Jun 11

Highlights from BIS quarterly review (learning objectives in the news)

by David Harper, CFA, FRM, CIPM

FRM |

About Understanding the Securitization of Subprime Mortgage Credit (Ashcraft):

The assigned reading has an introduction to the ABX Indices used to value subprime loans. These indices track the price of credit insurance (CDS) on baskets of home equity ABS deals (n=20).  The focus of Ashcraft's analysis is the BBB-rated, which is the lowest rated of the five ABX sub-indices. For valuing subprime, it pretty well known that ABX is imperfect.

The BIS report itemizes three pitfalls in using the ABX:

  • Different accounting treatments. While of course some banks hold subprime in trading book, others may hold to maturity. Holding "may would tend to deflate actual write-downs and impairment charges relative to estimates of mark to market losses on the basis of market indices, such as the ABX."
  • Market coverage. This has been well-covered and maybe even overstated (as all indices sample, the issue is, is the composition similar?): "ABX prices may not be representative of the total subprime universe, due to limited index coverage of the overall market."
  • Deal-level coverage. "ABX prices may not be representative because each index series covers only part of the capital structure of the 20 deals included in the index." Might be more relevant for AAA tranches than BBB-.

 

About the high-potential market for credit derivatives in Asia and the Pacific

I like the clear language definitions given by Remolona and Shim. They say "the three most significant instruments in the transformation of global credit markets have been single-name CDS contracts, traded CDS indices and CDO structures."

"A single-name CDS contract  is an over-the-counter derivative in which the buyer pays a fixed premium in return for protection against losses in the event of default by a specified borrower. CDS contracts are most actively traded in the form of CDS indices, which consist of standardized portfolios of single-name contracts."

And a wonderfully succinct summary of CDOs (emphasis mine as this has been a frequent forum topic):

Collateralised debt obligations (CDOs) are securitisations that transform credit risk by means of a subordination structure. Two basic types are balance sheet CDOs and arbitrage CDOs. In a balance sheet CDO, assets are taken from a single bank's balance sheet. In arbitrage CDOs, the manager assembles the collateral pool by buying bonds from the market. Balance sheet CDO deals have been arranged mainly to achieve regulatory capital relief and reduce constraints on fresh lending capacities.  To save on regulatory capital, banks put in a CDO those loans that require relatively high capital charges for a given level of risk. Arbitrage CDOs, by contrast, are designed to profit by arbitraging between market spreads and expected losses, where the former tend to be much larger than the latter. In practice, however, it is sometimes difficult to distinguish between balance sheet and arbitrage CDOs. CDOs can be further classified into cash and synthetic CDOs. In a cash CDO, the manager assembles a collateral pool of debt, transfers it to a special purpose vehicle (SPV) and uses the cash flow from the collateral to pay principal and interest to investors in the CDO. In a synthetic CDO, the manager assembles CDS contracts rather than actual debt. Compared to a cash CDO, a synthetic CDO has the advantage that the manager can quickly assemble a sufficient number of names by going to one or two CDS dealers"

Recent Basel II initiatives

BCBS already announced they intend to take steps in light of the credit crunch. They say (emphasis mine),

  • They "will revise the Framework to establish higher capital requirements for certain complex structured credit products, such as so-called "resecuritisations" or collateralised debt obligations referencing asset-backed securities (ABS CDOs)…will also strengthen the capital treatment of liquidity facilities extended to support off-balance sheet vehicles such as ABCP conduits."
  • "will strengthen the capital requirements in the trading book, where the current value-at-risk based treatment for assessing capital for trading book risk does not capture extraordinary events that can
    affect many exposures to complex, less liquid structured products."
  • "Pillar 2 provides supervisors with additional tools to assess banks' risk management and internal capital management processes. The Committee will issue Pillar 2 guidance in a number of areas to help strengthen risk management and supervisory practices. These relate to the management of firm-wide risks; banks' stress testing practices and capital planning processes; the management of off-balance sheet exposures and associated reputational risks"

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