Randy Alison Kaufman
head, global credit derivatives,
BankBoston

Credit derivatives will be a routine component of an active portfolio management approach to credit risk management for banks. Significant advances in information systems and analytical tools will provide management with more accurate and timely risk profiles. The top-down credit portfolio management function will play an increasingly active role as a complement to traditional relationship-management-line businesses. In addition, liquidity in credit derivatives will continue to increase as they become widely accepted as a powerful and flexible tool to manage credit risks without disrupting key client relationships. As a result, banks will be able to leverage their origination capabilities and improve risk-return profiles. The net result will be higher and more stable bank earnings profiles.

Institutional investors will have more investment choices, including more access to loans. Credit derivatives will be far more liquid, and as a result, will have much narrower illiquidity premiums. Investors will increasingly use credit derivatives to structure their investments and to access senior credits in the capital structure. In addition, a sharply defined credit curve will exist with a more fluid pricing mechanism for various credits.

The advances in tools to measure and manage credit risk, coupled with a more active portfolio management culture, will also lead to a shift in the regulatory capital framework for banks. Ultimately, the regulatory capital framework is likely to shift to an internal-models approach that quantifies credit risk more precisely and recognizes the benefits of diversification.

Other areas will have the ability to efficiently manage credit risk in the same way currency or interest rate risk is managed. Borrowers will have increased liquidity from their banks and insurance companies will have access to more capital-efficient investments.

David Friedman
executive director, credit derivatives group, SBC Warburg

Credit derivatives is a catch-all phrase, covering everything from credit spread options to currency-inconvertibility-linked notes. To me, it is the application of derivatives and structuring techniques to the world of credit risk. If credit derivatives succeed, the expertise the field develops will have far-reaching consequences.

Take a default swap for example. To understand and price a single default swap means understanding the comovements in creditworthiness of two different entities—the reference credit and the counterparty. This is just the portfolio problem writ small. Anyone with the expertise to price a default swap will immediately want to apply that expertise to looking at its credit risk on a portfolio basis. This means consolidating the credit risk in loan books, securities positions and over-the-counter replacement value exposures and looking at the institution's overall exposure to changes in creditworthiness.

With proper information on net portfolio exposures, perhaps even credit values-at-risk, financial institutions would be armed to revisit both capital and credit line/country line allocations. Scarce regulatory capital could be allocated against portfolio variance rather than on an individual, name-by-name basis. The current regulatory dichotomy between trading and banking books would be replaced by the portfolio concept of expected holding period.

A portfolio approach to credit risk would be an enormous breakthrough for the institutions with credit derivative skills. One can envision two tiers of banks—those with ability to look at regulatory capital on a portfolio basis and those who have to follow the name-by-name approach. The competitive differences would be great.

Internal credit lines could also be based on overall exposures to important sectors or regions rather than the current name-by-name approach used at most institutions. Of course, where an institution was unwilling to take more or any exposure to a given credit, the risk could be transferred—and this leads to the next major impact credit derivatives will have.

Much has been made of the ability of credit derivatives to transfer credit and political exposure. Ultimately, this will bring the insurance, credit and capital markets closer together. Insurance companies offering institutional products such as receivables insurance and political risk cover will face competition from the credit derivatives market. Both will quickly find that these risks can be syndicated in capital markets directly by the entities originating the risk. These trends will force parties to confront pricing, payout and subrogation disparities between the markets. Investors will be freer to chose their assets by looking at a range of credit and other risks they can purchase direct from a much wider range of players. Disintermediation, finer pricing and more transparency will be the results.

Yet, credit derivative techniques are only tools and they are only as good as the people and institutions using them. Five years from now, that will be clear as well.

Richard Rosenberg
senior vice president,
Exco Financial Products

The credit derivatives market will develop into several products over the next five years. The most liquid is likely to be the default put, which will be used to cover credit risks in many markets. Loan structuring groups and institutional investors are two of the most likely groups to use the product on a day-to-day basis. The packaging and repackaging of assets has long been the realm of derivative structures on the interest rate side. The ability to package credit will allow any asset to be converted to an acceptable credit risk level for any investor. This will allow for the valuation of all asset classes to each other. Through arbitrage, spreads will narrow toward equilibrium for each credit class. Investors will be able to choose the level of credit and interest rate risk they are seeking and have tailor-made securities available to them. They can also pick levels of return and have the market dictate credit and interest rate risk combinations that achieve a chosen target. The instruments that will allow for these developments will be the default put and credit spread options. Derivatives houses will actively make markets for individual credits and broad credit classes. These market-makers will provide the engine for the structured marketers. It is easy to imagine bands of like credits marked on a default curve, allowing for easy classification and pricing. Managing your credit band will become a consideration for all debt users regardless of geographic location. The truly global debt market will transcend political controls and the market will be the arbiter of value.

Credit will become a commodity that can be modeled to fit any situation. There will be credit guarantees on specific instruments or cash flows as well as broader cross-default protection. The level of protection can be specified to be total or partial recovery as well. These formats will have far-reaching effects on how the capital markets all work together. Bank loan departments will have the first means to truly manage the credit side of a portfolio. They will no longer have to be event-driven, but can employ broader portfolio-diversification practices without venturing beyond their traditional client base. This, in turn, will put more pressure on banks to shore up their client relationships as the ability for a borrower to gain funds will be ever greater. In turn, the regulators will be pressed to give better capital adequacy treatment to institutions that actively balance their credit exposures. The likelihood of a portfolio to cause financial strain is less likely the greater the spread of credit risks employed.

There is virtually no area of the financial markets that won't be affected. Traders will scour the earth in search of returns not previously available. The riskier the credit, the higher the cost of credit guarantees. Risk reward will still be the maxim—the only difference being that credit, for the first time, will be quantifiable and market-available.

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