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Transfer of credit risks Credit-risk transfer can be very complex and investors must make sure they understand what they are buying. The financial innovation that has taken place and to which the current financial turmoil in the developed markets can, to some extent, be attributed is highly complex. At the risk of over generalising, an appropriate and convenient term to describe it may be "credit-risk transfer". For a variety of reasons (including capital constraint, liquidity considerations and regulatory arbitrage), those who originate risky assets, for example banks making mortgage loans, have an incentive to transfer the risks, in this case the possibility that the borrowers may not be able to service the mortgages, to others who are more willing or able to assume them and earn the return associated with doing so. Credit-risk transfer is generally facilitated by securitisation. Risky and illiquid assets are turned into tradable securities and are sold by the transferor (the banks) to the transferees (the investors). There may be a need for some kind of credit-risk transformation to match the risk profiles of the underlying assets with the risk appetites of investors. One way of doing this is to group together different "tranches" of relatively homogeneous securities with different credit ratings and rates of return, rather than create just one pool of securities backed by heterogeneous underlying assets. Credit-risk transfer and credit-risk transformation can also be organised through credit enhancement or credit-guarantee arrangements. Securitisation is, in essence, a simple concept of making illiquid assets liquid, and therefore transferable, by creating a market for the asset-backed securities (ABS). After securitisation, the originators of the underlying assets often continue to provide administrative support for maintaining them, for example, collecting mortgage payments from mortgagors, for a fee. And there are other fees that financial institutions engaged in securitisation receive, such as the fees for structuring the transaction, distributing the securities, making a market for the securities, and fees for the credit rating agencies (CRA) to provide credit ratings for the securities. These fees and the income from trading in the securities provide an additional and significant incentive for securitisation. But this conceptually simple process of securitisation has many variations and has in recent years become much more complex. Securities can be created from a wide spectrum of financial assets, and different slices or tranches of securities can also be created and backed by a homogeneous category or a mixture of assets, and there are many variations in between. For example, a popular form of securitisation involves the issue of different tranches of securities to raise money for acquiring a portfolio of other securities such as ABS and loans. These are called collateralised debt obligations (CDO) or collateralised loan obligations (CLO), and the different tranches are ranked by ˇ§seniorityˇ¨ ˇV the super senior tranche, the senior tranche, the mezzanine tranche and the equity tranche. They are in increasing order of risk, in that losses arising from defaults in the underlying assets of the CDO or CLO will be absorbed first by the equity tranche and then the mezzanine tranche and so on. The credit-risk profile of the securitised underlying assets is therefore transformed into a different credit-risk profile that presumably provides a better match with investor appetites. The different tranches are given different ratings by the CRAs to facilitate marketing of the securities and decision-making by investors, and they obviously offer different rates of return. Another popular form of securitisation involves the setting up and the sponsoring of conduits or structured investments vehicles (SIVs) to buy longer-term and lower-quality assets off the books of banks or from the market (such as mortgages, corporate bonds and CDOs). The conduits and SIVs fund these purchases by issuing short-term commercial paper or asset-backed commercial paper, and in the case of SIVs they also issue income notes, which are in effect the equity tranche - again the first candidate to absorb potential losses. Credit risks can also be transferred through buying insurance against the default risks inherent in financial assets, such as a corporate bond or loan. The insurance takes the form of yet another popular, tradable financial instrument - credit default swaps. The buyer of the protection pays a premium (a percentage of the amount of protection ˇV in basis points per year) to the seller, who pays the protected amount in the event of default. Obviously the seller has to be in a position to honour the commitment, in effect taking over the credit risk, for this form of credit-risk transfer or credit-risk transformation to be meaningful. While the different types
of risk transfer I have described may make the distribution of risk
among investors more efficient, they can be very complex and
investors must make sure they understand what they are buying.
Financial innovation can also affect the stability of the financial
system in various ways, a topic I will find a time to write more
about in future. Joseph Yam ˇ@ Click here for previous articles in this column. ˇ@ |
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