SCI Magazine Aug 2010


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Features in this issue include: CDS Clearing: Correlation; ILS; Wholesale Structured Products; Australian MBS; interview with Amherst Securities; Prica Talk and Data

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SCI Magazine Aug 2010

  1. 1. Issue 3 August 2010Vanilla structures returnLess complex rate products in vogueFocusing on ILS issuance RMBS and Structured CDSrisk chemistry expectations bank ratings credit ideas clearing
  2. 2. Your securities. Priced.When you work withhard-to-price securities,you need a source youcan count on.Standard & Poor’sGlobal Evaluations.You know the big providers of global securities evaluations. But do you know whatmakes Standard & Poor’s different? With over 35 years of experience in the pricingbusiness, we’re continuously expanding to meet your evolving needs.ABS, MBS, CMBS, CDOs and more — we’ve got you covered. And, we work closely withyou to anticipate and address new market developments.Knowledge, independence, and direct access to the professionals behind the thinking.It’s what you expect from a market leader.For more information: Americas 1.212.438.4500 Europe +44 (0)20 7176 7454 & Poor’s Securities Evaluations, Inc. (SPSE) is a registered investment adviser, which is part of Standard & Poor’s Valuations & RiskStrategies, and is a wholly owned subsidiary of The McGraw-Hill Companies, Inc. SPSE publishes evaluated pricing, customized reports on valuations ofsecurities under various scenarios, and analyses of certain U.S. and European fixed income securities using its proprietary risk to price scoring methodology.Analytic services and products provided by Standard & Poor’s are the result of separate activities designed to preserve the independence and objectivity of eachanalytic process. Standard & Poor’s has established policies and procedures to maintain the confidentiality of non-public information received during each analytic process.
  3. 3. Issue 3 August 2010Contents 2 The Interview Navigating changing markets Joe Walsh, president of Amherst Securities, shares his views on 2 the ABS and MBS markets and the future strategy of his firm 6 Wholesale Structured Products Vanilla structures return Suddenly mundane is popular again. As Kathy Fitzpatrick Hoffelder discovers, complicated rate product strategies that have Editor been marketed as ‘too sophisticated to fail’ are out. Institutional Mark Pelham investors instead are contemplating ways to offset an ever 6+44 (0) 20 7438 1126 steepening yield curve and find a little bit of yield along the waymp@structuredcreditinvestor.comDesign and ProductionAndy Peat 11 Structured Risk chemistryContributors The relationship between credit trading and risk management is Jillian Ambrose attracting more attention in today’s plain vanilla, post-crisis world. Madhur Duggar, Batur Bicer, Matthew Many institutions are putting a greater focus on CVA and reserve 11Leeming, Søren Willemann and Rob models, while others are moving credit risk managers up the Hagemans of Barclays Capital Credit hierarchy. Rachael Horsewood reportsResearch 6 ILS 1Kathy Fitzpatrick HoffelderRachael HorsewoodJames LinacreRichard Lorenzo and Patrick Winsbury of Greater expectationsMoody’s Investors Service Insurance-linked securities are typically thought of as a specialist Corinne Smith asset class. However, as Jillian Ambrose explains, catastrophe bonds are generating increasing interest from non-insurance 16Managing Director investors, which in turn could be met by increased new issuance John-Owen Waller volumes+44 (0) 20 7061 6335jow@structuredcreditinvestor.comSales AssociateGrace O’Dwyer Smith 1 ABS 2+44 (0) 20 7061 RMBS, bank ratings and risk Richard Lorenzo, vp structured finance, and Patrick Winsbury, svp financial institutions, at Moody’s Investors Service look at the 21© SCI. All rights reserved. Reproduction in any form relationship between RMBS issuance and Australian bank ratingsis prohibited without the written permission of the publisher.ISSN: 2043-7900Although every effort has been made to ensure 5 Structured Credit 2the accuracy of the information contained in this publication, the publishers can accept no liabilities for inaccuracies that may appear. No statement made in Simplicity is keythis magazine is to be construed as a recommendation Madhur Duggar, Batur Bicer, Matthew Leeming, Sørento buy or sell securities. The views expressed in this publication by external contributors are not necessarily Willemann and Rob Hagemans of Barclays Capital Credit those of the publisher. Research take a look at the potential for structured credit productsPrinted in England by Hastings Printing Company 25 1 CDS ClearingLimited, Drury Lane, St Leonards-on-Sea, East Sussex TN38 9BJ is published by Cold Fountains Media Limited and 3distributed in the USA by SPP, 75 Aberdeen Road, Emigsville, PA. 17318-0437. Periodicals postage paid at Emigsville, PA. Clearing consensus A consensus has been reached about the benefits of CDS POSTMASTER: send address changes to SCI PO BOX 437, Emigsville, PA. 17318-0437. clearing. But, as Corinne Smith and James Linacre discover in Subscription Rates: this special report undertaken for SCI’s online service, concerns £930 +vat for an annual subscription over pricing and liquidity remain€1200 Europe $1650 ROW 31 7 Data 3Subscription enquiries: Ike Aneke +44 (0) 20 7061 6334 ABS, CDOs and natural catastrophe bonds issued over the last three months 1
  4. 4. The Interview NavigatingJoe Walsh, president of Amherst Securities,shares his views on the ABS and MBSmarkets and the future strategy of his firmQ: How would you characterise Amherst Securities’ role in the Q: How would you differentiate yourselves from other similar securitisation space? firms that have launched in the securitisation sector overA: Amherst is one of the leading US broker-dealers specialising the past few years? in the mortgage-backed securities space. We serve institutional A: Amherst has been around since 1993, so the first differentia- investors and actively work in both the new issue and second- tion really is our experience and significant track record of ary markets. success. We have helped our clients navigate several economic Our approach has always been to ensure we have a solid cycles, including the most recent one which resulted in many grasp on the market fundamentals by balancing our proprietary of our competitors dissolving or significantly scaling back their data and analytics with a deep understanding of the technical services. aspects of what moves the market. Our analytics and data serve The other real distinctions that separate our firm from as our strategic advantage over other firms and are highly others are the quality of our proprietary data and analytics, valued by our customer base. the quality of our people, and the fact that we have significant2 SCI August 2010
  5. 5. The Interviewchangingmarkets capital behind our operations, includ- form. As a firm, we are committed to in the space. The addition of these two ing capital from our employees and the looking at opportunities where access products will also diversify our rev- additional capital raised in 2008 from to fundamental performance data and enue stream and should make us even a group of institutional investors led by thorough and thoughtful analytics more meaningful to our customers. Stone Point Capital. can add value and we believe that the ABS and CMBS markets provide this Q: How does this affect your establishedQ: Over the past six months you’ve opportunity. RMBS business? made some major hires in ABS and Our aim is to succeed with the same A: Our expansion into ABS and CMBS is CMBS – what are your aims for strategy we’ve successfully deployed in a completely natural and complemen- these two asset classes in particular? the residential sector – providing better tary extension of our RMBS business,A: ABS and CMBS are natural exten- data, analysis and understanding of the which will continue to be a major focal sions of our leading residential plat- market fundamentals than anyone else point for our firm. There is significant 3
  6. 6. The Interview“Recently we have seen confidence in a steady,upward-sloping recovery erode and volatilityre-introduced into the marketplace” amount of customer overlap between Q: Where do you see the bulk of your Q: Which factors do you need to con- the different sectors and many of the business and/or market opportuni- sider in adapting to these changes? lessons we’ve learned over the years ties coming from in the second half A: There are a lot of economic, politi- in the RMBS space can be naturally of 2010 and why? cal and regulatory issues that are applied to these categories as well. A: Recently we have seen confidence in a impacting consumer and borrower steady, upward-sloping recovery erode behaviour. We believe it is criticalQ: What are the lessons you have and volatility re-introduced into the to appreciate the potential impact on learned in the RMBS space? marketplace. In addition, the funda- fundamental performance that theseA: There were really multiple conflicts in mental performance of residential issues create. the securitisation business model lead- and commercial mortgages and other In addition it is likely that we will ing up to the recent crisis and in large consumer and corporate assets contin- see a technical response from the part they are still being sorted out. The ues to evolve in the face of economic market to the extent the performance level of faulty analysis and decision- pressures and regulatory reform. differs from expectations. We pride making that went on in terms of select- These factors are going to lead ourselves on understanding the poten- ing which loans were securitised and investors to more actively seek out tial outcomes and factoring those into which weren’t was much higher than the expertise and analytical edge that a thoughtful view of risk and opportu- people anticipated. Amherst provides. People want a firm nity. We’ve been extremely focused on The origination and loan underwrit- they can trust, particularly in this type those things, as evidenced by some of ing standards that were applied in the of volatile market. our published strategy reports show- process were severely compromised We believe the market dynamics ing our early positions on things like and massively underestimated by the are going to provide some interesting loan modifications, second liens in the market. To navigate through the mess trading opportunities in the second half residential MBS market. that was left over you really need to of 2010. Investors will need to react to have access to great data and dynamic these changing conditions and we’re Q: Which specific impacts could those analytics to see through the carnage going to be there to help people form economic, political and regulatory and find opportunities. those reactions and opinions. issues have on performance?4 SCI August 2010
  7. 7. The Interview“Fundamental performance is going to continueto evolve and it’s likely going to end up beingdifferent than the market expects”A: Ultimately all of those factors could We think we’ll ultimately be better A: If the economy is going to make a have a very large impact because they positioned than others, but it’s going to substantial recovery, then you have all can change fundamental perform- evolve over a very long period of time. to believe the securitisation markets, ance. For example, there was a lot of which were such a big piece of provid- regulatory rule changing that went on Q: What sort of technical response ing the capital for the vibrant and when Bear Stearns essentially went do you anticipate from the market growing consumer-based economy last bankrupt and that changed the outcome if performance does differ from decade, are going to make a recovery allowing their debt to get paid 100 cents expectations? as well. But in general, those involved on the dollar. But it’s clear these factors A: I suspect there could be a series of knee in the securitisation market are going can have a real impact on actual per- jerk reactions, especially in situations to be very focused on making sure we formance. You have to understand the where people don’t truly understand can use securitisation to fuel growth potential of those impacts and under- why performance differs from expecta- while eliminating the obvious conflicts stand how exposed you are to them. tions. We could elicit some uninformed which historically dominated the new Political and regulatory pressures responses and that could be good or issue structured finance markets and become extremely influential on issues bad for market participants. resulted many failed transactions. I like loan modifications, so while you suspect what you will see in 2011 is may not be able to predict them, you Q: What is your position on loan the new issue market trying to address had better understand what various modifications and second liens in the those concerns and convince investors scenarios mean to you and factor that RMBS market? that they are adequately protected from into your strategy and make sure you A: Put simply, the second liens are stand- the mistakes that fuelled the recent are getting paid for that risk. Knowing ing in the way of a lot of loan modifica- credit crisis. what can happen to you, being able to tions. We believe the most effective see it happening and seeing it first it loan modifications involve principal Q: Beyond ABS and CMBS, does could create some very real and profit- reduction and it’s really difficult to do Amherst have plans to grow its busi- able opportunities. that when the second lien holder is the ness into other securitisation areas? servicer or is unwilling to have his debt A: Not at this time. We think there areQ: In general, what are the types reduced or written off at that point in plenty of opportunities in the RMBS, of trading opportunities you’ve the modification. As a result, use of CMBS and ABS space. We’re poised to mentioned? principal reductions in loan modifica- provide more knowledge, insight andA: Fundamental performance is going tions has yet to have a meaningful reliable data on the entire mortgage to continue to evolve and it’s likely impact. industry than any other broker-dealer. going to end up being different than the We may ultimately look to expand market expects. It’s hard to predict how Q: Longer-term, how do you see the beyond those products, but right now we will ultimately end up and why, securitisation market landscape in we are focused on building those exist- which is the challenge for us all, and 2011 and beyond? ing businesses. ultimately will separate the winners from the losers in this space. For instance, how loan modifica- About the interviewee tions or foreclosures ultimately play Joe Walsh, president of Amherst Securities, co-manages the business and out when the moratoriums are lifted operations of the Amherst Companies. He has been in the mortgage-backed will create outcomes that are likely to securities business for almost 25 years. be different than what people expect Walsh previously served as an md in the private equity business at Fortress at the moment. So companies that can Investment Group specialising in financial institutions. He also served for nine years see through that and see it first will as an md and head of mortgage and asset-backed origination, finance and trading at have an advantage. Everyone who is RBS Greenwich Capital. trading today has some opinion on how He earned his B.A. in Biology at Princeton University. and when these things will play out. 5
  8. 8. Wholesale Structured Products Vanilla structures returnSuddenly mundane is popular again. As Kathy FitzpatrickHoffelder discovers, complicated rate product strategiesthat have been marketed as ‘too sophisticated to fail’ areout. Institutional investors instead are contemplating ways tooffset an ever steepening yield curve and find a little bit ofyield along the way6 SCI August 2010
  9. 9. Wholesale Structured Products Chart 1 The BAML MOVE Index – three-year performance 300 250 200 150 100 0 Oct 2008 Apr Jul Oct 2009 Apr Jul Oct 2010 Apr Source: of America Merrill Lynch MOVE is the Merrill Option Volatility Estimate. This is a yield curve weighted index of the normalised implied volatility on 1-month treasury options. It is the weighted average of volatilities on the CT2, CT5, CT10, and CT30. `MOVE’ is a trademark product of Bank of America Merrill Lynch. puts it: “Most people are into preserva- currency concerns, he says, noting capital tion of capital but they are concerned preservation did not help European-based about exactly how you do that when your investors much since the euro has depre- historic risk free is now full of risk.” Fur- ciated against all major currencies. ther he says: “Everything has basically It is not all doom and gloom out there, become a credit including government however. A Goldman Sachs research bonds and that makes it very difficult. report in June notes the current macro That’s why you are seeing the kind of and regulatory backdrop is much better yields you are seeing on treasuries and than two years ago. For instance, private bunds.” sector imbalances are much smaller, Indeed, global bond markets have been having moved into surplus in the major rocked by a range of events from Lehman economies. “This means balance sheets and the start of the crisis, to sovereign are stronger and there are more savings debt issues with a few government bail- available to fund the deficits,” the reportT outs and periodic support thrown in for notes. good measure. Bank of America Merrill But try convincing institutional he landscape has changed for Lynch’s Option Volatility Estimate investors of that and one gets a myriad of creating interest rate deriva- (MOVE) Index, which measures option responses. “There’s so much risk, volatil- tives products that protect volatility on US treasuries, has seen dra- ity and uncertainty, it’s hard to turn the principal and offer attractive matic swings from its widest levels seen table and say you have to do this for 100% yields. First, the very amount in 2008 when it topped more than 260 to of your portfolio,” says Gary Pollack, mdof principal to protect has vastly dimin- the 70s currently (see chart). The 10-year and head of fixed income research andished for many investors and what kind of bund yield has dropped to 2.67%, in from trading for private wealth management atprotection is on offer is also up for grabs. a little over 3% last summer, while the Deutsche Bank Securities.Gone are the days when so-called liquid 10-year treasury yield has slid to 3.19% However volatile government securi-and transparent index based transactions from 3.5% at this time last year. ties and related products have been lately,promised ‘expected’ anything. Not much Capital preservation itself has also investors generally agree one has to putis expected anymore in this post credit altered in meaning and scope, according money to work somewhere. Everyonecrisis environment except uncertainty and to John Brynjolfsson, md at investment realises the natural rate for the 10-yearvolatility. management firm Armored Wolf. Capital treasury is not 3% but something higher, As Gary Jenkins, head of fixed income preservation is taking on a new defini- notes Walter Schmidt, svp and managerresearch at Evolution Securities aptly tion where people are more sensitive to of structured product strategies at FTN 7
  10. 10. Wholesale Structured Products asset side to match your liabilities,” notes Jochen Felsenheimer, co-head of credit at Assenagon Asset Management. Investors in general are a bit more sophisticated than prior years and demand at least a minimum return. This is the case with steepener trades put on between the 10-year and 30-year government bond curves, in which one sells CDS protection on the short end and buys protection on the long end. Along with the trades, some investors favour having a cap and a floor, which was not the case five years ago, adds Felsenheimer. One caveat is “if interest rates stay low, you probably just earn the minimum on the interest rate structure, but normally you do not have dramatic problems on the rest of the risky part of your portfolio,” he says. Walter Schmidt, FTN Financial Jochen Felsenheimer, Assenagon Capital Markets Seeking yield at the right cost Asset Management Since loan demand is very low, deposito-Financial Capital Markets. “People are ries continue to reach for yield in the port- Bill Gross, md at Pimco, reiteratedconcerned we might be in a bubble for folio, says Schmidt. “Right now for most the changed landscape for investors inbonds now. It’s just that we might be index based customers, and to a lesser his firm’s June commentary. “No longerhere for quite awhile so if we are here extent, even liability based customers like will ‘two get you three’ in the investmentfor a while and sitting in cash, you are depositories and insurance companies, world. Not 1,000%, but 4-6% annual-going to underperform and underperform everyone’s looking for some return in this ised returns for a diversified portfolio ofseverely,” he says. environment,” he notes. stocks and bonds is the likely outcome,” There is still a tremendous amount However, with the exception of the he writes.of liquidity in this system, Schmidt corporate bond market, it’s very dif- But where to get even that yield is upobserves. “We’ve been in this environ- ficult to continue to add assets without for debate. The high yield corporate bondment for almost two years now where the the overall market overpricing itself, he market in the US is the favoured segmentmarket is liquidity rich and capital poor. notes. “This is exactly this deflationary or of the market, says one US-based assetWhat the Fed is obviously trying to do is at least disinflationary environment that management firm’s research head. “Whenoffset the tremendous capital burden and Bernanke is quite concerned about.” you have a great year in high yield, ittremendous write-downs that still need to Schmidt adds: “Those that are ratings- leads to good years to follow and defaulttake place,” he explains. constrained are reaching a bit for yield rates come in,” he says. He also sees the Insurance companies, for one, are because they have to. The fact of the mat- sector as somewhat removed from thestill looking at interest rate structures ter is if you look at a state pension or cor- sovereign debt crisis in Europe. Returnssince they regularly need to match their porate pension, most of them have their often are in the 9% range, he says.liabilities. “A lot of insurance compa- returns at 6-10% but no one’s earning SocGen’s quantitative strategist Marcnies have probably blown through their 6-10% in any market, including equities. Teyssier adds that those investors that arereserve levels. It becomes harder and The reach for yield is very, very powerful, more bullish on the economy are willingharder to generate enough return on the very strong.” to invest in the high yield market – something that only has occurred in rapid pace since the beginning of the year. “You“On the one side, there’s a very have all non-financial companies that have very good results so far,” he says.bearish focus on sovereign “On the one side, there’s a very bearish focus on sovereign risk and on the other side, there’s more focus on what’s hap-risk and on the other side, pening on corporates,” Teyssier says. The result has led to a compression of creditthere’s more focus on what’s spreads. “Hedging credit portfolios is the hottest topic right now among investors.”happening on corporates” But for Pollack, he views the invest- ment grade bond market as a better bet in8 SCI August 2010
  11. 11. Wholesale Structured Productsthis post credit crisis environment. “Wethink this is a good opportunity to pickup some additional yield without really “We would expect a largepicking up that much increased risk as away to capture higher returns in the fixed amount of issuance from theincome markets,” he says. Pollack is underweight in treasury Treasury in the 30-year sector not just to finance existingholdings since he used that money toincrease exposure to corporate bonds. Hebelieves rates are likely to stay lower alittle longer than originally believed. deficits but to finance the rolloverFactoring in steepeningInvestors right now are also trying to take shorter maturity treasuries”advantage of the steep yield curve so theyare bidding up the price of fixed incomeassets, adds Schmidt. For the most part, good trade opportunities in the long end The Treasury recently extended its tar-they are focusing on the front end of the of the euro swap curve, but people tend to get maturity for federal debt to 84 monthscurve as opposed to the long end, he stay away from it since it’s a “pain trade” or 7 years from as low as 48 monthsexplains. The yield curve between the US due to the uncertainty in the market, says during 2009, which makes it more likelytwo-year treasury and the 10-year treas- Ungari. “If everything goes wrong, it’s to issue out the curve. At a Treasury Bor-ury stands at about 248bp, which is in the kind of trade you cannot get away rowing Advisory Committee meeting infrom 290bp earlier this year. Years earlier, from,” she adds. May, the Treasury said it believes its over-say in 2002, for example, the yield curve The 30-year maturity is also subject to all debt issuance schedule is appropriate.was closer to the 2% level at 220bp. huge volatility due to some flows coming “Consistent with the desire to increase While historically steep yield curves from pension funds, Ungari says. The the average maturity of outstanding debt,can be inflationary, they can also be a flows are not predictable and bring lots the Committee recommends that issuancestep in the right direction economically. of volatility in the 10s/30s sector of the sizes in two-year, three-year and five-year“Steepening trades are attractive because curve, she notes, adding that the segment maturities be reduced meaningfully, withthey pay good carry. People will try to also sees constant maturity swap hedging smaller reductions in seven-year, ten-yearfind trades which pay good carry over the flows as well. and thirty-year maturities.”short term,” says Sandrine Ungari, quan- To others, the key right now is to The Treasury also decided last May totitative strategist at SocGen, noting the avoid the long end at any cost. Particu- increase the frequency of Treasury Infla-trades make more sense in euros currently larly if interest rates rise, the US-based tion Protected Securities (TIPS) auctionsthan in US dollars. asset management firm’s research head by having a second reopening to 10-year But further out along the curve, inves- is turning away from bonds with a high TIPs offerings. It brings the total to sixtors start to get skittish. There are really duration. He is also advising clients to 10-year TIPS auctions per year. The new seek out maturities 5-years and under. “Most bonds even with a 10-year duration are getting called,” he adds. Some hedge funds and money manag- ers are, however, buying long-term US treasuries, and even have large mandates in place, but according to Brynjolfsson, the curve is still expected to be steep. “There are buyers of these long term treasuries, but I think the very steep yield curve is here to stay and possibly get steeper,” he says. Three large sellers of long-term treas- ures are likely to keep the curve steep, he explains. The Treasury, Federal Reserve and China all have their reasons to unload or sell the securities, says Brynjolfsson. “We would expect a large amount of issuance from the Treasury in the 30-year sector not just to finance existing deficits but to finance the rollover shorter matu- Marc Teyssier, SocGen rity treasuries.” Sandrine Ungari, SocGen 9
  12. 12. Wholesale Structured Products“More and more traditional really know how the new regulation is going to affect them,” says Teyssier. The tranche market is still, however,money accounts are now an outlet to hedge the volatility of mark to market. Lots of people buy protectionlooking to create different risk on senior index tranches, he adds, noting that the combination of systemic risk andreturn profiles by moving into regulatory risk is why spreads in this area have widened so far, especially in Europe. What is occurring more often, though,new asset classes” is a variety of hidden correlation offers, such as when banks are trying to hedge their exposure by selling part and bychange begins with the July new issue continues to monetise the fiscal deficits, keeping some correlation risk, notes10-year TIPs offering. explains Brynjolfsson. “I would expect Felsenheimer. But problems still exist The Fed’s decision last year to curtail that would cause the bond market to in selling the paper. “They need to findits planned US$300bn buying programme remain sceptical – both of inflationary a buyer for this stuff. Except for hedgesimilarly is still having an effect on the impact of those policies and the solvency funds I don’t see any trades,” he adds.curve. “The Fed is examining very care- impact of those policies increasing Credit index options, however, are prov-fully the possibility of selling their exist- amounts of federal liabilities,” he says. ing they are able to withstand the crediting holdings rather than let them mature,” crisis a bit more than other structuredsays Brynjolfsson. Seeking alternatives products. Options trading on iTraxx Main The existing plan was to hold onto Other investors are venturing a little bit and on CDX have been popular lately.their long-term treasuries and allow them beyond their comfort zone for yields – if “They [CDS index options] don’t suf-to mature through the natural seasoning ever so slightly. More and more tradi- fer from the bad reputation of tranches.process rather than sell them, he notes. The tional money accounts are now looking There are more clients willing to invest inprocess would still put selling pressure on to create different risk return profiles that kind of instrument against a spreadthe long-end, however, due to the Fed’s by moving into new asset classes, says widening,” says Teyssier. “An out-of-the-overweight position of long-term treasuries. Felsenheimer. But more often than not money option does not cost a lot but is Globally government issuance will it means implementing new strategies an efficient hedge against a spread blowremain high with net issuance in the cur- within traditional asset classes, or in out. Credit options are a very interest-rent financial year expected to be about a sense, creating a new definition for ing product for clients that want to hedgeUS$1.9trn in the US, €300bn in the euro what alternative investment means, he their credit exposure.”area and £150bn in the UK, according to explains. Whether or not rate products are thea report by Morgan Stanley analysts last Indeed, more exotic correlation trades panacea for investors right now remainsMarch. are not as popular as they once were with to be seen, but one thing is certain. Inves- A likely scenario going forward is investors, especially due to regulatory tors are not going to sit around and waitthat the Fed continues to keep short end measures to be implemented under Basel for the next bubble to appear – whether inrates low, below the inflation rate, and 3 in Europe. “Market participants don’t bonds or not.10 SCI August 2010
  13. 13. Structured Credit The relationship between credit trading and risk management is attracting more attention in today’s plain vanilla, post-crisis world. Many institutions are putting a greater focus on CVA and reserve models, while others are moving credit risk managers up the hierarchy. Rachael Horsewood reports Risk chemistryC redit risk management and trading are working “It is fair to say that the credit risk manager role has moved together more than ever before. Some sources say up a notch now. When you consider that credit risk is being this is how it should have always been. Others transferred from an originating desk to a credit risk management believe it is only perception given the market’s risk- group, it is only natural for the risk managers and traders to work averse mood since the crisis. “Credit risk manage- more closely. We see them working together more when it comesment is definitely experiencing a new evolution – it is viewed to valuation and pricing too. But traders are still the top dogsmore as a value-added function now,” asserts David Kelly, the when it comes to pay packages since they are the ones generatingdirector of credit product development at Quantifi, a specialist revenue,” Kelly company. A portfolio manager in London adds: “Traders are more He agrees credit risk management has distinguished itself more aware of credit risk and capital charges but not as much as theyfrom other types of risk management since the crisis. Market would if these things impacted their bonuses.” He says a lot ofrisk managers, for example, are still viewed as more of a middle- risk management heads at banks are trying to push credit riskoffice, support function. Their main responsibility is to make sure management down to the desk level, but trading desks don’t wanttraders trade within the limits and report numbers accurately. it. They see it as a firm-wide responsibility. 11
  14. 14. Structured Credit majority of institutions it is a game of hot potato right now,” he explains. Some sources argue that trading desks were well-aware of their counterparty exposures during the crisis. “Systems used to monitor credit risk at the desk level were reasonably well-established and working before the crisis. Most of the focus on the sell-side has been on the big drive towards centralised clearing,” explains Kevin Gould, a co-founder of Markit. He says he has seen some subtle organisational changes due to pending regulation, but that the bigger story is the greater focus on data quality and liquidity risk monitoring all around the market. The lack of liquidity in credit has made it much more difficult to trade. One head of credit trading from a French bank says this is another reason why David Kelly, Quantifi you see risk managers coming in to help Kevin Gould, Markit optimise the return on capital. “You can This is a sell-side trend since most hedge interest rate risk and, on a macro CVA movebuy-side exposures are heavily collateral- basis, you can hedge your credit risk. In Some sources say banks are also lookingised, according to the portfolio manager. Europe, we have sector indexes to help us at Credit Valuation Adjustment (CVA)“It was less of a priority before the crisis even hedge our funding risk, and because more than before because of the pressurewhen there were fewer defaults,” he adds. these products are so granular, we are to preserve capital and assess liquidity Marc Loomis, a credit product man- able to fine-tune the hedges. But there risks. “CVA is primarily an accountingager at Calypso, says the relationship is one thing none of us can hedge and requirement, b ut we are seeing morebetween trading and risk management that is liquidity risk.” He says the ability crossovers between credit risk manage-is “cyclical like most other things in the to execute transactions (at a reasonable ment and capital optimisation,” Kelly world. At the end of the day risk price) has worsened since 2007. He was previously a senior credit tradermanagers are paid to mitigate risk and A credit strategist from another on the global portfolio optimisation desktraders are paid to take it on – a bit like European bank adds that idiosyncratic at Citigroup. There he actively managedyin and yang.” risks are more specific to credit. “This the credit risk in derivatives positions and One London-based credit strategist also makes credit much less resilient than also established a CVA business.says that although some banks try to other assets. When you think of Greece CVA is a valuation of the credit riskmake it look like risk management is in and what has happened there as well, of all contracts an institution has with acharge of their capital, traders really are you realise there are so many more lay- given counterparty – the aggregate risksthe ones who own the risk. “Everyone is ers of risk within the credit market that of all counterparties. It is nothing new.putting more resources into credit risk we didn’t see a few years ago,” he says. The first ones became known back in themanagement, but it is a mixed bag when “Many banks are now trying to combine 90s, when fair value accounting emergedit comes to how they organise it. Several all the talent they have in the structured and the chief risk manager positionof the larger banks have established, cen- credit space to create a more industrial- became norm. Back then, credit defaulttralised top-down approaches, but for the ised credit department.” swap (CDS) pioneers on Wall Street were also emphasising the importance of counterparty risk management and how it and trading desks should work together“Everyone is putting more to optimise capital, especially after the repeal of Glass Steagall in 1999.resources into credit risk Jonathan Di Giambattista, md at Fitch Solutions in New York, agrees CVA has become a more topical subject. He saysmanagement, but it is a mixed it is also because of the greater focus on derivatives counterparty risk. He explainsbag when it comes to how they that CVA managers buy credit protection as part of their mandate to level out risks,organise it” especially concentration risks created from trading desks.12 SCI August 2010
  15. 15. Structured Credit “You can say that the CVA function is Figure 1there to capitalise on the compensation of Elements of pricing and valuation infrastructure and operationsrisks since profit is relative to the risk thatis taken. But it really is meant to ensure Cash Instruments Flow OTC Structured Derivatives e.g. Credit Derivatives e.g. Structured Creditrisk is accounted for. It is a centralised e.g. Corporate Bondsrisk control discipline for all asset classes Front Hardware/software Front-to-Back Excel-based Structuring/ Excel-based Illustrative Only (Bloomberg, Trading / Risk Portfoliowithin an institution. We believe most of Office Reuters) Systems ‘Pricers’ Mgmt Apps ‘Pricers’the top-tier international banks have a Market data Market data (e.g. Market data (e.g.CVA function in place, but we have not (e.g Bloomberg, Bloomberg, Markit, Bloomberg, Markit,seen any on the buy-side,” Di Giambattista Reuters) CMA, BQuotes) CMA, BQuotes)says. Risk and Risk and Risk and Analytics are Product control Product control Product control He continues: “We find that apart from portfolio risk, accounting, etc. etc. portfolio risk, accounting, etc. portfolio risk, accounting, etc. Risk control, collateral mgmt, Risk control, collateral mgmt, Risk control, collateral mgmt, required and Middle often ‘embeddeda few of the biggest international institu- Office • Deal level and portfolio IPV • Deal level and portfolio IPV • Deal level and portfolio IPV in these systemstional investors most buy-side firms really • P&L risk control • P&L risk control • P&L risk control and processes • In-house • In-house • In-housedo not hedge counterparty risk exposures. • Independent • Independent • IndependentThis is an expensive proposition for them 3rd party 3rd party 3rd party valuations valuations valuationsgenerally due to the transaction costs of Backhedging. The economies of scale are not Officethere if it is only five names you are wor- Recurring Recurring Recurring valuations valuations valuationsried about. Smaller players might put on abilateral trade every once in a while whenit makes economic sense, but they tend to Related to Front Office Related to Middle/Back Other users of pricing orrely more on internal controls, limit set- price discovery Office valuation of positions valuation datating and the monitoring of counterparty Source: Celentrelationships.” However, a number of hedge funds andother large institutional investors havebeen hiring seasoned traders and risk Ed James, a senior consultant in the Salary increasemanagers that used to work on the credit risk management group at Joslin Rowe According to recruiters, salaries for riskdesks at investment banks. “Former struc- Associates in London, confirms that a lot management roles in general are increas-tured credit traders could be valuable in of new credit risk management positions ing by around 15% from last year. Somemany other areas of trading and managing have been created this year. “We see banks are increasing salaries 25% orcredit risk. If you look at the composition demand across all types of risk manage- more in order to attract the best, mostof credit risk there is a securitisation ele- ment, and not just from banks but also experienced candidates. Consultantsment in transactions that are not cleared asset management firms.” say that some senior risk managementso their skills could be applied to any of He adds: “Many of these roles were salaries might look larger because theirthose,” Kelly adds. considered part of the finance or opera- pay is normally not tied to performance or tions groups four or five years ago. But risk profitability, it is fixed. management has become more high-profile Loomis agrees that while risk manag- and is now a bigger group in its own right ers’ influence might be increasing, they at most financial institutions. On the credit are never going to be paid as revenue side, the risk manager’s opinions matter a generators. “Pay packages are unlikely to lot more than they used to.” change. Giving risk managers a bonus for “You can say that the CVA function is there to capitalise on the compensation of risks since profit is relative to the risk that is taken. But it really is meant toJonathan Di Giambattista, Fitch Solutions ensure risk is accounted for” 13
  16. 16. Structured CreditFigure 2 sight of the shadow banking system and off-balance sheet entities is necessary.Total lifecycle costs for derivatives analytics (Shadow banking institutions are typi-USD$million cally intermediaries between investors Total Cost of Derivatives Analytics ? ? and borrowers – e.g. hedge funds, SIVs,50 Unknown costs conduits, investment banks and other45 ? Represents the non-bank financial institutions. By cost of complexity and a drag on the definition, shadow institutions do not40 Ranges between $11-$22m Integration costs competitiveness of the firm accept deposits like a depository bank with internal &35 external systems and therefore are not subject to the same30 •Enhancements • Inefficiencies & regulations.) ‘drag’due to 22.525 •Upgrades fragmented data, Acharya explains how the cycli- analytics, platforms cal nature of credit means there can be20 • If there are silos, data disparities & 11.3 Known costs a significant amount of aggregate and $4.5m over 5 years15 quality issues will Between ~$25 liquidity risks when trading in this asset •Bug Fixes continue to exist 4.510 $9m •Support • In an ideal world, to $36 million class and that many financial institutions Initial this would be zero. 9.0 underestimated both. “This is where the5 specification, build and test importance of capital adequacy comes in0 Development Support / Evolve / Indirect 3rd party apps/ Total because if there is not sufficient capital Maintenance Enhance costs integration to absorb losses then people outside of the financial sector become affected. So, One-off, Recurring costs totaled over one key issue is whether regulators can initial costs a 5-year production lifecycle address such socio-economic risks thatSource: Celent have not shown up before,” he asserts. Regulatory spirit Kelly agrees that the spirit of most of thecatching a certain type of risk is unlikely managers might even be gaining more new regulations is to make sure securiti-too. A risk manager is not paid to discover power to curtail trades. But the point is sation and the product engineering aroundwhere the bank should take risk. That that risk management means a lot more it has some socio-economic benefit. “Itis what a trader does. Traders look for a than it did before this crisis, partly due is pretty clear that the securitisations ofcheap asset and then hope that the value to all of the pending regulation. Risk mortgages, student loans and credit cards,of it goes up. The risk manager is there to management is not just credit-related and for example, are beneficial to economiesmake sure the bank doesn’t over-expose it is not just about calculating your delta. as long as the risk is transferred to peopleitself,” he adds. It is also about transparency and suitabil- who want it. I think regulators are a lot Sources say compliance is behind a lot ity. It is about digging deeper and looking more on the ball when it comes to creditof the new risk roles and Europe’s sover- not only at the counterparties more buteign debt crisis is definitely accelerating also the motivation behind each trade,”the regulatory effects on banks’ organi- explains Loomis.sation structures and risk management Viral Acharya, a professor of financepractices. “The risk manager’s statue at New York University’s Stern School ofmight be increasing a bit more now. Risk Business, says this is why some over-“This is where the importanceof capital adequacy comes inbecause if there is not sufficientcapital to absorb losses thenpeople outside of the financialsector become affected” Viral Acharya, New York University Stern School of Business14 SCI August 2010
  17. 17. Structured Credittrading and risk management, but I wouldnot say they are providing a guidinglight for big international banks. These “Valuation is definitely what linksinstitutions know what they need to do,”he asserts. trading and risk management. When it comes to the credit side, It is clear that banks continue to investheavily in the credit risk managementarea, partly due to Basel III. But somesources say that if these regulations pushmore transactions onto exchanges, some pricing and risk management areof the credit risk management functionscould become extinct. “A lot of the coun- instrumental in getting any dealterparty risks will be mitigated by centralclearing and standardised CDS contractswill have daily margining like futures off the ground right now”contracts,” Kelly notes. Even so, sources do not expect centralclearing will actually replace risk man-agement roles. “Central clearing is one the International Swaps and Derivatives written by Anton Valukas, an examinerof the main focuses of change right now Association introduced last year are help- who was hired by a US court to probebut I don’t believe it will diffuse coun- ing to improve transparency in the OTC Lehman Brothers’ failure, also explainedterparty risk management and I don’t market. “The modelling for bespoke deals how the bank’s product control team wasbelieve it will cover every type of CDS. is long and complicated. That is part of too small to be an effective independentBanks have been trying to price counter- the reason why that market remains so check on business risk for years. It is a dark science. illiquid.” Inadequate product control has beenIn other words it is not just about the pure Sources say that although the market cited in the financial markets many timescredit worthiness of your counterparty. for bespoke credit deals (cash and syn- since the crisis. The UK’s Financial Serv-It is also about your risk profile and the thetic) is very thin, interest has not totally ices Authority (FSA) has taken actionexposures you have to that counterparty,” disappeared. “The secondary credit against a number of institutions oversays Loomis. market is extremely fragmented and the the past couple of years. In its write-up Di Giambattista adds that central lack of price transparency is what is keep- against one American investment bankclearing for OTC derivatives would ing investors from participating or acting last year the FSA said: “Whilst juniornot reduce the effectiveness of a CVA. regularly. The basis risk is so volatile that global product control staff understoodSources believe there will always be you cannot really use CDS the way they that their role was to ensure P&L wasdemand for bi-lateral contracts whether are meant to in the fixed income world,” fully attributed, reconciled and explainedthey are plain vanilla or the complex and the French dealer says. in accordance with the firm’s systems,esoteric type. He also says corporates “Valuation is definitely what links senior product controllers expected thatwill continue to use the OTC market for trading and risk management. When it juniors would undertake analysis ofcustomised hedges. “There will always be comes to the credit side, pricing and risk P&L and whether it was consistent witha need to mitigate counterparty risk when management are instrumental in getting changes in risk and market movement. Inyou are dealing with different counterpar- any deal off the ground right now,” the particular there was a lack of understand-ties around the world. Most CDS trades European credit strategist adds. ing among junior controllers of volatilityare still executed bilaterally anyway,” he as a driver for the P&L.”says. Lessons learned? Last year, McKinsey & Company Greater standardisation will no doubt This close relationship with new issuance also addressed this issue in a paper titledhelp make pricing more transparent and is driving greater reflection on lessons ‘Turning Risk Management into a Truebid-offer spreads tighter. Loomis adds: from the past and there is no shortage of Competitive Advantage: Lessons from“Valuation has always been a job for information being published to examine. the Recent Crisis’. It states: “In sometraders and I do not expect that to change. For example, a new report explains that cases, revenue producers are clearly inWhat will continue to change is the Lehman Brothers’ use of ‘inconsistent charge and tend not to involve the riskinformation that goes into models. People, and highly subjective’ valuation methods management function in their decisions.mainly buy-side players, thought they did was what brought the bank down. In best-in-class organisations, the risknot need to understand the model because Released in March, the report said that management function is seen as a keythe credit rating was all that mattered. while there is always some subjectivity enabler of profitable growth. ProblemsThat got a lot of them into trouble during in assigning prices to complex securities, can arise when the risk function isthe crisis.” Lehman Brothers’ used differing valua- viewed by quickly evolving businesses as Loomis says open source initiatives tion methods for trading desks that were a cop or a goalie trying to catch the badsuch as the standardised pricing model that even of the same asset class. The report, shots.” 15
  18. 18. ILS Insurance-linked securities are typically thought of as a specialist asset class. However, as Jillian Ambrose explains, catastrophe bonds are generating increasing interest from non-insurance investors, which in turn could be met by increased new issuance volumes GreaterA s the 2009 global market rally falters to a limp in Those involved in the space are quick to point out that while 2010 due to the European sovereign debt situation, other fixed income asset classes buckled under credit pressures, catastrophe bonds are enjoying a new-found popu- ILS remained largely uncorrelated, with the exception of those larity. While it is unlikely that insurance-linked bonds affected by the Lehman bankruptcy. “Cat bonds have securities (ILS) will become as mainstream as posted strong performance throughout the crisis,” points outother structured finance asset classes, investors are increasingly Christophe Fritsch, head of ILS at AXA Investment Managers.interested in adding diversification to their portfolios and those “Investors have real positive elements from which they can judgein the ILS space are eager to encourage this, which should also the main reasons they should be investing in cat bonds: such asencourage great volumes of new issuance. their low correlation and their resilience in the midst of strong In a post financial-crisis context, investing in ILS seems to financial tensions on the markets.”be an increasingly appealing prospect for investors. Speaking As a result, adding ILS instruments to an investment portfo-at the 2nd Insurance Linked Securities Summit held in London lio is emerging as a promising new diversification play. “Whenat the end of April, ceo of Hanover Re, Ulrich Wallin painted a people look back on the financial crisis this is the one area ofbright picture for the future of the ILS industry. In particular he the fixed income market that still had liquidity because it’s trulyexplained that while the Lehman bankruptcy led to a total return diversified,” explains md and head of ILS distribution for Swissswap default on four cat bonds, this consequence was an indirect Re, Judy Klugman. “Our investors still had cash and we wereone. Structural problems within the market have since been trading bonds. The basic tenants of this sector were really vali-addressed, according to Wallin. dated during the crisis and as a result, investors value the diver-16 SCI August 2010
  19. 19. ILSexpectationssification that these assets have to offer. one-year agreement. As a result, sponsorsAlthough further developments need to be are increasingly interested in exploringmade within the space, those within the the benefits of ILS.sector are now calling for a greater inves- However, despite many ILS markettor involvement in the market in order to participants bordering on the evangelicalbring ILS into the mainstream. in their calls for greater investment in the Historically an insurer would seek sector, the vast majority of investors haveto transfer risk through a reinsurance remained indifferent until now. “So far,agreement in order to remain solvent in there have not been that many institu-the event of a large-scale natural catas- tional investors that have taken the cattrophe. Although ILS does not seek to bond leap,” confirms Fritsch.replace reinsurance, it is being touted as But Henning Ludolphs, director ofa complement to the traditional reinsur- Hanover Re’s ILS unit, adds that he isance sector. From the point of view of the currently seeing an increase in interestsponsors, ILS offers the added benefit of from institutional investors. “We believea multi-year transaction with exposure to that there are a lot of investors, pensionthe capacity of the capital markets, while funds for example, who are starting toreinsurance transactions are typically a look at allocating a small portion of their Judy Klugman, Swiss Re 17
  20. 20. ILS problem may have to do with the overall going to hit Los Angeles in the next two perception of the market. years. Using hundreds of years of science, “It needs to be more widely looked at independent firms assess the risk for as a mainstream asset class, rather than an investors,” she explains. ‘esoteric asset class’ which scares some Klugman adds that the models used investors off,” says Klugman. “Really are not created specifically for the ILS it should be part of everyone’s diversi- markets, but are developed within the fication strategy. The sector needs to be scientific community and used by third- demystified.” party firms in analysing securitisations. Any enthusiasm that non-insurance This, she says, adds a degree of subjectiv- specialist investors have for ILS can be ity to the process. “When I look at credit dampened by confusion regarding the and what can go wrong in terms of fraud underlying data, market processes and the and misunderstanding, I think there are structures of the cat bonds themselves. more variables in credit than there is in Participants in the space simultaneously analysing the risk in a catastrophe bond.” argue that the market is not as complex as it may initially appear and point to recent Increasing transparency developments and innovations within In order to attract a wider investment base the market as evidence of its increasing into the market, greater calls have come Christophe Fritsch, AXA accessibility. for increased transparency in the market. Investment Managers Concerns regarding the performance “Transparency and liquidity is good for indicators used are perhaps justifiable any market, and cat bonds are no excep-funds to ILS,” he says. “A small portion for investors unfamiliar with the market, tion,” says Fritsch.of a large fund would be a huge amount of especially in light of the persistent con- Ludolphs believes that various stepsmoney coming into the ILS market.” troversy and distrust surrounding rating could be taken to make the market more Fritsch predicts that as new investors agencies in the broader credit markets. transparent and easily understood by newenter the space, development within the Those involved in ILS insist that the mod- investors to the space. “The market needsmarket will increase. “As large inves- els used in analysing the securitisations to be open with underlying exposure datators such as pension funds and insurance offer investors a non-subjective means of and underlying investment data,” he says.companies start investing more heavily understanding the underlying risks. Further, Ludolphs suggests that under-in this sector, a new market dynamic will Rupert Flatscher, head of Munich Re’s lying data could be posted on websites inbe created,” he says. “This obviously goes risk trading unit, says: “New investors the same way as regulation now requireshand in hand with a larger number of need to understand that ILS are based on mainstream structured finance deals tosponsors as well as an increased diversifi- models which are used in the insurance do. “We need to share information andcation of perils.” industry sometimes for decades. It is not make underlying information transpar- only investors relying on such models but ent,” he stresses.Mainstream option? also a far bigger industry.” Ludolphs also advocates the greaterHowever, ILS is still far from being Furthermore, Klugman argues that use of indices and parameters whichaccepted as a mainstream investment assessing risks in ILS may be more reli-option and current participants believe able than methods used in other creditthat it’s vital to make the necessary markets. “We don’t expect an investor tochanges to the market in order to develop be able to analyse what the probabilityILS beyond a niche market. Part of the is that a magnitude seven earthquake is“When I look at credit and whatcan go wrong in terms of fraudand misunderstanding, I thinkthere are more variables incredit than there is in analysingthe risk in a catastrophe bond” Rupert Flatscher, Munich Re18 SCI August 2010