Investing in credit derivatives

Abstract

The ongoing turmoil in the United States sub-prime mortgage market - and, more recently, the sub-prime mortgage-related losses being reported by some of the worlds largest banks - have brought into sharp focus the risks of investing in credit derivatives, even where the credit derivatives are not linked predominantly to subprime mortgages but, instead, cover apparently diversified pools of mortgages and other bank loans (Economist 2007). The obvious credit risk associated with subprime mortgages and the losses that have eventuated when, as expected, many of these mortgages defaulted or could not be re-financed have, however, taken many investors by surprise. Yet this element of surprise is perhaps explicable when one takes into account the complex and often opaque nature of the arrangements by which the credit risk of sub-prime mortgages has often been passed on to investors. Commercial banks and other originators of mortgages have routinely made use of securitization to both fund and hedge their exposure to mortgages (and other loans). The RMBS (Residential Mortgage-Backed Securities) structures employed to accomplish this are relatively transparent - and so should be well understood - as regards the transfer of credit risk to investors. Debt securities are issued to investors and the cash proceeds from the issuance of the securities are used to purchase mortgages, with the cash-flows generated from the repayment of the mortgages being used to service principal and interest payments on the securities. There is a direct - and clear - link between the performance of the securities and the performance of the securitized mortgages. In addition, it should be no surprise to an investor that where different tranches of securities are issued, the junior or subordinated tranches are more exposed to the credit risk of the underlying mortgages than the senior tranches. This link may, however, be less obvious to investors where the securities have been "re-securitized" and there is at least a second securitization structure interposed between the securities held by the investors and the mortgages (Moodys Investors Service 2007). In a typical re-securitization involving mortgages, known as a cash CDO (Collateralized Debt Obligations), the securities held by the investors are used, not to fund the acquisition of mortgages, but, instead, to fund the acquisition of securities that have been issued as part of a RMBS structure. The securitization and re-securitization of mortgages are depicted in Exhibit 21.1. For many investors, the first inkling of their exposure to sub-prime mortgages has come in the form of losses incurred on the junior tranches of CDO securities, due to defaults on the sub-primemortgages to which those tranches are linked. CDO securities backed (indirectly) by sub-prime mortgages now appear to be the single largest medium through which institutional investors, in particular pension funds and money market funds, have assumed exposure to the credit risk of sub-prime mortgages (Evans 2007a,b). This is, moreover, increasing evidence that educational endowments have also invested heavily in CDO securities linked to sub-primemortgages (Evans 2008a,b). This, however, is only an incomplete description of the use of securitization to transfer the credit risk of mortgages (and other bank loans) to investors. In the case of both the RMBS and CDO structures outlined above, the transfer of credit risk is effected through the acquisition of mortgages and mortgage-backed securities, respectively. The issuer, by acquiring mortgages or mortgage-backed securities, assumes, as a consequence of its ownership of those assets, all of the risks, including credit risk, associated with the assets. Those risks are, in turn, passed on to the investors as the acquisition has been funded by the investors and the repayment of the monies owed to the investors (in the form of principal and interest on the securities issued to the investors) is dependent upon the acquired assets generating sufficient cash-flows (Ali 2005). The same result - in the form of exposure to the credit risk of sub-prime mortgages and other bank loans - can be achieved through investing in credit derivatives. Credit derivatives make it possible to separate the credit risk of an asset from both ownership of that asset and the other risks associated with the asset (Ali 2005). This has greatly facilitated the hedging of credit risk in relation to bank loans (and allowed banks to free-up the risk capital that would otherwise have to be held against those loans) (Ali 2005). Moreover, credit derivatives can, in common with all other derivatives, be used to create credit risk for investors as opposed to transferring an existing credit risk to investors. Just as it is no longer necessary to transfer ownership of an asset in order to lay-off the credit risk associated with that asset so too is it now no longer necessary for a bank or any other party "transferring" the credit risk in relation to an asset to own asset or even have an existing exposure to that credit risk (via a credit risk mitigation instrument such as a guarantee, letter of credit, or even other credit derivatives) (Ali, 2005). Accordingly, investors can readily obtain exposure to the credit risk of mortgages and other bank loans by investing in securities backed by credit derivatives linked to those assets without the need for the issuer of the securities to acquire the assets. This allows for a considerably more customized form of credit exposure, tailored to the risk appetite of particular investors as the extent and type of exposure created is no longer dependent upon the sourcing of actual assets (Nomura Securities 2004). Transparency is unlikely to be an issue for investors where the credit derivatives backing the securities are linked directly to mortgages, including sub-prime mortgages. That, however, is not usually the case with investments in credit derivatives linked to mortgages. It is far more common for such securities to be backed by credit derivatives linked to RMBS or even CDO securities (where the latter are, in turn, backed by RMBS). It is these "synthetic" securitizations of CDO securities and RMBS where the link to the credit risk of the underlying sub-prime mortgages may not be transparent to the investors, particularly where the RMBS includesmortgages other than sub-prime mortgages or the CDO includes debt instruments other than mortgages. That link is depicted in Exhibit 21.2. This chapter discusses the legal aspects of investing in credit derivatives. First, the chapter explains more fully the securitization structures involving credit derivatives through which investors have obtained exposure to sub-prime mortgages (and other bank loans). Second, the chapter examines the key legal constraint on investing in credit derivatives in the context of institutional investors, such as pension funds and money market funds, which constitute the single largest class of investors in credit derivatives. © 2009 Springer-Verlag Berlin Heidelberg.