Book 1. Foundations of Risk Management

FRM Part 1

FRM 4. Credit Risk Transfer Mechanisms

Presented by: Prateek

Module 1. Credit Risk Transfer

Topic 1. Types of Credit Derivatives

Topic 2. Credit Default Swaps (CDS)

Topic 3. Collateralized Debt Obligations (CDOs)

Topic 4. Collateralized Loan Obligations (CLOs)

Topic 5. Reducing Credit Risk Exposure

Topic 6. Credit Derivatives in the Global Financial Crisis (GFC)

Topic 7. Role of CDS in GFC

Topic 8. Role of CDOs in GFC

Topic 9. Dodd-Frank Act

Topic 10. Securitization and Special Purpose Vehicles (SPVs)

Topic 11. Originate-to-Distribute (OTD) Model

Topic 1. Type of Credit Derivatives

  • Instruments to isolate and transfer credit risk without selling the underlying asset.

  • Common types:

    • Credit Default Swaps (CDSs)

    • Collateralized Debt Obligations (CDOs)

    • Collateralized Loan Obligations (CLOs)

  • Purpose: Off-balance sheet tools used to transfer specific credit exposures.

  • Example: CDS market notional value exceeded $45 trillion in 2007.

Topic 2. Credit Default Swaps (CDS)

  • Definition: CDS are contracts that pay the buyer upon the default of a reference entity.

  • Functions like insurance: Buyer pays periodic premiums for protection.

  • Advantages:

    • Enables price discovery of credit risk.

    • Provides cash flow potential for sellers.

    • Facilitates innovation and capital allocation.

  • Disadvantages:

    • Unregulated pre-GFC, leading to counterparty risk.

    • Created a false sense of security, promoting riskier behavior.

Topic 3. Collateralized Debt Obligations (CDOs)

  • Definition: CDOs are structured products composed of repackaged loans (e.g., mortgages, ABS).

  • Tranches:

    • Equity/Junior Tranche ("Toxic Waste")

    • Mezzanine Tranches

    • Senior and Super-Senior Tranches (AAA)

  • Advantages:

    • Boosts profitability through faster loan turnover.

    • Transfers credit risk directly to investors.

    • Expands loan access.

  • Disadvantages:

    • Promotes risky lending practices.

    • Concentrated exposure to subprime debt.

    • High complexity and opacity.

Practice Questions: Q1

Q1. From the perspective of a bank, which of the following is not an advantage of using a collateralized debt obligation (CDO) to transfer credit risk?

A. Bank profitability can be accelerated due to higher loan turnover.

B. Credit risk is effectively transferred to investors.

C. There will always be a market for CDO products.

D. A larger pool of potential borrowers will exist due to less concern for lending (underwriting) standards.

Practice Questions: Q1 Answer

Explanation: C is correct.  

Collateralized debt obligations transfer credit risk from banks to investors. This process enables banks to accelerate the loan origination cycle and therefore enjoy potentially higher profitability due to sourcing more loans than would otherwise

be accessible.

The pool of potential borrowers is increased because banks are less concerned with lending standards. However, when investors lose interest in CDO products due to higher-than-expected default rates, the loan originator (the bank) can be stuck with a large amount of credit risk on their balance sheet.

Topic 4. Collateralized Loan Obligations (CLOs)

  • CLOs are similar to CDOs but composed of bank loans (not mortgages).

  • Loans typically have stricter underwriting standards.

  • Resilient during GFC compared to CDOs.

  • Continued to attract investor interest post-2008.

Topic 5. Reducing Credit Risk Exposure

  • Traditional mechanisms:

    • Third-party insurance/guarantees

    • Exposure netting

    • Mark-to-market settlements

    • Requiring collateral (note: risk of wrong-way risk)

    • Termination clauses on trigger events

    • Reassignment of credit risk

    • Loan syndication to distribute large exposures

Practice Questions: Q2

Q2. Which of the following is not a traditional credit risk transfer approach used by banks?

A. Marking-to-market.

B. Call feature.

C. Exposure netting.

D. Loan syndication.

Practice Questions: Q2 Answer

Explanation: B is correct.

Marking-to-market, exposure netting, and loan syndication are all mechanisms that banks use to transfer credit risk. They also might use a termination clause. A call feature could be used to protect an issuer from interest rate risk, but not credit risk.

Topic 6. Credit Derivatives in the Global Financial Crisis (GFC)

  • CDS market grew to $45 trillion notional by 2007.

  • Speculative misuse of CDSs on assets not held.

  • Systemic risk due to few counterparties (e.g., AIG, Citadel).

  • CDO defaults due to subprime mortgage exposure and rate resets.

  • Resulted in a credit freeze, bank failures, and massive bailouts.

Topic 7. Role of CDS in GFC

  • CDSs amplified contagion:

    • Lehman’s $400B CDS exposure triggered panic.

    • Counterparty failures led to systemic collapse.

  • Lacked collateralization and regulation.

  • Misused for speculation rather than protection.

Topic 8. Role of CDOs in GFC

  • Packaged high-risk subprime loans.

  • Enabled via the originate-to-distribute model.

  • Use of adjustable-rate mortgages + housing price decline = wave of defaults.

  • CDO-squared products created complexity without transparency.

  • Banks left with unsellable toxic assets.

Topic 9. Dodd-Frank Act

  • Enacted in 2010 to restore financial stability.

  • Volcker Rule:

    • Prohibits proprietary trading by commercial banks.

    • Limits investment in CDSs.

  • Regulated swap contracts under CFTC.

  • Section 15G (2014): Requires 5% risk retention by securitization originators—cannot be hedged or sold.

Topic 10. Securitization and Special Purpose Vehicles (SPVs)

  • Securitization process:

    1. Create SPV (off-balance sheet entity).

    2. Transfer loans to SPV.

    3. Structure into tranches.

    4. Sell to investors.

  • SPV advantages:

    • Isolate credit risk

    • Off-balance sheet for banks

  • SPV risks: Opaqueness, limited investor insight

  • Structured Investment Vehicles (SIVs) were highly leveraged SPVs that failed during GFC.

Practice Questions: Q3

Q3. Which of the following was not a direct cause of the financial crisis of 2007–2009?

A. The use of credit derivatives.

B. Weak regulation.

C. Excessive speculation.

D. Adjustable-rate loan rate resets.

Practice Questions: Q3 Answer

Explanation: A is correct.

The financial crisis of 2007–2009 was made possible by weak regulation and government encouragement of loan to subprime borrowers.

Banks responded by sourcing a high number of high-risk loans that ultimately fell apart when adjustable-rate loans reached their reset dates.

Investors also speculated very heavily in the CDS and CDO markets. It was the misuse of credit derivatives, not merely their use, that led to the crisis.

Topic 11. Originate-to-Distribute (OTD) Model

  • Definition: Loans are originated with the intent to securitize and sell, not hold.

  • Advantages:

    • Higher bank profitability

    • Broader loan access

    • Risk distribution among participants

  • Disadvantages:

    • Moral hazard: Poor underwriting standards

    • Misaligned incentives: Focus on loan volume, not quality

    • Opacity in understanding product risk

Practice Questions: Q4

Q4. Which of the following is not a strength of the securitization process?

A. Enhances credit product access for low-quality borrowers.

B. Credit risk can be distributed to multiple market participants.

C. Enables a transparent four-step process.

D. Enables borrowers to lower their borrowing costs.

Practice Questions: Q4 Answer

Explanation: C is correct.  

The securitization process enhances loan access for low-quality borrowers. It also gives borrowers access to additional credit products at lower borrowing costs.

Banks using an OTD model get higher fees for sourcing loans with higher interest rates. Investors get access to higher-yielding loan products as long as default rates are not an issue.

The core of this process is to distribute credit risk to

multiple market participants. The securitization process is not transparent.