Going the wrong way

Dealers have suffered billions of dollars of losses from wrong-way counterparty credit exposures with monoline insurers. Could they have been avoided? Mark Pengelly investigates


Counterparty credit risk has become an increasingly significant issue since losses on US subprime mortgages became a cause for concern in July 2007. In the past six months, worries about dealing with vulnerable counterparties have even infected the interbank market, turning once-placid Libor rates into a gauge of market fear (Risk January 2008, pages 74-76).

From being a somewhat mysterious back-office preoccupation, counterparty credit risk is stepping out from the shadows, acknowledges Rob O'Rahilly, London-based head of trading for the credit portfolio group at JP Morgan in London. "It's now even more at the forefront of peoples' minds at the point of origination, rather than sitting in the back of the institution," he says.

This is partly because the credit crisis has seen dealers plagued by billions of dollars of losses on counterparty credit exposures, principally emanating from monoline insurers. "Counterparty credit risk has hit a lot of banks this time around. People have taken some serious pain on it," says O'Rahilly.

Prior to the turmoil, monoline insurers were sought to guarantee a host of structured credit products, such as collateralised debt obligations of asset-backed securities (CDOs of ABSs). Arrangers would buy protection against the default of senior CDO of ABS tranches from monolines, often in the form of a credit default swap (CDS). In February, a report by New York-based Moody's Investors Service estimated banks had $120 billion notional of CDSs referenced to CDOs of ABSs outstanding with monoline insurers. These exposures were spread across 20 different banks and securities firms, the agency said.

Delinquencies in the collateral pools of many CDOs of ABSs have exploded since July, causing the mark-to-market on these CDS hedges to increase strongly. But the failure of monolines to anticipate defaults has left them hopelessly under-capitalised, threatened with the loss of their AAA ratings and, with them, their business model. Accordingly, credit spreads on monoline insurers have mushroomed. Last July, five-year CDSs on New York-based guarantors Ambac and MBIA traded at around 53 and 72 basis points, respectively. By January 22, the cost of protection on these entities had spiked to about 733bp and 721bp, although this had tightened to 377bp and 360bp by February 25.

For dealers holding CDSs referenced to CDOs of ABSs, the blowing-out of credit spreads on monoline insurers represents a massive increase in counterparty credit risk. Moreover, it has occurred at the very time the underlying contracts have become most valuable on a mark-to-market basis. Most major dealers assess counterparty credit exposures using the default rates implied by credit spreads. This means massive losses will have been booked due to the ballooning spreads on monolines - counterparties that are not required to post collateral or make margin payments.

"Counterparty credit risk has always been significant, but an awful lot more people are sitting up and taking notice now," says David Murphy, London-based head of counterparty portfolio management at Dresdner Kleinwort. "And the reason they're sitting up and taking notice is because it's hitting the bottom line."

Bank risk managers characterise these exposures as an archetypal example of wrong-way correlation with a counterparty credit. In other words, the value of the underlying CDSs on CDOs of ABSs has proven to be unfavourably correlated with the credit quality of monoline counterparties. Murphy, who calls this the worst kind of wrong-way risk, believes senior managers at many banks simply weren't aware they were holding it. Others say dealers were aware of the risks, yet didn't take them seriously enough given the perceived strength of the monoline sector.

Potential correlations between the credit of counterparties and over-the-counter derivatives trades are usually identified within dealers' counterparty credit hedging desks. A wrong-way correlation, like that between the counterparty credit of monoline insurers and the value of CDS protection sold by them, involves deterioration in the value of counterparty credit as such trades come into-the-money. Another example, given by Murphy, is an emerging market bank selling CDS protection on a company based in the same country. In such a trade, counterparty credit risk is likely to increase with the value of the swap - so, if the emerging market company nears default, it is likely to be accompanied by a widening of spreads across that market, increasing the likelihood the counterparty won't be able to pay out on the CDS.

Right-way correlation

Conversely, a right-way correlation with counterparty credit could occur through the purchase of a gold futures contract from a mining company, for instance. In this case, as the price of gold rises and the value of the futures contract increases, the credit quality of the gold producer is also likely to improve.

Typically, counterparty credit hedging desks would attempt to price both right- and wrong-way correlations into trades when possible. But they can be difficult to determine. "The difficulty is not the methodology for how to calculate right- and wrong-way risk; the difficulty is the lack of appropriate correlation data to use in the model. It's certainly an ongoing challenge," says Dresdner's Murphy.

JP Morgan's O'Rahilly explains that while wrong-way correlations are relatively easy to identify, teasing out right-way correlations is often much more challenging. For a gold mining company looking to trade gold futures, for example, the competitiveness of pricing offered by dealers may depend on how weak or strong their correlation assumptions are. But although these assumptions could have a tangible impact on pricing, O'Rahilly says it is tricky to gauge them from the market. "Often, there's only one or two types of trade with a particular counterparty, so getting a handle on where the Street marks its correlation - or is willing to offer its correlation - can be difficult and very subjective."

Some dealers hope to eventually be able to obtain greater transparency in pricing through the contingent CDS (CCDS) market. CCDSs, which first began to trade in 2002, are similar to traditional CDS contracts, but are designed to dynamically respond to changing counterparty risk exposures. In theory, this makes them a better hedge for counterparty credit risk. Like a CDS, a credit event related to the reference entity results in the protection buyer delivering a debt obligation to the seller of an amount equal to the contract's notional value, in exchange for payment at par. However, the reference notional in a CCDS contract is variable and equal to the value of an underlying OTC derivatives trade, such as an interest rate or cross-currency swap. CCDSs thereby strive to address the thorniest problem with counterparty risk, as the changes in the contract's value tend to closely offset changes in the underlying OTC trade's credit risk premium (Risk June 2007, pages 28-30).

Paul Bowmar, head of credit valuation adjustment for rates and commodities at Lehman Brothers in New York, says his firm is actively making a market in CCDSs. "They're a very neat product tailored to suit counterparty risk," he says.

With some development, a liquid interbank CCDS market should enable dealers to gain an insight into market-implied correlations between OTC derivatives trades and counterparty credit risk across various asset classes. "The risk premium for right- and wrong-way trades varies with market conditions, which is one of the reasons we've focused on CCDSs. We want to make sure we're calibrating our counterparty risk to market appetites, rather than relying too much on a model," adds Bowmar.

Nevertheless, he admits the CCDS market remains "spotty". Others say building the level of liquidity needed to determine market-implied correlations between counterparty credit risk and OTC derivatives trades across various asset classes will take time.

Furthermore, not all dealers remain convinced of the worth of using CCDSs. In the case of counterparty risk arising from an OTC interest rate swap, for example, it is often cheaper to dynamically manage the credit and interest rate risk independently, says Dresdner's Murphy: "We would hedge the interest rate risk and the credit risk in a trade separately. It's cheaper to do that than buy a CCDS."

While a lack of liquidity makes the hedging of counterparty credit risk via these instruments relatively expensive at present, Spiro Santoni, London-based head of risk management at Royal Bank of Scotland in London, believes this will eventually change. "Any market that isn't very liquid to start with is expensive. My view is that when more banks enter - and they will enter - the market will become more efficient."

He also counters that while CCDSs may look comparatively dear when held against disaggregated hedges, this does not account for operational risks involved in continuously rebalancing them. Hedging the counterparty risk associated with an OTC commodity derivatives trade, for example, might require substantial infrastructure spanning both commodity and credit markets. Moreover, the amount of resources that need to be dedicated to hedging each leg of the trade will also vary with the level of market volatility.

This is less of an issue for some. JP Morgan's O'Rahilly says that, under certain circumstances, the bank would prefer the flexibility to fine-tune such hedges rather than use a CCDS: "Obviously, a CCDS is a bespoke product and any changes or unwinds further down the line will also come at a non-vanilla price." When presented with the possible cost of unwinding trades and putting them on again, JP Morgan often places more value on the ability to trade in and out of hedges deftly, he adds. And despite the nascent interdealer market in CCDSs, the bank prefers to lay off its counterparty credit exposures through trading CCDSs with its own clients.

With doubts lingering over the utility of CCDSs for hedging counterparty risk, the ability to price right- and wrong-way risks from market-implied correlations might yet be far off. Even so, the subjectivity of some assumptions on these correlations should not be ignored, says Damiano Brigo, managing director at Fitch Solutions and visiting professor at Imperial College Department of Mathematics in London. Many banks, for example, would generally assume zero correlation between the credit of most counterparties and interest rates or foreign exchange underlyings. But such correlations should not be underestimated systematically, warns Brigo. "In some cases, it can be important," he says.

Brigo recently co-wrote a paper that found counterparty credit risk can have a significant impact on interest rate derivatives payouts (Risk February 2008, pages 84-88). He stresses the need to incorporate the potential for correlation into dealer models from the outset, to cater for the possibility it could arise at a later date.

"If you're trading a CDS on an automotive name with a financial, and you have a feeling the financial sector and the automotive sector are not correlated, you can value this product with zero correlation. But in a systemic crisis, typically, the correlation across sectors tends to increase," Brigo says. If this were to happen, the models of many dealers would not allow them to take these correlations into account, he adds.

The frailty of the zero-correlation assumption for interest rates and foreign exchange has been known for some time. Emmanuel Ramambason, London-based head of fixed-income counterparty risk management at BNP Paribas, says: "Right- and wrong-way correlations sometimes have a very large impact. Still, we tend to have risk management assuming zero correlation between interest rates or foreign exchange and credit for a large part of our exposures, given the lack of evidence of a strong realised correlation."

Considering correlations between counterparty credit and currency pairs or interest rates could well be useful, concurs Ramambason, but deducing correlations between credit spreads and counterparty credit is much more complicated. "It requires a commonsense approach," he argues.

Brigo says he is considering the impact of credit spread volatility on counterparty credit risk for CDS trades themselves. "One thing that is often neglected in the standard approaches you find in the market, where default correlation is modelled as a copula, is a model that accounts for credit spread volatility in the underlying CDS," he says. If the counterparty risk on a CDS is viewed as an option on its residual value with a maturity at the time of default, failing to consider volatility in the option valuation could be seen as a simplistic assumption. "We think the impact of spread volatility could be relevant and we want to check that precisely and in a no-arbitrage way. Then we can look into more specific applications," says Brigo.

Much of the existing literature on counterparty credit for interest rate payouts considers volatility in underlyings but ignores correlation, he says. On the other hand, standard approaches to counterparty risk and credit underlyings consider correlation yet fail to consider underlying volatility - something Brigo hopes to rectify.

Dealers' multi-billion-dollar monoline losses could well prove to be a good case study. Nevertheless, whether a better understanding of the impact of credit spreads upon counterparty risk for CDS trades might have prevented the recent problems is probably a moot point. Referring to the zero-correlation assumption for interest rates, one London-based counterparty risk manager says: "There are circumstances under which people might be massively correlated the wrong-way around with interest rate risk. But you can't be the only one who prices it in because you won't do any business."

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