We invited Price Lowenstein, President of Sovereign Risk Insurance Ltd., to discuss the relationships between credit derivatives and PRI.

The fallout from the sub-prime crisis continues to generate turmoil in the banking and financial guarantee insurance industries. The depth and ultimate outcome of the current crisis, which arose primarily because complex derivative structures based on poor underlying credits were packaged and sold to investors, is difficult to predict. There is certainly the possibility that the entire market for derivative-type instruments could be dramatically different six months or a year from now. Still, there are synergies and relationships between PRI and credit derivatives that may be worth exploring.

What is a credit derivative?

While there is considerable complexity associated with it, a credit derivative is basically a security, like an option or futures contract, whose value depends on the performance of an underlying security or asset. In other words, a derivative is a financial contract whose value is based on, or derived from, a traditional security (such as a stock or bond) or an asset (such as a commodity).

The volume of credit derivatives has exploded in the past ten years, as investors have seized the opportunity to trade in (i.e., to assume or to lay off) the generic credit risk of an asset such as a loan or a bond without having to hold the actual credit asset itself. Because this “synthetic” market does not have the limitations of the “real” market for bonds or loans, credit derivatives have become an alternative, parallel trading vehicle for investors who seek to buy or sell credit protection in order to hedge exposure to corporate or government debt. The most common form of credit derivatives is a credit default swap (CDS), where one party sells credit default protection on an underlying asset to another party for a price.

Why is credit risk management so crucial to the global economy?

Our society lives on credit and depends on credit. Governments (both emerging and developed), corporations and individual consumers all increase their spending power by utilizing credit. Credit allows us to consume far more than we can pay for with cash or other current assets, and therefore is the basis of consumerism. On a macroeconomic basis, credit is the driving force of the world economy. In its simplest form, offering credit means parting with value today against the promise of increased value in the future. Credit risk is simply the risk that this promise will be broken. The advent of credit derivatives has made it much easier to manage the myriad forms of credit risk in a transparent and legally enforceable framework.

The credit derivative market.

During the past ten years, credit derivatives have become a basic tool for risk management in the banking sector for both corporate credit and country risk management. Since the mid-1990s, banks have increasingly used credit protection to diversify and reduce corporate and emerging market exposure inherent in their lending activities. Insurance companies have also participated (mostly in the non-emerging market arena) both as providers of protection (to capture higher returns and better spreads), and as buyers of protection (to manage their exposure and diversify their portfolios). Corporates use the instruments to mitigate effects of adverse credit cycles, and asset managers use them in order to capture higher yields. According to the Wall Street Journal, (January 18, 2008) the current market for CDS is estimated at roughly $45 trillion.

The CDS market for emerging market sovereign/sub-sovereign obligations has also grown rapidly over the past ten years. The standardized documentation that was developed for credit derivatives within the framework of the International Swaps and Derivatives Association (“ISDA”) Master Agreement in 1998 and 1999 contributed to this growth by facilitating participation of a wider range of protection for buyers and sellers. As a result, the market has become more liquid, and tenors for derivative products have increased up to 10 years, and even longer for certain countries. Today, the volume of emerging market credit derivatives is far larger than the underlying emerging market bond market itself.

Credit protection from the PRI market

As most readers of this Newsletter already know, PRI is a broad term which encompasses two very different, distinct categories of risk:

  • Pure political risks such as expropriatory actions, currency inconvertibility or political violence, which lead to a loan default or loss of equity investment; and
  • Comprehensive nonpayment risks, essentially loan defaults which occur for any reason (i.e. political or commercial).

The nonpayment insurance product, which for the purposes of this article we will call NPI, has become increasingly popular over the past five years as banks seek more tools to manage their credit exposures and country limits under the new Basel II Framework. For example, we at Sovereign have seen the demand for our NPI product more than double in the past three years. Because Sovereign does not underwrite private sector Trade Credit (NPI on loans to private sector corporates), for the purposes of this article, I will restrict the product discussion to what Sovereign underwrites, which is NPI for loans to sovereign and sub-sovereign (i.e. at least 51% government-owned) borrowers.

Key differences between NPI and credit derivatives

Although NPI covers the same underlying risk as a credit derivative, the buyers and sellers of the product treat the two products quite differently. The key structural differences are:

  • Conditionality: NPI policies have some of the same Representations, Warranties and Exclusions as standard PRI policies. Due to this conditionality, NPI is not considered “a guarantee of timely payment of principal and interest” as a credit derivative is, but rather as a conditional insurance contract. It should be noted though that some NPI policies now appear to qualify as accepted “Credit Risk Mitigants” under Basel II.
  • Waiting Period: Like standard PRI policies, NPI policies have waiting periods of 90 to 180 days between the actual missed payment date and the date a claim can be made. Credit derivatives have no waiting period, just a settlement period of somewhere between 5 and 30 days.
  • Non-Acceleration: Unlike credit derivatives, NPI does not follow an acceleration of an obligation and NPI does not pay the entire amount of a loss on the date of loss (as credit derivatives do). NPI policies typically indemnify the Insured over the original schedule of principal and interest payments, following the waiting period.
  • Restructurings: In a restructuring scenario, a claim can be made under an NPI policy if the maturity of the insured obligation has been lengthened (since, in effect, there has been a deviation from a scheduled payment). With most credit derivatives, there must be an economic loss to trigger a claim, so that a restructuring under the same or better terms than the original reference obligation is not always considered a “credit event” (i.e., a loss).
  • Premium Payments/Funding: Under a traditional NPI policy, in the event of a claim, premium must continue to be paid throughout the life of the deal whereas under a CDS structure no further premium is paid once there is a loss.
  • Pricing: Because of the conditionality and waiting periods, NPI rates are generally around 70% to 80% of a transaction’s all-in margin. Credit default swaps are generally priced in accordance with market conditions and generally capture 100% of the all-in risk price.

How do banks decide whether to use NPI or CDS on a particular transaction?

Banks have a wide variety of risk mitigation tools available to them.  These include syndication, insurance, derivative protection and various forms of financial guarantees. In our experience, banks use whatever form of risk mitigant is the most strategically advantageous and the most cost efficient for a given transaction. On straightforward, short or medium tenor transactions with well-known borrowers (for example, a three to five-year working capital loan to a large state company like Petrobras or Gazprom), banks tend to use CDS protection, as it is seen as a cleaner, less conditional and more efficient risk transfer tool than NPI. In more complex or longer-dated transactions, NPI may provide better protection by avoiding the “basis risk” (i.e. the risk that CDS protection is not sufficiently tailored and may not respond to certain transaction-specific risks).

As we are seeing the volume of inquiries for NPI increase significantly, it is clear that there are more and more circumstances where banks are choosing insurance over derivatives. The fact that NPI, depending on policy wording, may now qualify as an accepted Credit Risk Mitigant under Basel II, makes it more likely that NPI will become a more attractive alternative for banks protecting themselves against credit risk accumulation.

The CDS market is more limited than the insurance market in terms of the tenors available, the names which can be covered, and in many cases, the total amounts which can be covered. We are seeing a growing trend where large commercial banks are lending to sub-sovereign entities for which there is no CDS market, and also more and more cases where emerging countries are successfully demanding longer tenors (Vietnam is a prime example) than are available in the CDS market.

Derivatives Utilization by the PRI Market.

There are four main areas where PRI underwriters are using, or can utilize, credit derivatives:

Pricing benchmarks – Sovereign, and most PRI underwriters, use the CDS market every day to help us analyze and price risk for our NPI product. Looking at CDS pricing is a very efficient, transparent way to look at the global financial market’s credit risk perception of countries and companies. Since taking CDS protection is an efficient and frequently used option for a bank to transfer risk (and therefore one of the prime complementary, and in some cases, competing products to NPI), looking at CDS pricing provides underwriters with a very accurate view of the pricing dynamics for sovereigns, sub-sovereigns and corporates.

Underwriting NPI on Single Names or Portfolios – Although Sovereign does not, several PRI underwriters do underwrite nonpayment risk on CDS structures (generally for investment banks). This is typically done by modifying NPI policies to cover credit derivative-structured transactions. Although this can be done on a single name basis, it is usually done as a portfolio of synthetic Credit Default Obligations (CDOs), in which a bond is the underlying asset. In the latter, a CDO portfolio can be structured as a “basket” of sovereign credits which are then “tranched” into equity (in insurance terminology – “first loss”), mezzanine (“first excess”) and senior (“high excess”) layers. “Coverage” would then be assumed on a first, second, third, etc. to default basis (i.e. a loss would not occur until a number of the individual names in the portfolio had defaulted). This is a similar structure to an excess-of-loss insurance policy.

Alternatively, credit default exposure can be structured as a single name (i.e. – one credit) basis or on a “first-to-default” position on a portfolio basis. Like insurance, pricing is higher the closer the underwriter gets to assuming a first loss position. These structures also allow PRI underwriters (sellers of protection) to structure coverage in accordance with their individual risk/return appetite as well as their regional and country-specific portfolio balancing requirements.

One of the attractive features of this type of “synthetic portfolio” is the ability to cherry pick the countries which go into the “basket”. Both excess of loss (second/third/fourth to default) portfolios and/or first loss positions can be structured with the mix of exposures that best fit the portfolio balancing needs of each individual underwriter.

Counterparty Limits ManagementBecause major PRI insurers underwrite a large volume of business with the leading commercial and investment banks, on occasion the bank will reach its counterparty limits on the insurer. Some banks will solve this problem by buying CDS protection on the individual insurance company, and can therefore undertake further transactions with the insurer without adding additional counterparty credit risk to the bank’s balance sheet. The bad news for insurers is that this “counterparty credit charge” is generally deducted from the premium being paid to the insurer.

Individual Credit Risk ManagementUnlike insurance risk, which is generally taken on an “underwrite-and-hold” basis, derivatives can be actively traded and hedged. Depending on what the derivatives market will look like once the current sub-prime crisis subsides, it is likely that credit derivatives will become an increasingly common form of risk management, complementing traditional reinsurance programs, for the major PRI underwriters. As seen in the following example on Argentina, with sufficient macroeconomic analytical foresight, large “meltdown” scenarios can potentially be hedged through credit derivative protection. As currency inconvertibility (and, to a lesser extent, expropriation), are collateral risks stemming from economic meltdown/default events, it seems clear that having the knowledge and ability to use CDS protection will be a valuable tool in managing large PRI and NPI portfolios. It seems inevitable that a more active management of risk will be a natural and prudent evolution for the PRI industry rather than continuing to operate indefinitely in the traditional “underwrite-and-hold” format.

Hypothetical Argentina Hedging Scenario.

As an example of how the CDS market could be used in a scenario where traditional PRI underwriters are facing large losses, several years ago Sovereign undertook a study of how credit derivatives could have been used to hedge risk during Argentina’s economic meltdown in 2000-2001. We found that over the sixteen-month period preceding the Argentine default in December 2001, the cost of a one-year CDS for Argentina grew from 360 bp to 8039 bp, and the cost of a two-year CDS for Argentina grew from 460 to 7020 bp. Assuming a PRI underwriter had a CEN/CI portfolio totaling $500 million in Argentina and NPI exposure of $100 million, the following strategies could have been implemented:

In December 2000, a year from the crisis, the insurer could have spent $10 million and purchased two-year CDS protection on Argentina for 585 bps. When the default occurred 12 months later, the CDS default protection would have paid out roughly $170 million. This would have covered not only the $100 million NPI exposure but could also have been used to compensate up to $70 million in potential CEN and CI losses as well. Even assuming the insurer had waited until April, 2001, the same $10 million expenditure for CDS protection would have paid out roughly $81 million.

We also found that significant recoveries could also have been achieved by buying CDS protection in increments at intervals over the same period.

To have an effective sovereign hedging strategy using CDS instruments, it is imperative to maintain a steady, consistent and detailed analysis of macroeconomic and political trends in countries of high exposure. As seen from the movement in CDS spreads leading up to Argentina’s default, a buyer of default protection will always be racing against market sentiment once the negative economic trends become increasingly acute. This will almost certainly conflict with insurance underwriters’ views that a crisis will work itself out (as they often do) rather than go all the way to a full scale meltdown and default. It is also important to keep in mind that CDS protection does not pay out unless there is a defined ‘credit event’ (debt default), so that even if a PRI underwriter adopted the strategy outlined above, they could still be liable for CEN and CI claims had there been no sovereign default (and therefore no payout by the CDS instrument).

Why derivatives may not work for everyone.

There are several issues that we at Sovereign have had over the years which have prevented us from entering into transactions where insurance policies would be used to cover derivative instruments or baskets of derivatives. The principal issue has been the accounting practice known as “mark-to-market.”

Mark-to-market is the practice of monitoring the changes in the daily (or quarterly) value of a derivative contract by calculating the gain or loss in cash flows in relation to the current market value of the position. This practice ensures that the account between counterparties is supported by the minimum amount of margin funds required by the Federal Reserve Board, the Stock Exchange and/or the brokerage house involved. With a relatively small team and a rapidly growing business volume of traditional PRI and NPI business, we do not have the resources to conduct a mark-to-market exercise every quarter, which would be required if a PRI underwriter insures a derivatives portfolio or individual names.

In a broader, more philosophical context, it has been our experience that it is very difficult to convince senior management of large multinational insurance companies that sovereign or sub-sovereign bond exposures are more efficiently handled by writing insurance protection (and getting paid less than the full bond spread), rather than simply buying the bond, or slice of a bond portfolio, adding it to the insurer’s investment portfolio (and getting paid 100% of the bond or portfolio spread). As the fallout from the current sub-prime crisis escalates in global markets and the financial guarantee industry faces downgrades and massive write-downs, it may also be some time before the ultimate utility of credit derivatives as a risk management tool for our industry is clear. It does appear, however, that recent developments have made traditional NPI products comparatively attractive as a means of managing risks. ■