- International Monetary Fund. Monetary and Capital Markets Department
- Published Date:
- May 2006
Bank for International Settlements (BIS), 2005, BIS 75th Annual Report (Basel, June).
Bank for International Settlements (BIS), Committee on the Global Financial System (CGFS),2003, Credit Risk Transfer (Basel, January).
Bank for International Settlements (BIS), 2005, The Role of Ratings in Structured Finance: Issues and Implications (Basel, January).
Belsham, ThomasVause, NicholasWells, Simon2005, “Credit Correlation: Interpretation and Risks,” Bank of England,Financial Stability Review, No. 19 (December), pp. 103–15.
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Blanco, RobertoBrennan, SimonMarsh, Ian W.2005, “An Empirical Analysis of the Dynamic Relationship Between Investment-Grade Bonds and Credit Default Swaps,” Journal of Finance, Vol. 60 (October), pp. 2255–81.
British Bankers’ Association (BBA), 2004, Credit Derivatives Report 2003/04 (London, September 22).
Campbell, AlexanderLong Chen, Xiao2005, “A Smaller Piece of the Pie,”Risk (September), pp. 36–37.
Chan-Lau, Jorge A.Sook Kim, Yoon2005, “Equity Prices, Credit Default Swaps, and Bond Spreads in Emerging Markets,” ICFAI Journal of Derivatives Markets, Vol. 2 (July), pp. 26–48.
Counterparty Risk Management Policy Group II, 2005, “Toward Greater Financial Stability: A Private Sector Perspective” (July 27). Available via the Internet: http://www.crmpolicygroup.org/docs/CRMPG-II.pdf.
Creditflux, 2006a, “Citigroup Trades First Synthetic CDO of EM Corporates,”Creditflux (January1).
Creditflux, 2006b, “Special Report: Synthetic CDO League Tables: A Year of Evolution,”Creditflux,February1).
Diamond, Douglas1984, “Financial Intermediation and Delegated Monitoring,” Review of Economic Studies, Vol. 51 (July), pp. 393–414.
Diamond, Douglas,1991, “Monitoring and Reputation: The Choice Between Bank Loans and Privately Placed Debt,” Journal of Political Economy, Vol. 99 (August), pp. 689–721.
Dynan, Karen E.Elmendorf, Douglas W.Sichel, Daniel E.2005, “Can Financial Innovation Help to Explain the Reduced Volatility of Economic Activity?” Finance and Economics Discussion Paper No. 2005-54 (Washington: Federal Reserve Board, November).
El Qorchi, Mohammed2005, “Islamic Finance Gears Up,” Finance & Development, Vol. 42 (December).
Estrella, Arturo2002, “Securitization and the Efficacy of Monetary Policy,” Federal Reserve Board of New York, Economic Policy Review (May), pp. 243–55.
Fender, IngoKiff, John2005, “CDO Rating Methodology: Some Thoughts on Model Risk and Its Implications,” Journal of Credit Risk, Vol. 1 (Summer), pp. 37–58.
Fender, IngoMitchell, Janet2005, “Structured Finance: Complexity, Risk and the Use of Ratings,” Bank for International Settlements Quarterly Review (June), pp. 67–79.
Financial Services Authority (FSA),2005, Financial Risk Outlook (London, January).
FitchRatings2004a, “2003 Global Credit Derivatives Survey (Single-Name CDS Fuel Growth),” Fitch Ratings Special ReportSeptember7).
FitchRatings2004b, “CDS Market Liquidity: Show Me the Money,”Fitch Ratings Global Credit DerivativesNovember15).
FitchRatings2004c, “Liquidity in the Credit Default Swap Market: Too Little Too Late,” Fitch Ratings Special ReportJune7).
FitchRatings, “Global Credit Derivatives Survey: Risk Dispersion Accelerates,” Fitch Ratings Special ReportNovember17).
FitchRatings2005b, “Hedge Funds: An Emerging Force in the Global Credit Markets,” Fitch Ratings Special ReportJuly18).
FitchRatings2005c, “Securitization and Shari’ah Law,” Emerging Markets Special ReportMarch24).
Flanagan, ChristopherAhluwalia, RishadSchmude, Mark2005, “Activity in the Synthetic Bespoke and Tranched Index Markets,”JPMorgan Global Structured Finance ResearchDecember22).
Geithner, Timothy F.2005, “Overview of the U.S. Financial System,”remarks at the Bond Market Association’s Annual Meeting, New York, April20.
Geithner, Timothy F.2006a, “Risk Management Challenges in the U.S. Financial System,”speech delivered to the Global Association of Risk Professionals, 7th Annual Risk Management Convention and Exhibition, New York, February28.
Geithner, Timothy F.,2006b, “Some Perspectives on U.S. Monetary Policy,”speech delivered to the New York Association for Business Economics, New York, January11.
Gibson, Michael S.2004, “Understanding the Risk of Synthetic CDOs,” Finance and Economics Discussion Paper No. 36 (Washington: Federal Reserve Board, May).
Greenspan, Alan2005, “Risk Transfer and Financial Stability,”speech delivered to the Federal Reserve Bank of Chicago’s Forty-First Annual Conference on Bank Structure, Chicago, May5.
Group of Thirty, 2003, “Global Clearing and Settlement: A Plan of Action,” Study Group Report (Washington, January).
Group of Thirty, 2006, “Reinsurance and International Financial Markets,” Study Group Report (Washington, January23).
Helbling, ThomasMarco E.Terrones,2003a, “Asset Price Booms and Busts—Stylized Facts from the Last Three Decades of the 20th Century,”paper presented at a European Central Bank workshop, “Asset Prices and Monetary Policy,” Frankfurt,December11–12.
Helbling, Thomas,2003b, “Real and Financial Effects of Bursting Asset Price Bubbles,” in World Economic Outlook, World Economic and Financial Surveys (Washington, April).
Ho, Hann2004, “Emerging Market CDOs: A Developing Asset Class?” Risk, Credit Risk Supplement, Vol. 17 (October).
Hunt, Ben2005, “How Should Policymakers Respond to a Decline in House Prices?” in United Kingdom: Selected Issues, IMF Country Report No. 05/81 (Washington: International Monetary Fund).
International Monetary Fund, 2004a, Global Financial Stability Report, World Economic and Financial Surveys (Washington, April).
International Monetary Fund, 2004b, Global Financial Stability Report, World Economic and Financial Surveys (Washington, September).
International Monetary Fund, 2005, Global Financial Stability Report, World Economic and Financial Surveys (Washington, September).
International Swaps and Derivatives Association, 2003–2005, “ISDA Operations Benchmarking Survey” (Annual).
JointForum2005, Credit Risk Transfer, Joint Forum Working Group on Risk Assessment and Capital (Basel: Bank for International Settlements, March).
JointForum2006, The Management of Liquidity Risk in Financial Groups, Joint Forum Working Group on Risk Assessment and Capital (Basel: Bank for International Settlements).
Kashyap, Anil K.Stein C., Jeremy2000, “What Do a Million Observations on Banks Say About the Transmission of Monetary Policy?” American Economic Review, Vol. 90 (June), pp. 407–28.
Kiff, JohnFrançois-LouisMichaud, and JanetMitchell,2003, “An Analytical Review of Credit Risk Transfer Instruments,” Banque de France, Financial Stability Review (June), pp. 106–31.
Kimbell, DeborahDavidSkalinder,AndrewNewby,2005, “FX Poll 2005: The Big Get Bigger—But Is It for the Best?”Euromoney (May), pp. 74–85.
King, Robert G.RossLevine,1993, “Finance, Entrepreneurship, and Growth: Theory and Evidence,” Journal of Monetary Economics, Vol. 32 (December), pp. 513–42.
Kodres, Laura2004, “Adjustable- or Fixed-Rate Mortgages: What Influences a Country’s Choices?” in World Economic Outlook, World Economic and Financial Surveys (Washington, September).
Kolari, James W.Donald R.Fraser,AliAnari,1998, “The Effects of Securitization on Mortgage Market Yields: A Cointegration Analysis,” Real Estate Economics, Vol. 26 (Winter), pp. 677–93.
Large, Andrew2005, “Financial Stability: Managing Liquidity Risk in a Global System,”speech delivered to the 14th City of London Central Banking and Regulatory Conference, London, November28.
LehmanBrothers2005, “CDO/Structured Credit Annual 2006,”Lehman Brothers Structured Credit Research (December21).
Levine, Ross1996, “Financial Development and Economic Growth: Views and Agenda,” Policy Research Working Paper No. 1678 (Washington: World Bank).
Loutskina, ElenaPhilip E.Strahan,2006, “Securitization and the Declining Impact of Bank Finance on Loan Supply: Evidence from Mortgage Acceptance Rates,” NBER Working Paper No. 11983 (Cambridge, Massachusetts: National Bureau of Economic Research).
Minton, Bernadette A.RenéStulz,RohanWilliamson,2005, “How Much Do Banks Use Credit Derivatives to Reduce Risk?” NBER Working Paper No. 11579 (Cambridge, Massachusetts: National Bureau of Economic Research).
Moody’s Investors Service, 2006, “Structured Finance Rating Transitions:1983–2005,”Moody’s Investors Service Global Credit Research Special Comment (February).
Morrison, Alan D.2005, “Credit Derivatives, Disintermediation, and Investment Decisions,” Journal of Business, Vol. 78 (March), pp. 621–48.
Neftci, SalihAndre OliveiraSantos,YinquiLu,2006, “Credit Default Swaps and Financial Crisis Prediction” (unpublished).
Norden, LarsMartinWeber,2004, “The Comovement of Credit Default Swap, Bond and Stock Markets: An Empirical Analysis,” CFA Working Paper No. 2004/20 (Frankfurt: Center for Financial Studies, September).
Prince, Jeffrey T.2005, “Is One Rating Enough?”Journal of Structured Finance (Summer), pp. 40–43.
Reardon, Edward J.Flanagan, ChristopherSankaran, Srikanth2006, “Basel 2 and Securitization: A Paradigm Shift,”JP Morgan European Securitized Products Research (January30).
Rosenberg, David A.2005, “Macro and Market Performance During Fed Tightening Cycles,”Economic Commentary, Merrill Lynch Global Securities Research & Economics GroupJanuary20).
Schnure, Calvin2005, “Boom-Bust Cycles in Housing: The Changing Role of Financial Structure,” IMF Working Paper 05/200 (Washington: International Monetary Fund, October).
Scott, Andrew J.AlexSbityakov,EricBeinstein,2005, “Delphi Corporation: CDX Cash Settlement Protocol Update,”JP Morgan Corporate Quantitative Research (October24).
Standard & Poor’s, 2005, “Lending Concentrations Linger at Potentially Risky Levels at Banks Around the Globe,”Standard & Poor’s Ratings Direct (December7).
Standard & Poor’s, 2006a, “CDO Spotlight: European CDO Market Challenges to Continue with Innovation and Diversity Key,”Standard & Poor’s Structured Finance (February1).
Standard & Poor’s, 2006b, “Increasing Maturity and Issuance for Spanish Securitization in 2006,”Standard & Poor’s Structured Finance Country Outlook Report (January30).
Re, Swiss2005, “World Insurance in 2004: Growing Premiums and Stronger Balance Sheets,”Sigma, No. 2.
Violi, Roberto2004, “Credit Rating Transition in Structured Finance,”Bank for International Settlements, Committee on the Global Financial System Working Group on Ratings in Structured Finance (Basel, December).
See Geithner (2006a) for a recent speech regarding credit derivatives, risk management, and related financial stability issues.
See Box 2.1 for an explanation of these products.
The International Swaps and Derivatives Association’s (ISDA’s) semiannual survey. The Bank for International Settlements (BIS), which also conducts a semiannual survey, estimated outstandings to be $10.2 trillion at mid-2005, although the BIS survey covers fewer market participants and surveys only CDSs and portfolio swaps. Neither survey includes hedge funds, and only ISDA’s survey includes insurance companies.
Detailed data on outstanding European and Asian CDOs are generally less available than for the United States. CDO activity in the United States and Europe is increasingly interlinked with synthetic activity. Globally, in 2005, about $205 billion of cash CDOs were issued, versus synthetic issuance of $65 billion (see Lehman Brothers, 2005). This should not be confused with portfolio swap activity, which is sometimes reported as “synthetic” CDO activity. According to Creditflux (2006b), whose survey covers about 60 percent of market volume, $224 billion of bespoke portfolio swaps and $455 billion of index tranche transactions were also executed in 2005.
According to the most recent Fitch Ratings (2005a) survey, asset-backed securities and other structured credit products comprised only 4 percent of underlying reference assets, but their share is expected to grow.
The more correlated the underlying assets, the more difficult it is to build a diversified structured credit product from the underlying portfolio.
According to the Fitch Ratings (2005a) survey, banks and broker-dealers accounted for the vast majority of the outstanding credit derivative protection purchased at year-end 2004. However, Fitch does not survey hedge funds, which they estimate account for up to 30 percent of credit derivative trading volume. In addition, although much of the trading occurs between banks, it is not necessarily between the same institutions, geographically or by type. For example, Fitch Ratings (2005a) reports that protection buying is dominated by large sophisticated banks, while smaller regional banks typically sell protection to realize more diversified credit exposure (i.e., outside their local market). In addition, insurers and financial guarantors accounted for 13 percent of protection sales in the Fitch survey, and 20 percent in the British Bankers’ Association (BBA) (2004) survey.
Figure 2.3 shows how credit derivative growth has paralleled the growth of credit hedge funds. Although such hedge fund allocations remain small relative to the overall credit market and credit derivative market, such funds are typically the most active traders of credit products and have facilitated many of the innovations witnessed in recent years. The BBA (2004) survey estimated hedge fund exposure at $2 trillion.
Correlation trading involves trading on the basis of anticipated changes in the expected correlations of credit defaults and spread movements among specific credits and indices. See Belsham, Vause, and Wells (2005).
See Standard & Poor’s (2006a).
See Standard & Poor’s (2006b) for a discussion about how Basel II is expected to influence Spanish securitization. See also Reardon, Flanagan, and Sankaran (2006) for an analysis of Basel II securitization incentives.
Swiss Re (2005, Statistical Appendix, Table 1).
For example, in the Republic of Korea, the Foreign Exchange Transactions Act obliges insurance companies to obtain prior approval for credit derivative transactions from the central bank, and while most transactions are eventually approved, the approval process is reportedly lengthy. In addition, all derivative transactions that involve foreign currency must also be approved by the central bank. Similar procedures and requirements exist in other countries.
In Germany, steps have been taken to reduce obstacles to true sale transactions (see IMF, 2004a).
For example, there appears to be significant potential for the pooling of Japanese nonperforming loans (NPLs) into structured credit products. However, at least until FY2004, most Japanese banks preferred to make loan-loss provisions to write-off NPLs and enjoyed relatively generous regulatory treatment (e.g., the ability to include loss provisions and deferred taxes in Tier I capital), which provided disincentives to pursue market alternatives.
Discussions with market participants raised questions as to whether the increased focus on “structuring” skills, relative to “credit” analysis, may itself present a concern.
For example, for some mezzanine structured credit products, zero recovery rates are much more likely than on similarly rated corporate bonds, yet the resulting default probabilities and expected losses are mapped into traditional corporate bond ratings, which are based on recovery rates that tend to be in the 40–60 percent range. Prince (2005) discusses some alternative structured credit rating methodologies that may better account for unexpected losses. See also Joint Forum (2005); Fender and Kiff (2005); and CGFS (2005).
See Violi (2004) and Moody’s Investors Service (2006) for an analysis of credit rating migration risk, and Fender and Mitchell (2005) for a discussion of how CDO structural risk increases the potential for multinotch rating downgrades. For example, the potential for zero recoveries on “thin” mezzanine tranches, where “thinness” is defined by the difference between attachment and detachment points, can produce “cliff” effects in tranche loss distributions.
CDO-squared tranches, which reference mezza-nine tranches of other CDOs, were introduced as CDS spreads narrowed to levels that made it less cost-effective for arrangers to issue straight mezzanine tranches.
At this stage, these markets are mainly used by large banks. Smaller banks that, according to the Federal Reserve Board’s U.S. commercial bank surveys, account for about half of U.S. real estate and consumer lending are not very active in risk transfer markets. See Standard & Poor’s (2005); and Minton, Stulz, and Williamson (2005).
These funds include those primarily or solely focused on credit and fixed-income markets, including, but not limited to, hedge funds.
Most market participants base their tranche risk metrics on the tranche’s “delta” (see Box 2.5). Leverage is calculated by dividing each tranche’s delta, expressed as a percent of its notional amount, by the delta of the underlying portfolio.
See Large (2005).
Among EM sovereign issuers, Mexico, Brazil, Russia, and the Philippines are the most regularly traded names.
However, going forward, they may be subject to higher balance sheet and earnings volatility because of new and proposed accounting rules, as discussed in previous issues of the GFSR (IMF, 2004a, 2004b, and 2005).
Under the auspices of the Joint Forum, banking, securities, and insurance supervisors are currently conducting work on the management of balance sheet liquidity risk in these different sectors (see Joint Forum, 2006). Issues related to liquidity risks are also included in the proposed work program of the Institute of International Finance.
Many of the recommendations of the Counterparty Risk Management Policy Group II (2005) targeted reducing confirmation backlogs and ensuring the integrity of trade reassignments. More broadly, the Group of Thirty (2003, p. 5) report has raised concerns that “unevenly developed national clearing and settlement infrastructure, and inconsistent business practices across markets, could be a source of significant systemic risk, and certainly of inefficiency.”
Geithner (2005) called for commitments to reduce the backlog of unconfirmed trades, shorten confirm times, and increase the use of automated platforms. Other regulators have raised similar concerns, including the U.K. FSA and the former U.S. Federal Reserve Chairman Alan Greenspan. See FSA (2005) and Greenspan (2005).
Confirmations outstanding for more than 30 days for the group of 14 major dealers were reduced by 54 percent, thereby meeting the January 31, 2006, target of reducing such outstanding confirmations from September 2005 levels by 30 percent. On March 10, 2006, the dealers set a 70 percent target for June 30, 2006, and committed to numerous trade-processing initiatives going forward.
Unlike other financial instruments, obtaining approvals for reassigning credit derivative contracts involves a relatively more cumbersome three-party process. The original procedures in the ISDA master agreement were designed for situations where novations were infrequent.
For example, comments from buy-side industry representatives, particularly hedge funds, noted that the same-day (6 p.m.) deadline specified in the ISDA protocol did not make sufficient allowance for trading across time zones. A subsequent ISDA guidance note to the novation protocol requests (but does not require) parties to accept notices received the following business day.
See Scott, Sbityakov, and Beinstein (2005) for more detail on the Delphi settlement protocol.
See Blanco, Brennan, and Marsh (2005), who concluded that CDS spreads led changes in bond spreads. Zhu (2004) and Norden and Weber (2004) came to a similar conclusion. It is interesting that one of the data challenges in both cases was finding useful daily bond price data. For example, Blanco, Brennan, and Marsh (2005) started with 119 liquid CDS names, but they had to eliminate most because of insufficient bond price data. See also ChanLau and Kim (2005) and Neftci, Santos, and Lu (2006), whose empirical results suggest that for EM credits, the CDS market was the best source of price discovery.
See Diamond (1984 and 1991) and Morrison (2005) on bank incentives to screen and monitor borrowers. See also Kiff, Michaud, and Mitchell (2003) for a general review of literature on factors affecting bank credit supply.
Such early transactions were typically pools of loans (called collateralized loan obligations, or CLOs), and the banks were perceived to have an informational and monitoring advantage.
Until recently, some banks and/or arrangers of structured products retained the equity tranches because of their perceived attractive rates of return. However, with the growth of hedge fund participation in these markets, the ability to transfer first loss tranches has significantly increased, and premium returns have declined.
Credit cycles can be defined with different metrics (e.g., credit quantity growth and spreads) and using different aggregates. Since the reference entities for credit derivatives are primarily nonfinancial corporations (62 percent), the volume of credit extended to these firms (i.e., bond and bank lending) will be the relevant measure for gauging credit cycle dynamics for this study.
U.S. data from the Flow of Funds and National Accounts are used for illustrative purposes.
One example of anticipatory behavior is the effect that recent monetary policy approaches (including transparency and gradualism) have had on economic activity since 1980 in the United States. It contributed to sharply reduced inflation and volatility of GDP growth, resulting in less volatile economic cycles. The standard deviation of GDP growth declined from 2.7 percent during the 1980s to 1.5 percent during the period 1990–2005 (and to 1.3 percent in 1995–2005). See Rosenberg (2005) for a discussion of the impact of transparent monetary policy during the Greenspan era.
Helbling and Terrones (2003a) and Hunt (2005) study the impact of housing price declines on output loss. Kodres (2004) notes the importance of the structure of mortgage markets on house price growth and volatility. Schnure (2005) discusses how the rise in securitization activity since the mid-1970s in the United States may have significantly reduced the cyclical variability (or dampened the credit cycle) in mortgage finance. There is also significant literature connecting financial market innovations and developments with economic growth (see Levine, 1996; and King and Levine, 1993).
Helbling and Terrones (2003b, p. 74).
Estrella (2002) presents econometric evidence that securitization may have reduced the sensitivity of output to monetary policy and related interest rate changes. He concludes that securitization may have reduced the efficacy of monetary policy by influencing credit availability (i.e., dampening the credit channel). Loutskina and Strahan (2006) also present empirical evidence suggesting that securitization limits the Federal Reserve’s ability to influence bank lending. See also Dynan, Elmendorf, and Sichel (2005) for a discussion of the impact of financial innovations on reducing output volatility.
See Geithner (2006b) on the increasing importance of understanding the interaction of asset prices and market liquidity for monetary policy decisions.
Creditflux collects arguably the most detailed portfolio swap data necessary to measure, with any reasonableness, economic risk transfer (see Box 2.5).
See Joint Forum (2005, Annex 4).