Credit Risk Management Post Dodd-Frank and MF

GlobalApril 11, 2012

Vince KaminskiPresentation to the

CFA Society of Houston

Credit Risk

Credit RiskThe risk of losing market value due to changes in your own or counterparty credit quality and / or counter party failure to performThree conventional wisdoms

Credit risk management is limited to analysis and mitigation of counterparty credit riskCredit risk arises exclusively from a counterparty bankruptcyFinancial 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 levelCredit risk management is particularly important to energy trading operationsManagement of credit risk requires cooperation of professionals with multiple skills, using different conceptual frameworks and languages

LawyersRisk analystsQuantitative 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 transactionsDifferent counterparties across all the transactionsOverall 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

Source: Jones School, Rice University

Credit Exposure

Current PotentialAccountsReceivable

Current UnbilledExposure

Current MTM

Potential MTM

Provisional UnbilledExposure

Potential MTM Exposure

CurrentMTM

1 Year

Exposure“Maximum” Potential Forward Exposure

95 % Confidence Interval

50 % Confidence Interval

1 Year Swap

3 Months

Threshold

Bilateral Credit Risk Management

Credit AgreementsCredit Limits and Credit ThresholdsCollateralization of Credit RiskNettingCredit Risk Hedging

Credit DerivativesCredit Insurance

Credit Risk Mitigation

Master Agreements Master credit agreements cover netting, set-off, cross-

default 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 transactionFrequent use of over collateralization (O/C) for these

counter-parties (>100%)Counter-parties prefer O/C over contract termination

Threshold ExampleS&P Rating Moody’s Rating ThresholdAA- or above Aa3 or above $30,000,000A+ A1 $20,000,000A A2 $17,500,000A- A3 $15,000,000BBB+ Baa1 $12,500,000BBB Baa2 $10,000,000BBB- Baa3 $ 5,000,000BB+ 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 assuranceThresholds 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 industryComingling of collateral with the firm’s own fund

and using it for general corporate purposesRe-hypothecation is the mechanism behind the

growth of shadow bankingDifferences between the US and UK laws

governing re-hypothecation

Central Clearing Counterparties

Central Clearing CounterpartiesClearinghouse 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 FranceCaisse 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

2

3

45

1

Bilateral Clearing

2

3

45

1 CCP

Central Clearing

Central Clearing Counterparties (2)

Two CCP designs used in practiceVertical, integrated structure: a clearinghouse

owned by/associated with an exchangeAn example: The CME

A horizontal structure: a CCP accepting for clearing transactions executed on multiple exchanges

An example: London ClearinghouseA trend towards establishment of vertical

structures

Mechanics of Clearing

NovationBoth 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-to-market and margining)Defining financial strength thresholds for clearing

members Audits of clearing membersStrict governance rules for the CCP and clearing

membersThe right to liquidate and/or transfer positions of

clearing members and their customersDefault fund and additional insurance

FCMFCM (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 USTop 30 FCMs held over $163 billion of customer

funds as of March 2011An 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 1.10Regulation 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: DFDodd-Frank requires mandatory clearing of

standardized derivatives Exemption for the end-users of derivativesA 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 widely-held 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-the-counter 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 clearinghousesClearinghouses may become a source of systemic

risk Solution:

Access to central bank liquidityRestrictions on clearinghouse membership

Minimum capitalization levels for clearing members

Higher assessments and fees to build up a default fund

Additional insurance

Lessons Learned – MF GlobalBankruptcy of MF Global and the curious case of

missing funds in segregated accountsBalkanization 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 rewrittenThe 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 revisitedAre 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 managementUsing several FCMs to reduce potential

exposure to any single broker