Download CFA Society April 2012

Credit Risk Management
Post Dodd-Frank and MF
Global
April 11, 2012
Vince Kaminski
Presentation to the
CFA Society of Houston
Credit Risk
Credit Risk
The risk of losing market value due to
changes in your own or counterparty credit
quality and / or counter party failure to
perform
Three conventional wisdoms
Credit risk management is limited to
analysis and mitigation of counterparty
credit risk
Credit risk arises exclusively from a
counterparty bankruptcy
Financial innovations reduced overall
market and credit risk
Credit Risk (2)
Walter Bagehot: If you have to prove
you are worthy of credit, your credit is
already gone.
Credit Risk (3)
Again, it may be said that we need not be alarmed at the magnitude of our
credit system or at its refinement, for that we have learned by experience the
way of controlling it, and always manage it with discretion. But we do not
always manage it with discretion. There is the astounding instance of
Overend, Gurney, and Co. to the contrary. Ten years ago that house stood
next to the Bank of England in the City of London; it was better known
abroad than any similar firm known, perhaps, better than any purely English
firm. The partners had great estates, which had mostly been made in the
business. They still derived an immense income from it. Yet in six years they
lost all their own wealth, sold the business to the company, and then lost a
large part of the company's capital. And these losses were made in a manner
so reckless and so foolish, that one would think a child who had lent money
in the City of London would have lent it better. After this example, we must
not confide too surely in long-established credit, or in firmly-rooted traditions
of business. We must examine the system on which these great masses of
money are manipulated, and assure ourselves that it is safe and right.
Walter Bagehot, “The Lombard Street,” London 1873
Credit Risk (4)
Most energy companies have specialized
units responsible for management of credit
risk at the corporate level
Credit risk management is particularly
important to energy trading operations
Management of credit risk requires
cooperation of professionals with multiple
skills, using different conceptual
frameworks and languages
Lawyers
Risk analysts
Quantitative modelers
Credit Group’s Responsibility
 Development of systems and procedures for assessment and
management of credit risk
 Development of the counterparty data base
 Negotiation of credit agreements with trade counterparties
 Establishment and enforcement of credit lines and credit
limits
 Assessment of credit risk related to
Specific transactions
Different counterparties across all the transactions
Overall credit risk of the entire portfolio
 Mitigation of credit risk
Credit Risk Measurement
Credit Risk Measurement
 Credit risk can be measured at the level of a single transaction
or the entire portfolio
 Credit risk of an individual transaction may be measured as
current + potential risk
 Current credit risk of a single transaction is the cost of
replacing the transaction in the market place in case of the
counterparty default
 Portfolio credit risk requires assessment of credit risk across a
portfolio of
 Different transactions with the same counterparty
In case of transactions with the same counterparty netting
may apply (assets and liabilities netted)
 A portfolio of original transactions with many counterparties,
possibly supplemented with risk mitigation instruments
Credit Exposure
Credit Exposure
Current
Accounts
Receivable
Current
Unbilled
Exposure
Source: Jones School, Rice University
Potential
Current
MTM
Potential
MTM
Provisional
Unbilled
Exposure
Potential MTM Exposure
“Maximum”
Exposure
Potential
Forward
Exposure
1 Year Swap
95 %
Confidence
Interval
50 %
Confidence
Interval
Threshold
Current
MTM
3 Months
1 Year
Bilateral Credit Risk
Management
Credit Risk Mitigation
Credit Agreements
Credit Limits and Credit Thresholds
Collateralization of Credit Risk
Netting
Credit Risk Hedging
Credit Derivatives
Credit Insurance
Master Agreements
 Master credit agreements cover netting, set-off, crossdefault and collateral arrangements
 The templates are provided by a number of standardized
documents:
 International Swap Derivatives Association Inc. ― Master
Agreement (ISDA)
 Edison Electric Institute ― Master Purchase & Sale
Agreement (EEI)
 Western Systems Power Pool ― Western Systems Power
Pool Agreement (WSPP)
 North American Energy Standards Board ― Base
Contract for Sale and Purchase of Natural Gas ―
(NAESB)
 Gas Industry Standards Board ― Base Contract for
Short-Term Sale and Purchase of Natural Gas (GISB)
Master Netting Agreements
 Benefits. Master netting agreements:
 Reduce credit risk
 Free up cash and corporate guarantees
 Facilitate integration of risk management systems and allow
for development of Enterprise-Wide Risk Management System
 Reduce legal overhead requirements
 Master credit agreements should address the issues of netting
 Across different product lines
 Across physical and financial transactions
 Across different jurisdictions
 Many provisions of the credit agreements have not been tested in
bankruptcy
Credit Thresholds and Credit Limits
 Bilateral credit risk is managed primarily through the
establishment of the credit limits and credit thresholds
 Credit limits define the maximum credit exposure with
respect to a given counterparty
 Additional transactions require approval of the credit
department
 Credit thresholds define maximum credit exposure
that does not require posting collateral
 Once credit exposure exceeds the credit limit, the
excess credit exposure will be collateralized
 Credit thresholds can be adjusted based on the credit
ratings changes or the so-called MAC clauses in credit
agreements
Setting Collateral Requirements
 Collateral provides a level of assurance regarding counter-party
performance – “bankruptcy safe”
 Once credit threshold is set, collateral is normally required for
transactions that exceed this threshold
 Example, counter-party has been extended $20MM of credit
based upon its BBB+ investment grade rating and certain
financial characteristics
 Transaction with counter-party is now marked-to-market at
$25MM
 Counter-party must provide $5MM of collateral
 Counter-parties below investment grade
 Collateral is usually 100% (or more) of the marked-to-market
amount of the transaction
Frequent use of over collateralization (O/C) for these
counter-parties (>100%)
Counter-parties prefer O/C over contract termination
Threshold Example
S&P Rating
Moody’s Rating
Threshold
AA- or above
Aa3 or above
$30,000,000
A+
A1
$20,000,000
A
A2
$17,500,000
A-
A3
$15,000,000
BBB+
Baa1
$12,500,000
BBB
Baa2
$10,000,000
BBB-
Baa3
$ 5,000,000
BB+ or below (or
unrated)
Ba1 or below (or
unrated)
Zero
Setting Collateral Requirements
 Material adverse change in financial conditions (MAC)
language allows either party to increase its collateral
requirements or terminate contract
 If financial conditions imply performance impairment:
Counter-party must post-adequate assurance
Thresholds may be reduced (possibly to zero)
Reduction of credit thresholds may start a death
spiral
 Credit downgrade below investment grade has similar
consequences
 The potential for death spiral
Problems with Using Collateral Requirements
 Differences in transaction valuation between counter-parties
 Illiquid markets
 Often a negotiated value is used by the counter-parties
Valuation differences are often split 50-50 – potential
collateral shortfall may result
Disturbing trend – credit personnel negotiating contracts
lacking experience in financial valuation techniques
 Time lag of transaction valuation vs. receipt of collateral (2 5 days)
 Linking a subsidiary with the parent company (establishing
parent-child relationship) is a challenging task
 Many financial firms offer hedging instruments combined with
automatic credit lines (secured with physical assets) that can
be used to post collateral
Problems with Using Collateral Requirements
(2)
 Major risk: re-hypothecation
 This is a critical risk that has no been recognized
by the industry
Comingling of collateral with the firm’s own fund
and using it for general corporate purposes
Re-hypothecation is the mechanism behind the
growth of shadow banking
Differences between the US and UK laws
governing re-hypothecation
Central Clearing
Counterparties
Central Clearing Counterparties
Clearinghouse mechanics
A bilateral transaction is broken up through a
process called novation into two transactions
A clearinghouse is inserted between two
original counterparties
The concept of a clearinghouse was developed
in France
Caisse de Liquidation des Affaires en
Marchandise (1882)
Predecessors
Dojima: rice futures market in Osaka,
Japan, in the 18th century
Coffee Exchange in New York City
Bilateral Clearing
2
1
3
5
4
Central Clearing
2
1
3
CC
P
5
4
Central Clearing Counterparties (2)
Two CCP designs used in practice
Vertical, integrated structure: a
clearinghouse owned by/associated with an
exchange
An example: The CME
A horizontal structure: a CCP accepting for
clearing transactions executed on multiple
exchanges
An example: London Clearinghouse
A trend towards establishment of vertical
structures
Mechanics of Clearing
Novation
Both counterparties post an initial margin
(performance bond)
The positions are marked-to-market (usually
twice a day)
If the equity in the account of a counterparty
falls below the so-called maintenance margin,
variation margin has to be posted
The failure to post variation margin triggers
liquidation of positions
Central Clearing Counterparties (3)
CCPs have a number of safeguards to protect
against a default by a clearing member, other members
and their clients
Such measures include (in addition to marking-tomarket and margining)
Defining financial strength thresholds for clearing
members
Audits of clearing members
Strict governance rules for the CCP and clearing
members
The right to liquidate and/or transfer positions of
clearing members and their customers
Default fund and additional insurance
FCM
FCM (Futures Commission Merchant)
Executes orders to buy or sell futures or
options on futures
Collects from customers funds or other assets
to support these orders
Funds collected from the customers remain
their property and cannot be comingled with the
FCM’s own assets
There are currently 65 FCMs in the US
Top 30 FCMs held over $163 billion of customer
funds as of March 2011
An FCM typically collects more funds than the
minimum required by a clearing organization
FCM (2)
The CEA and CFTC regulations require that the
customer collateral received by FCMs be segregated
An FCM is allowed to invest funds held in the
customers accounts
CFTC Rule 1.25 determines what are allowed
investments
The value of customer account must remain intact
all the times
FCM are subject to the CFTC regulations which are
enforced by DSROs (Designated Self Regulatory
Organizations)
Regulation 1.10
Regulation 1.16
FCM (3)
Regulation 1.10
The CFTC Regulation 1.10 requires FCMs to
file monthly unaudited financial reports with
the Commission and the DSRO
Segregation and net capital schedules
details
“Further material information as may be
necessary to make the required
statements and schedules not
misleading.”
Reports are filed under oath (CEO or
CFO)
FCM (4)
Regulation 1.16
The CFTC requires FCMs to file annual
certified financial reports with the
Commission and the DSRO
Audits requirements include:
 Information about disagreements with
statements made in reports prepared by
prior auditors
Inadequacy tests for internal controls
that may inhibit an FCM from effectively
protecting customers’ assets or result in
violation of the CFTC’s segregation
requirements
Lessons Learned
Recent Developments: DF
Dodd-Frank requires mandatory clearing of
standardized derivatives
Exemption for the end-users of derivatives
A likely outcome: proliferation of clearing
houses
“As long as the clearinghouse is well capitalized and
manages its risks well, there is no material counterparty
risk with the clearinghouse. This fact explains the widelyheld belief that requiring clearing for over-the-counter
derivatives will significantly reduce systemic risk. It is
important, however, to understand that we have much
experience with exchange clearinghouses and little
experience with over-the-counter clearinghouses. Over-thecounter clearinghouses have not been tested in a financial
crisis.” “Testimony of René M. Stulz to The House Committee on
Financial Services”
Recent Developments: DF (2)
Potential for concentration of credit risk in a small
number of clearinghouses
Clearinghouses may become a source of systemic
risk
Solution:
Access to central bank liquidity
Restrictions on clearinghouse membership
Minimum capitalization levels for
clearing members
Higher assessments and fees to build up
a default fund
Additional insurance
Lessons Learned – MF Global
Bankruptcy of MF Global and the curious case of
missing funds in segregated accounts
Balkanization of the regulatory infrastructure
The CFTC regulates FCMs but lacks resource
to implement effective oversight infrastructure
The day-to-day oversight responsibilities are
delegated to the DSROs
 The trend towards demutualization of
exchanges creates profit pressures
The CFTC rules covering FCMs will be rewritten
The CFTC is likely to receive additional funding to
enhance oversight of FCMs
Lessons Learned – MF Global (2)
Consequences and potential remedies:
An adverse impact on the efficiency of the US
economy
Risk management principles should be
revisited
Are risk managers truly independent?
Changes in management of relationships with
brokers
More proactive management and monitoring
of the financial conditions of a broker
More effective cash management
Using several FCMs to reduce potential
exposure to any single broker