lecture notes on risk management, public policy, and the ...amm26/lecture...

Lecture notes on risk management, public policy, and the financial system

Credit and counterparty risk

Allan M. Malz

Columbia University


Outline

Debt and default

Bankruptcy and resolution

© 2019 Allan M. Malz Last updated: October 11, 2019 2 / 32


Debt and default

Debt and defaultEquity, debt and leverageCost of credit intermediationDefaultCounterparty riskCredit and market risk losses in banks


3/32


Debt and default

Equity, debt and leverage

Firm balance sheet

Equity: residual claim on earnings

� Ownership of firm and control over management� Prevalent since 19th century: enjoys limited liability� Value of equity ≥ 0, no recourse to property of shareholders orpartners

Debt: fixed-income obligations; claims only to contractually-stipulatedreturns

Hybrids have characteristics of both, e.g. preferred shares

Schematic balance sheet:

Assets Liabilities

Equity (Et)Value of assets (At)

Debt (Dt)

4/32


Debt and default

Equity, debt and leverage

Leverage

� The ratio of assets to equity L = At

Et

� “Equity” can be shareholder or partner equity, down payment on ahouse, margin on a transaction with a dealer or exchange

� Leverage enhances returns or losses relative to equity capital (RoE)

� Each “turn” of leverage increases RoE by the difference betweenreturn on assets and cost of debt

5/32


Debt and default

Cost of credit intermediation

Credit intermediation faces special costs

Information costs: lending is an information-intensive business

Agency costs: intermediaries generally function as agents of principals,owners of funds being lent

� Consequent potential for conflicts of interest costly to resolve

Externalities: actions by one market participant imposes costs orprovides benefits to others that can’t be compensated through marketmechanisms

Can be considered as transaction costs

� All these special costs are interrelated

6/32


Debt and default


Information costs in credit intermediation

� Asymmetric information: borrower has more information aboutability to repay than lender

� Mitigated through costly monitoring

� Adverse selection: likelihood a seller but not buyer knows ofdefects of a security (or any good—“lemons problem”)

� Examples: market-maker widens bid-ask spread because of informedtraders, originate-to-distribute model in securitization

7/32


Debt and default


An example of information costs

A Mafia Godfather learns his bookkeeper, Guido, cheated him out of $10 million. His bookkeeperis deaf. That was the reason he got the job: Guido would hear nothing and couldn’t testify incourt. The Godfather, accompanied by a lawyer who knows sign language, confronts Guido aboutthe missing money. The Godfather tells the lawyer:“Ask him where the money is!”The lawyer, using sign language, asks Guido:“Where’s the money?”Guido signs back:“I don’t know what you are talking about.”The lawyer tells the Godfather:“He says he doesn’t know what you are talking about.”The Godfather pulls out a pistol, puts it to Guido’s head and says:“Ask him again or I’ll kill him!”The lawyer signs to Guido:“He’ll kill you if you don’t tell him.”Guido trembles and signs back:“OK! You win! The money is in a brown briefcase, buried behind the shed at my cousin Bruno’shouse.”The Godfather asks the lawyer:“What did he say?”The lawyer replies:“He says you don’t have the balls to pull the trigger.”

8/32


Debt and default


Agency costs in credit intermediation

Principal-agent problem: costly to align incentives when a principalemploys an agent

� Example: investment manager may maximize fee and tradingincome rather than investor returns

� Consequent potential for conflicts of interest costly to resolve

Risk shifting: asymmetry of risks and rewards→option-like payoffs

� Examples: equity investors vs. lenders, Too-Big-To-Fail

Moral hazard: insurance or guarantees diminishes incentives to monitor,perform due diligence, mitigate risks

That inscrutable thing is chiefly what I hate; and be the white whale

agent, or be the white whale principal, I will wreak that hate upon

him. Ahab, in Melville, Moby-Dick

9/32


Debt and default


Externalities in credit intermediation

Coordination failures or collective action problems: parties cannotagree on action that benefits all

� Examples: holdouts in bankruptcy restructuring, bank runs

Systemic risk: risk-taking by one intermediary may increase risks ofothers

10/32


Debt and default

Default

Default concepts

Default or default event: failure of obligor (borrower) to fulfill termsof debt contract, e.g.

Failure to pay contractually-agreed interest or principalFraud or breach of representations and warranties (e.g. lying)Cross-default: default under a different debt contract may be a

triggering event

Insolvency: inability to pay debts, defined two ways

� Cash-flow insolvency: cash insufficient to meet debt obligations� Balance-sheet insolvency: debt exceeds assets⇒ negativecapital or net worth

Bankruptcy: legal procedure in which insolvent debtor “seeks relief”from creditors

11/32


Debt and default

Default

U.S. default rates 1920–2016

1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

0.0

0.5

1.0

1.5

0

5

10

15

Investment grade (left) Speculative grade (right)

Issuer-weighted default rates (fraction of rated issuers defaulting each year), annual,percent. Source: Moody’s Investors Service.

12/32


Debt and default

Default

Collateral

� Many credit transactions are secured, i.e. supported by collateral:

� Assets (securities, factory or subsidiary), cash flows or revenuespledged to repay debt if borrower fails to meet specific obligations

� Highly developed markets based on use of financial assets ascollateral by intermediaries→collateralized securities transactions

� Collateral held by lender, but borrower retains ownership or otherclaim

� And debt contract permits it to be sold by lender if borrower defaults

� Secured=general obligation debt backed by overall cash flows

� Amount of collateral may be frequently adjusted in certain types ofcredit transactions, esp.

� Collateralized securities and derivatives transactions� Central bank monetary operations

� Other forms of credit support include guarantees

13/32


Debt and default

Default

Credit rating agencies

� Lenders may engage advisory services to assess and monitor obligors’creditworthiness

� Particularly economical for

� Smaller lenders and smaller loans (→credit scoring)� Bonds and other marketable credit exposures

� Rating agencies: services providing alphanumerical credit ratingsof borrower or security creditworthiness

� Distinction between investment grade (higher-rated) andspeculative grade (lower-rated) securities

� Original subscriber-pays business model superseded by issuer-pays

� Prompted by advances in copying technology from 1970s� Said to induce conflict of interest with investors

14/32


Debt and default

Default

Ratings requirements in regulation

� 1936: banks’ bond holdings restricted to investment-grade rated

� 1975: ratings of “recognized” agencies used to determine securitiesfirms’ capital requirements

� SEC-sanctioned Nationally Recognized Statistical RatingOrganization (NRSRO)

� Dodd-Frank reduces regulatory reliance on ratings by removinglanguage requiring them

15/32


Debt and default

Default

Credit rating migration

� Credit rating migration: change in credit rating,

� May be upgrade or downgrade� Migration both a credit and market risk event

� Ratings correspond to probabilities of default and migration

� Summarized in transition matrix

� Displays probability of obligor/security having a given rating at endof period, conditional on rating at beginning of period

16/32


Debt and default

Counterparty risk

Basics of counterparty risk

� Counterparty: not an obligor, but other party to a financial contract

� Major sources: OTC derivatives, e.g. options, interest rate swaps,credit derivatives

� Key differences from conventional credit risk:

� Credit exposure not a fixed par value but varies with market riskfactors

� ⇒Credit exposure at time of default not known now, but uncertain� Combines market and credit risk� For swaps, forwards (but not options), cash flows bilateral, not one

way→either party may owe other, depending on market conditions� Large gross notional amounts→high volatility of net exposure

� Managed/mitigated by monitoring, diversification of counterparties,limits, hedging via CDS, collateral, netting

� Collateral, netting typically governed by ISDA Master Agreement

17/32


Debt and default

Counterparty risk

Some specific forms of counterparty risk

Wrong-way risk: asset-price fluctuations that increase credit exposurealso adversely affect counterparty credit

� Example: foreign-exchange swap in which local bank paysdollars

Double default risk of CDS or guarantee

� Both underlying credit and counterparty must default togenerate loss

18/32


Debt and default

Counterparty risk

Credit Valuation Adjustment� Credit Valuation Adjustment (CVA) is the difference between themarket value of the derivatives contract and its market value if itwere free of credit risk

� Thus equal to expected loss due to counterparty default� Market value of counterparty risk, equal in principle to hedging cost� Net of collateral

� Required for fair-value hedge accounting and by Basel capitalstandards

� If derivatives contract closed out without loss, CVA returned to P&L� Contra-asset account, similar to banks’ ALL account

� CVA measured using estimates of exposure and credit riskparameters: default probability, recovery, etc.

� Methods based on full simulation of future exposures and defaults� Simpler approaches based on current exposures

� Debt Valuation Adjustment (DVA) is the reduction in CVAresulting from the firm’s own default risk

� DVA controversial: reduction in DVA due to own creditdeterioration→reduction in liabilities

� Permitted under accounting, but not under Basel capital rules

19/32


Debt and default

Credit and market risk losses in banks

Banks: economic and accounting loss concepts

� Economic concept of credit loss focuses on when loss becomes likely

� Accounting, regulatory and tax rules influence timing of lossrecognition and impact lender’s reported income and balance sheet

� Regulation requires banks to report an allowance or reserve forloan and lease losses (ALLL) account

� Contra-asset account corresponding to expense item provision forloan losses on income statement

� When loss recognized, loan assets and ALLL account reduced byamount called charge-off or write-down

� Income statement not affected unless losses differ from initialestimate

� Loss provisioning: if losses expected to be greater than initiallyestimated, banks add to ALLL account

� ALLL represents amount not expected to be collected, intended tomake financial statements more informative

� But can be manipulated to smooth earnings, gain tax advantages

20/32


Debt and default


Bank charge-off and delinquency rates 1985–2013

charge-off rateH¬L

delinquencyrateH®L

1985 1990 1995 2000 2005 2010

0.5

1.0

1.5

2.0

2.5

3.0

2

3

4

5

6

7

All commercial banks, all loans. Percent of aggregate loan balances, seas. adj. ann.rate, Q1 1985–Q2 2013. Charge-offs are the value of loans removed from the booksand charged against loss reserves, net of recoveries. Delinquent loans are those pastdue 30 days or more and still accruing interest as well as those in nonaccrual status.Vertically shaded intervals denote recessions, as determined by the National Bureau ofEconomic Research (NBER). Source: Federal Reserve Board.

21/32


Debt and default


Bank securities holdings

� In addition to loans, banks, insurance companies and other financialservices firms hold marketable securities

� Broker-dealers follow somewhat different accounting guidance

� Securities portfolios a large and growing share of interest-earningassets on bank balance sheets

� Fall into accounting categories

Trading: securities purchased and held principally for the purpose ofselling in the near term

� Valued at fair value

Available for sale (AFS): debt securities purchased with the intentof selling if the need (e.g. liquidity) arises

� Generally the largest part of the regulatory (→)trading book� Valued at fair value

Held to maturity (HTM): debt securities intended to be held asinvestments to maturity

� Valued at amortized cost

22/32


Debt and default


Accounting treatment of bank securities holdings

� Two basic types of change must be accounted for:

Changes in market or fair value: mark-to-market (MTM) gainsand losses affect trading and AFS, but not HTM securities

� Trading: flow through earnings/net income� AFS: affect capital account through accumulated other

comprehensive income (AOCI) account� MTM loss increases AOCI and reduces retained earnings, but notearnings/net income

Changes in creditworthiness affect trading, AFS, HTM securities

� Other than temporary impairment (OTTI) reflected inearnings/net income

� Analogous to loss provisioning for bank loans

� Problem of opportunistic reclassification

� E.g. Citibank Q1 2011 (reported in FT Alphaville 19Apr11):round-trip transfer to HTM, then to trading

� To discourage reclassification, selling any HTM securities causesentire HTM portfolio to be reclassified as AFS and fair-valued

23/32



Debt and default

Bankruptcy and resolutionDebt priority and capital structureBankruptcyResolution of financial firms

24/32



Debt priority and capital structure

Debt priority

� Debt priority: order in which debts are required to be repaid

� May be modified during bankruptcy

� →Allocation of credit risk to lenders: last in line bears greatest risk

� Determined by law and by terms, characteristics of all debtcontracts, including

Security: debt secured by collateral paid in full before unsecured

� Debenture: bond backed by obligor’s general credit

Seniority: debt contract itself may provide for subordination tosenior debt

� Junior or subordinated debt has priority over dividends

Maturity: short-term generally safer than long-term debtCorporate structure: holding company obligations generally

subordinate to those of operating subsidiaries

� Top of “capital stack” generally bank loans, senior secured debt

25/32



Bankruptcy

What happens in bankruptcy?

� Legal process under bankruptcy court supervision

� Adjudicate conflicting claims of creditors, shareholders

� Automatic stay: injunction stops creditor actions to recover debt

� E.g. lawsuits, seizure of debtor’s property, netting of debts� Aims to prevent value-destroying race to grab assets by creditors

� Resolution via court of law

� Two forms under U.S. Title 11

Reorganization (U.S. Chapter 11): rehabilitate firm byrestructuring balance sheet and operations

Liquidation (U.S. Chapter 7): firm goes out of business, withequitable distribution of remaining assets to creditors

� Recovery: bankrupt firm likely still has valuable assets, so creditordoesn’t lose entire amount of debt

� Creditors share in losses beyond debtors ability to pay

� Bankruptcy culminates in bankruptcy discharge

26/32



Bankruptcy

Conflicts of interest among stakeholders

� Senior and secured creditors

� Biased toward liquidation� Have less interest in realization of full value

� Junior creditors and equity owners

� Biased toward reorganization� Have acute interest in realization of full value

� Latent subordination: subordination after the fact

� Form of legal risk: new creditors get in front of old� Debtor-in-possesion (DIP) financing in Chapter 7� Loans by supranationals to distressed sovereigns� European sovereign debt crisis: central bank, supranational

purchases of peripherals’ debt subordinate private holdings

27/32



Bankruptcy

What happens to debt in bankruptcy?� Impaired debt holders become residual claimants, gain control rights

� Capital structure and judicial system determine fulcrum security� Liquidation: debt receives proceeds in priority order

� Senior and/or secured creditors may get full recovery� Subordinated debt may get “haircut” (reduction in par value)

� Reorganization: debt may be converted to equity in newreorganized firm

� Subject to both bankruptcy rules and negotiation by creditors� Cramdown: plan forced upon dissenting class of creditors

� Must adhere to absolute priority rule: if senior class impaired, anyjunior class, e.g. equity, must be wiped out

� Senior creditors may get larger equity stake than subordinated� Senior creditors may get newly-issued bonds and subordinated

creditors may get equity stake� Distressed exchanges: creditor receives securities with lower value

or an amount of cash less than par in exchange for the original debt.Examples: CIT in 2009, Greece in 2012

� Voluntary restructuring as an alternative to bankruptcy: similaroutcome, lower cost

28/32



Bankruptcy

Economic impact of resolution regimes

� Resolution regime: legal processes and institutions applied in eventof firm insolvency or default

� Procedures for resolution of corporate insolvency related to severalefficiency objectives

� Reorganization facilitates maximization of recovery to benefit ofcreditors and possibly owners

� Solution of coordination/collective action problem among creditors� Facilitates fair distribution among claimants, prevents “race to

courthouse”� Preserves going-concern value of estate if larger than liquidation

value

� Alternative view: bankruptcy takes account of wider circle ofstakeholders, e.g. employees, customers and suppliers

29/32



Bankruptcy

International differences in resolution regimes

� Countries vary widely in speed, efficiency, and certainty of legalprocedures

� Better resolution regimes lead to higher recovery rates

� Insolvency leads to nonperforming loans (NPLs) on banks’ balancesheets

� Slow and uncertain resolution leads to larger volume of NPLs forlonger, slow recovery from crises e.g. Italian banks

� Resolution part of broader mechanisms of debt enforcement:ability of creditors to enforce contracts with debtors

30/32



Resolution of financial firms

Financial firms and contracts resolved differently

� !Court-supervised process applied to nonfinancial firms

� In U.S., bank resolution via Federal Deposit InsuranceCorporation (FDIC)

� Depositors senior to other unsecured creditors� Problem of regulatory forbearance

� Broker-dealers excluded from Chapter 11 under Securities InvestorProtection Act of 1970 (SIPA)

� But not their holding companies, e.g. Drexel Burnham bankruptcy1990

� Important exceptions to automatic stay for derivatives and sometypes of short-term credit

� Post-crisis changes, esp. for (→)systemically important financialinstitutions (SIFIs)

31/32



Resolution of financial firms

Rationale for an administrative procedure� Complexity of financial intermediaries

� Potential for disruption of financial system (→systemic risk,contagion)

� Nonfinancial economy dependent on uninterrupted flow of credit� (→)Contagion� Maintain clearing and payment systems

� ⇒Need to resolve speedily� Standard resolution generally involves lengthy negotiations� Example: Lehman Bros. Holdings Inc. bankruptcy filing 15Sep2008,

still ongoing

� Need for predictability in financial resolutions→limit judicialdiscretion

� Protection of retail customers, taxpayers� And correspondingly reduced emphasis on rights of creditors and

shareholders

� Outstanding issue: cross-border resolution regime to be appliedto global intermediaries, esp. banks

32/32

lecture notes on risk management, public policy, and the ...amm26/lecture...

Documents