Counterparty risk in a post Lehmans World -- January, 2010


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Results from joint Credit/FitchSolutions survey shows most buy-side firms do not hedge counterparty risk.

Those surveyed cited hedging as too expensive.

The presentation suggest using CDS as early market systems of increasing risk from counterparties.

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Counterparty risk in a post Lehmans World -- January, 2010

  1. 1. Counterparty Risk in a Post Lehman’s World January 28th, 2010
  2. 2. Fitch Solutions Representatives Presenter ● Jonathan DiGiambattista, Managing Director, Global Head of Risk and Performance Analytics The Panel ● Damiano Brigo, Managing Director, Quantitative Analytics ● Diana Allmendinger, Director, Research ● Catherine Downhill, Director, Integrated Data Services ● Jesse Waters, Director, Risk and Performance Platform January 28, 2010 1
  3. 3. Fitch Solutions is a leading provider of credit related analytics and data services ● Products & Services include: – Risk & Performance Platform for monitoring market-based credit risk signals and CDS price movements – Integrated Data Services providing CDS & ABCDS pricing, fundamental financials, Fitch Ratings and market-based risk data – credit research portal ● Market leading Quantitative Analytics team ● Commentaries and Publications: – Weekly Risk and Performance Monitor providing overview of credit-related market movements of sectors and regions – Bi-weekly Liquidity commentaries highlighting liquidity in the CDS market – Available on January 28, 2010 2
  4. 4. Agenda ● Results of Counterparty Risk survey ● Meeting the challenges posed throughout the credit risk monitoring workflow ● Benefits, shortcomings and options for using the CDS market for risk signals ● A real-world example of counterparty risk management in a post- Lehman world ● Question and Answer January 28, 2010 3
  5. 5. Counterparty Risk Survey 2009 January 28, 2010 4
  6. 6. Counterparty Risk Management Survey 2009 ● 85 Counterparty Risk Manager interviews during October 2009 ● 11 broad questions were asked re: current practices and changes since the Lehman default Do you actively hedge counterparty risk? Are you set up to use central counterparties? What other measures do you have in place to How many banks do you regularly deal with now? manage counterparty risk? Pre-Lehman? What measures do you have in place to monitor What factors influence your decisions not to trade counterparty risk? with the best priced dealer? How common are break clauses? Which dealers include their own credit risk as a discount? Are you in favor of segregated margin accounts? How have your counterparty risk practices changed over the past year? What is the impact of central counterparties on your business? ● Results published in December issue of CREDIT ● Full results of the report and related articles available for download on January 28, 2010 5
  7. 7. Counterparty Risk Survey Results ● Results from joint Credit/FitchSolutions survey shows most buy-side firms do not hedge counterparty risk ● Those surveyed cited hedging as too expensive – ‘manage’ counterparty risk – Limits and collateral – Calculating exposure – Monitoring for ‘early warning’ Source: credit/FitchSolutions Counterparty Risk Survey ● >75% of respondents are not set-up to trade on CCPs January 28, 2010 6
  8. 8. Survey shows increased efforts on monitoring CP credit quality ● 63% of respondents deal with fewer counterparties today than before Lehman defaulted – Respondents did not see benefit of counterparty diversification due to nature of derivatives, correlation of derivatives and FI credit risks – Fewer counterparties allows for better monitoring and enforcement of credit quality standards ● Market participants were least satisfied with counterparty credit risk monitoring and Market Liquidity Source: credit/FitchSolutions Counterparty Risk Survey January 28, 2010 7
  9. 9. Survey respondents cited internal workflows pose challenges for monitoring CP credit risk 66% of CRMs depend upon risk Counterparty selection: >60% of assessments from a centralized CRMs deem credit risk the leading Credit Risk function for an official reason to NOT trade with an risk assessment; 33% do not use a ‘approved’ counterparty; 40% cited formal credit risk assessment liquidity 5-10 Active Counterparties CRMs adjust limits and collateral requirements according to perceived likelihood of downgrades or credit events. January 28, 2010 8
  10. 10. 5-10 Active Counterparties Central Risk Assessments form ‘short-list’ of approved counterparties; also used for allocating capital ● Assessments made by credit analyst and guided by formal credit policy – Factors include: Financial Performance Agency Ratings Capital Adequacy Sovereign Support Market Signals Sovereign Risks / Ratings Industry Standing Management Quality – Central risk assessments are ‘official’ views of entity credit risk often using rigid methodologies, particularly among BIS-II compliant firms ● Internal assessments impact P&Ls as enterprise capital requirements are based on internal-risk-weighted exposures January 28, 2010 9
  11. 11. 5-10 Active Counterparties Counterparty Risk Manager challenges: Avoiding adverse counterparty selection & optimize exposure to existing counterparties ● Imperative for CRMs to select counterparties on short-list with least likelihood of future downgrade or credit event within contract horizon ● CRMs take action on limits, collateral and hedging based on continuous monitoring of counterparties for risk migration relative to existing exposure Additional Capital Charge Future Increase Exposure Possible forced ‘sale’ for Economic Loss Downgrade economic loss Maintain limits & collateral Req’s Reduce limits Stable Stable Capital Charge Economic Loss Increase Collateral Req’s Rating Aggressively reduce limits Increase collateral req’s Hedge to eliminate exposure Future Reduced Capital Charge Upgrade Economic Loss No Future Credit Event Future Credit Event January 28, 2010 10
  12. 12. Meeting the challenges for monitoring counterparty credit risk January 28, 2010 11
  13. 13. CRMs are dissatisfied with their ability to access and integrate CP credit risk signals ● CRMs have significant informational needs around current risk levels and potential for credit risk migration – Anticipating changes to internal risk assessments – Full transparency into central risk methodologies and policies, and access to relevant data: Fundamental Financials Agency Ratings Capital Adequacy Sovereign Support Market Signals Sovereign Risks / Ratings Industry Standing Management Quality – Anticipating future credit events – External credit risk assessments – Early warning, benchmark and relative risk indicators – “News flow” January 28, 2010 12
  14. 14. CDS market and derived metrics are best early warning signals available ● Cardinal and ordinal levels observed in the CDS market have most direct implications for credit risk managers ● From the CDS market we can derive: – PDs for individual entities – Relative risk levels by region/sector – Historical cycle comparisons – Sector performance – Aggregate expectations for future default rates January 28, 2010 13
  15. 15. But Cardinal values are difficult to rationalize Implied PD for FI’s = 9.1% (40% recovery) Source: FitchSolutions January 28, 2010 14
  16. 16. False signals can cloud decision-making 450 400 350 300 250 200 150 100 50 0 11/4/07 11/19/07 12/4/07 12/19/07 1/3/08 1/18/08 2/2/08 2/17/08 3/3/08 3/18/08 4/2/08 4/17/08 5/2/08 5/17/08 6/1/08 January 28, 2010 15
  17. 17. March 5th, 2008: Bear & Lehman have non-IG trading patterns Merrill Bear Stearns Source: FitchSolutions Risk & Performance Platform Source: FitchSolutions Risk & Performance Platform Lehman January 28, 2010 16
  18. 18. CDS liquidity signals uncertainty Citigroup Inc. Lehman Brothers Holdings Inc. Royal Bank of Scotland Plc (Liquidity Score) 12 RBS percentile Rk = 72 11 RBS 10 nationalization RBS Citigroup percentile percentile Rk = 63 9 Rk = 7 8 Lehman percentile Rk = 8 7 Citigroup 6 percentile Citigroup Rk = 2 Lehman bankruptcy capital injection 5 Jan 07 Jun 07 Nov 07 May 08 Oct 08 Mar 09 Sep 09 Source: Fitch Solutions January 28, 2010 17
  19. 19. CDS early warning proved valuable through the crisis January 28, 2010 18
  20. 20. A return to uncertainty for Financials, Sovereigns Liquidity for 25 Most Liquid Financials vs Sovereigns 6 6.5 FS Liquidity Score 7 7.5 8 8.5 9 6/1/07 8/1/07 10/1/07 12/1/07 2/1/08 4/1/08 6/1/08 8/1/08 10/1/08 12/1/08 2/1/09 4/1/09 6/1/09 8/1/09 10/1/09 12/1/09 Financials Sovereigns
  21. 21. Using Fitch Solutions content to monitor Counterparty Credit Risk January 28, 2010 20
  22. 22. A counterparty risk manager requires timely and accurate data to meet 3 key needs: January 28, 2010 21
  23. 23. Fitch client counterparty risk monitoring practices ● Mid-sized buy-side firm transacts with financial institutions for interest rate, foreign exchange hedging, and utilizes banks for cash management – Short-list determined by screening the Fitch international bank universe for firms with individual rating of ‘B’ or better, at least $100bn in assets and a maximum leverage ratio. – Per internal credit policy, maximum exposure limit scales with the Fitch individual rating. – The CRM has the ability to further limit exposure depending on perceived risk migration. To do so, the CRM monitors the following on his portfolio of counterparties : – CDS Implied Ratings (and ‘gap’ with Agency ratings), CDS spot- spreads and CDS benchmarks – Fitch Ratings status (outlooks, watches) and research and announcements – Financial results January 28, 2010 22
  24. 24. Counterparty Risk Management Post-Lehman ● Increased focus on counterparty selection and credit risk monitoring ● CRMs have taken on additional responsibilities for anticipating future credit events ● Information challenges persist in anticipating future movements in credit risk assessments and potential credit events ● Integration of fundamental financial data, market data, agency ratings, and fundamental research is essential for the contemporary counterparty risk manager January 28, 2010 23
  25. 25. Fitch Solutions Research, Commentaries and Related Information ● All our research and commentaries can be found on and include: – Risk and Performance Monitor – Weekly monitor assessing geographical CDS spread movements and market indicators of credit risk – Fitch Solutions/Credit 2009 Counterparty Risk Survey – A write up of the survey we undertook with Credit into Counterparty Risk – Fitch Solutions' Global CDS Liquidity Scores Commentaries – Bi-weekly commentaries on the liquidity in the CDS market – Quantitative Research • Articles include: “Counterparty Risk for Credit Default Swaps” ● If you’d like to learn more about our products or research please contact the Fitch Solutions team: – – – – – January 28, 2010 24
  26. 26. Fitch Solutions New York London One State Street Plaza 101 Finsbury Pavement New York, NY 10004 London +1 212 908 0500 EC2A 1RS +1 800 75 FITCH +44 20 7417 4222 Fitch Group Fitch Ratings Fitch Solutions Algorithmics January 28, 2010 25