Structured Credit — Introduction

Details 11 Dec 2013

This document is a map of the world of credit, with an emphasis on exploring the key shifts in the financial markets and the technology that have led to the range of complex products transacted today.

Intended to explain financial concepts, this text focuses on issues of particular relevance to the legal community.

It sets a framework for the world of credit and structured credit. We also hope to explain some of the technical aspects behind these innovations and highlight some of the pivotal characteristics that generic texts on finance often glance over or omit.

Different sections will focus on specific products, their workings, valuation and risk, and the type of market participants who would engage in trading the respective products.

The concept of ‘credit risk’ is as old as trading itself. The simplest definition of ‘credit risk’ is the risk that a counterpart is unable to fulfil its obligations, and typically it applies to the obligation to make payments in kind as and when due.

As a result of an explosion in the trading and development of ‘credit risk’ over the past three decades, market participants have, through their trading agreements, defined ‘credit risk’.

Market bodies, such as the International Swaps and Derivatives Association (ISDA), have defined documentation standards, having issued a set of standard credit derivatives definitions in 1999 (revised in 2003). These have become the references that market documentation across the credit derivatives world works to. These definitions apply to the term-sheets and trade confirmations of outstanding contracts at the end of 2012, which amounted to a notional face amount of US$25tn[1]. ISDA documentation is now the industry standard benchmark from which a definition of ‘credit risk’ can be inferred.

[1] Source: Bank of International Settlements

2) Measuring Credit Risk 20Measuring%20Credit%20Risk.jpg /%

Measurement of risk and linked concepts, such as value, are subjective processes. ‘Subjectivity’ is particularly elastic when parameters for measuring risks are sparse.

The first entities to develop processes to measure credit risk were banks. A natural requirement, given their core activity of money lending, banks developed internal processes to measure a borrower’s credit-worthiness.

With the development of bond markets, investors too became lenders of funds (via bonds as opposed to loans). The growth of the bond market created demand for new services from investors, who would pay for the bonds’ credit-worthiness to be measured. The first credit ratings on bonds were issued in 1909 by Moody’s, followed by Poor’s in 1916, Fitch in 1924 and Standard Statistics in 1941.  Originally separate companies, Poor’s and Standard Statistics later merged to form Standard & Poor’s.

The history of ‘credit risk’ and the growth of Rating Agencies are intertwined. Initially, Ratings Agencies were paid by investors for information and thus their interests were aligned. However, after 1970, following the shocks in the bond market as a result of the bankruptcy of the Penn-Central Railroad, bond issuers began to pay Ratings Agencies to ensure their products carried at least one major rating and thereby assuage investor concerns. This inadvertently moved the revenue base to issuers and away from investors.

Ratings Agencies’ analysis would typically constitute a non-trivial investigation of the variety of factors which might affect the credit worthiness of a bond issuer, from the financial condition of the company to its industry sector and management.

Both banks and Rating Agencies would categorise borrowers based upon proprietary methodologies and grading systems. For example ‘Aaa’/’AAA’ would be Moody’s/Standards & Poor’s highest rating for a borrower, and ‘C’ would be their lowest for those not yet in default. Special designation ratings evolved for other cases, for example Standard & Poor’s marks those who have defaulted ‘D’ or ‘SD’, not rated ‘NR’, or under regulatory supervision ‘R’.

Over time the history of ‘default rate’ data expanded, allowing Rating Agencies to map ‘recovery rates’, ‘probability of default’ and ‘expected losses’ with a specific rating. These quantifications of ‘credit risk’ became a key pillar in the development of more complex structured credit products.

Table: Long-term debt ratings scales