Practice Leader, ERM and Structured Products Advisory, Promontory Financial, New York
As we rolled over from the mortgage credit-related woes of 2007 into the first quarter of 2008, a new aspect of credit risk emerged. Monoline insurers have traditionally been offering insurance to back up municipal and other bonds. The wrap or guarantee provided would bring up the credit rating of the bond to AAA. Over the past decade, the monoline insurers have been providing guarantees against the chance that certain reference entities would default, by writing protection on credit default swap (CDS) contracts. These reference entities are often complex bundles of mortgage-backed assets – portfolio of RMBS tranches or super-senior collateralized debt obligation (CDO) with RMBS tranches as underlying.
Monolines have always operated at relatively low levels of capital. Rarely has there been a case where a monoline was called upon to pay on its obligation under the wrap. As the delinquencies and losses in mortgages have moved up, the fear of a monoline having to pay on the CDS protection sold has led to fears of the ratings downgrade and being undercapitalized. Even though the monolines have not lost their AAA ratings yet, the CDS spreads on monolines are much higher than typical AAA-rated reference entities.
A wrap that upgrades a bond to AAA status is valuable only if the insurance company standing behind the wrap has AAA or better rating. Otherwise the effective rating of the bond reverts back to its original rating. Or does it? The wrap does not require the monoline to pay up if it loses its AAA rating. What really happens is that the monoline's business model is at risk, in the sense that issuers will no longer seek a wrap to get an AAA rating from the monoline. Even if the wrap is not worth much, it does not imply that the CDS protection is not worth much. In fact, the lower the valuation of the reference CDO, the higher is the valuation of the CDS. The CDS protection will not be worth much if only the monoline defaults. Thus the economic value of the wrap on a loan should not be confused with the economic value of a CDS protection sold. In the absence of collateral-placement agreement, an estimate of the valuation adjustment owing to higher counterparty credit risk, as the monoline is now more risky, can be obtained by using the market CDS spreads at which trades are still occurring.
In this issue, we present three full-length research papers and one technical report. The first paper, “An approximation for credit portfolio losses,” by Frey et al, investigates a second-order approximation for credit portfolio losses based on a central limit theorem for structural models. Structural models for measuring the risk of credit portfolios are widespread, and the Vasicek approximation for loss distribution is popularly accepted in practice. Closed-form or semianalytical
solution avoids expensive Monte Carlo simulation as well as throw intuitive insights into the workings of a complex model. The authors also present an application to synthetic CDO tranches.
The second paper, “Accurate allocation of risk capital in credit portfolios,” is by Kwiatkowski and Burridge. Taking recourse to a recursive algorithm suggested by Andersen et al (2003), the authors describe how to efficiently calculate credit risk capital at portfolio level and single exposure level. Attribution of economic capital to the credit risk of a single obligor is an issue of considerable practical interest.
The third paper, “A Markov copulae approach to pricing and hedging of credit index derivatives and ratings triggered step-up bonds,” by Bielecki et al, proposes a dynamic bottom-up approach by using Markov copula for pricing and hedging credit index derivatives and ratings-triggered corporate step-up bonds. The Markov copula helps to capture the correlation and dependence structure between default process and actual loss. The paper effectively applies Monte Carlo simulation to valuate the derivatives and compute the hedge ratios. It also provides the calibration of the proposed model. From the simulation and calibration results, it turns out that the Markov copula procedure works efficiently and the fit is very good. The article is an interesting and useful step towards developing a copula-like formalism for multivariate processes, with applications to the modeling of credit derivatives.
The last paper in this issue is a technical report. A technical report describes a particular practical technique and enumerates situations in which the technique works well and others in which it does not. Such reports provide extremely useful information to practitioners in terms of saved time and duplication of efforts. The content of technical reports complement rigorous conceptual and model developments presented in the research papers and provide a lot of value to practitioners.
The technical report, “Estimating EAD for retail exposures for Basel II purposes,” is by Valvonis. The author enumerates Basel II expectations on estimation of credit conversion factors to arrive at exposure at default (EAD) and provides practical suggestions for such estimation. Literature is sparse on the topic of EAD, and this technical report attempts to tackle practical problems on estimation with specific illustration for retail credit card portfolios.
Andersen, L., Sidenius, J., and Basu, S. (2003). All your hedges in one basket. Risk November.
A Markov copulae approach to pricing and hedging of credit index derivatives and ratings triggered step-up bonds