ADDITIONAL ELEMENTS CONSIDERED IN CREDIT ENHANCEMENTS
In the identification and analysis of credit enhancements, credit institutions must also consider the possibility of double default—of both obligor and guarantor—the specific and general wrong way risks which can be also be linked with double default, the maturity mismatch between the exposure and the collaterals, as well as the dependencies of contracts and counterparties via credit enhancements.
10.4.1 Double default
A double default occurs when both the obligor (lender) and the guarantor default at the same time. Even though a guarantor promised to cover losses in case of a default, he may find himself/herself without the necessary capital to fulfill this obligation in times of need. When large parts of the market are under stress, the risk of double default is at its highest. A few additional considerations with double default are important.
Credit enhancements are directly or indirectly linked to counterparties. Guarantors on guarantee agreements and protection sellers in credit derivatives are counterparties who agree to cover losses stemming from counterparty credit risk. Most financial collaterals, except commodities, are also linked to counterparties; which implies that any downgrading will affect the value of the bond.
With the help of credit enhancements, banks migrate the risk, directly or indirectly, from the obligor to a third counterparty. In the case of counterparty-based credit enhancements, direct mitigation of the counterparty risk is applied. Thus, institutions treat the credit exposure as if it were an exposure from the guarantor rather than from the original creditor. Depending on the type of credit enhancement, we should consider the following cases:
1. Obligor (borrower) defaults or downgrades; guarantor or protection seller is capable of recovering the agreed amount of the corresponding losses.
2.
Guarantor downgrades (at a lower degree of credit rating than the obligor), or defaults; obligor is still fulfilling the agreed obligations; as there is no credit event, no loss needs to be recovered. As the guarantee contract is invalid, the net exposure is estimated by excluding the collateralized amount agreed by the downgraded or defaulted guarantor or protection seller.3. Double default: both the obligor and the guarantor or protection seller default. The credit exposure that the guarantor agreed to cover is now an additional, to net exposure, actual credit loss.
In the analysis of double default, we should make two different assumptions about correlations between the parties:
1. The two parties, obligor and guarantor or protection seller, are independent of each other; thus, the likelihood of double default is expected to be rather low. Statistically, the joint default probability is defined as PDdouble default = PDobligor ■ PDguarantor.
2. There is correlation between the two parties. That is, the same or correlated risk factors influence them at the time of default of the obligor. This case falls into general wrong way risk, which we will discuss later.
We can also apply the above combinations and analysis in a similar way with asset-based credit enhancements, for example:
1. Only the obligor (borrower) defaults but not the asset-based credit enhancements, therefore the asset recovers the credit losses.
2. Only the counterparty linked to the asset defaults, but not the obligor. Net exposure does not consider the defaulted asset.
3. Double default, this is both the obligor and the asset defaulting at the same time. The remaining net exposure, excluding the defaulted asset, will be the actual loss.
The assumption that the underlying risk factors linked to the obligor and asset-based credit enhancements are independent can be risky. Indeed, under general wrong way risk, a strong dependency exists.
Moreover, when financial collateral belongs to the obligor, additional expected losses are indicated. This gives rise to additional types of risks named specific and general wrong way risk as discussed in the following section.10.4.2 Wrongwayrisk
Another special type of risk is so-called wrong way risk. This risk has to do with identifying and measuring the unfavorable dependency between the counterparties' default probability with the current and future credit exposures. This dependency can be direct, which we describe as specific wrong way risk. When the dependency is indirect, we speak of general wrong way risk. In both kinds of wrong way risk there is a direct and indirect link correspondingly between the obligor (e.g., borrower), with the collateral attached to the credit exposure.
Let us imagine a case where a corporate borrows an amount A and uses, as financial collateral, its own stocks or other assets that have a value C. The resulting net exposure, estimated as N = A - C, is under specific wrong way risk. This is because if the corporate downgrades or defaults the value of the applied collateral will be changed, i.e., reduced, and adjusted accordingly to Cadjusted. In fact, the net exposure changes to N = A - Cadjusted due to the obligor's change of credit status.
The size of credit exposure under specific wrong way risk is often not fully transparent; indeed, there could be cases4 with an additional degree of complexity to the one mentioned in the above example. Normally, practitioners and regulators5 focus on exposures where there is a legal connection between the obligor and the counterparty linked to the underlying credit enhancement(s). There are examples where collateral does not directly belong to the obligor but to a third party that has a legal connection with the obligor (for instance, a parent company).
The identification of general wrong way risk is usually more complex than the specific one.
Such risk usually arises when the counterparty credit status of the obligor is dependent on the market conditions referenced to credit enhancements applied to the credit exposure. A typical case in this category is the use of collateral stocks or indexes belonging to the same sector as the obligor; assuming that the obligor has no strong idiosyncratic sensitivity, we expect that both obligor credit status and such collateral value will deteriorate synchronously. Another instance would be when an obligor, such as a financial institution, is using governmental bonds. In practice, there is an alliance between the downgrading of the governmental bonds and financial institutions belonging to the same country/region. In fact, there are several financial instruments6 affected by general wrong way risk.We can therefore say that general wrong way risk indicates the unfavorable dependencies between the counterparty’s credit quality, i.e., rating, with general market risk factors. Such factors could be the region, industry, sector, and other categories that are germane to the descriptive characteristics of the counterparty. Moreover, the idiosyncratic strength of the counterparty and the degree of sensitivities against the market risk factors, discussed in Chapter 7, are essential parameters used in the identification of general wrong way risk.
10.4.3 Maturity mismatch and payment times
The duration where the credit enhancements are valid plays an important role in exposure and credit loss analysis. Imagine a case where a financial collateral, such as a bond, matures in six months covering an exposure that matures in one year. This means that for the first six months in the calculation of the net exposure, we can consider this collateral but not for the last six months. Thus, the maturity mismatch between an exposure and recognized credit enhancements must be well identified and considered.
How should one deal with maturity mismatch? One way is to try to quantify the mismatch in advance and monitor it closely for each particular exposure.
However, this is complex and tedious. For this reason, institutions may apply adjustment factors7 at the portfolio level for approximating the maturity mismatch.Another important variable to consider is time: the point-in-time where the credit enhancement will recover the credit losses. Thus, for the financial assets the degree of market liquidity, discussed in Chapter 12 (Liquidity, Value, Income, Risk and New Production), plays a key role; that is, liquid assets can be liquidated almost after the default event whereas illiquid assets introduce time delays. The payments from the guaranties have further uncertainties in regards to time; legal issues and administrating processes may also cause unexpected delays.
10.4.4 Contracts and counterparties dependencies via credit enhancements
As we have seen, different types of credit enhancements are attached to a single or several counterparties and/or to specific contract exposure(s). This means that due to credit enhancements there may be dependencies between different contracts and counterparties. Technically speaking, such dependencies are usually mapped by grouping them using multidimensional matrixes.8 Thus, as can be seen in Figure 10.6, if counterparty CPb ensures the exposure for contract L1 of counterparty CPa through a guarantee GAR1 and L1 is also covered by a financial collateral bond B1, which belongs to CPc, then CPb, GAR1, contract L1, bond B1 and CPC belong to the same group. Groups are useful to measure and report the counterparty and contract dependencies.
10.5