Creative ways to transfer credit risk

There was a time when the only avenue for institutions such as corporates and financials to access cash was in the form of bilateral loans from large financial institutions which considered these to be their “bread and butter” relationship business. As a result, a handful of banks were left holding concentrated credit risk to the loan borrowers. Over time, other avenues developed which provided cash to large institutions outside the traditional loan market – namely, the global syndicated loan market and the international bond market. But the loan business remained a major contributor to large capital raisings, continuing to leave significant concentration of credit risk in the hands of financial institutions. Credit risk protection In the mid-1990s, financial institutions began to realise that, although they had strong relationships with borrowers and had the best access to cash, they were not necessarily the most efficient holders of the credit risk, due to their strict regulatory capital requirements. This sparked interest in separating the credit risk of these loans from the funding risk. If this could be achieved, financial institutions would be able to retain their relationships and provide loans to their clients without retaining credit risk. They were effectively looking for a way to buy protection from a third party against borrower default. This development soon took the market by storm, and so, the credit derivatives market was born, becoming one of the fastest growing markets. Investors gained access to credit risk that had previously only existed in the loan market. It soon became apparent to market participants that this separation of credit and funding could be applied to other forms of lending as well. Synthetic products The next leap forward in the development of the credit derivative product was its synthetic nature. Since credit derivatives are contracts and not cash transfers (that is, bonds or loans), dealers can effectively create credit risk synthetically. In other words, there is no need to own the loan or the bond. This synthetic creation of credit risk enables banks to structure tailor-made products for investors. From the creation of synthetic risk, coupled with access to a wider range of credits, a wide spectrum of products evolved. A recent and innovative development is the managed synthetic securitisation, or the collateralised synthetic obligation (CSO) product. This product marries credit derivatives and traditional cash securitisation techniques. It allows investors to gain access to a diversified portfolio of credits where the default risk is managed by an experienced asset manager. The primary feature of CSO investments is that they provide efficient access to leverage simply because there is no cash aspect to the underlying credit risk. The other valuable features of the product are based on the fundamental drivers of the credit derivatives market. In a traditional cash securitisation, a credit must exist in cash form (bond or loan) for the asset manager to add it to the portfolio. With a CSO, there is no need for the credit to exist in cash form. If the company exists, a credit derivative can be created on that name, in the exact maturity and currency that the CSO requires. Tailored portfolios Furthermore, the portfolio of credits can be tailored to the strengths of the asset manager as well as to the interests of the investors. If the asset manager has predominantly European credit expertise, the portfolio can consist of predominantly European credits. Similarly, if the investors are interested in five-year dollar-denominated investments, the CSO can produce a five-year dollar-denominated investment. As the credit derivative market continues to grow and develop, more innovative products that are designed to address specific investor needs are expected to come into play. In the synthetic securitisation market, JPMorgan expects the base product for ongoing innovation to be the CSO. Terri Duhon is vice-president of European synthetic structured product at JPMorgan Securities Ltd.