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Credit Risk Management Post Dodd-Frank and MF
GlobalApril 11, 2012
Vince KaminskiPresentation to the
CFA Society of Houston
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Credit Risk
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Credit RiskThe risk of losing market value due to changes in your own or counterparty credit quality and / or counter party failure to performThree conventional wisdoms
Credit risk management is limited to analysis and mitigation of counterparty credit riskCredit risk arises exclusively from a counterparty bankruptcyFinancial innovations reduced overall market and credit risk
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Credit Risk (2)
Walter Bagehot: If you have to prove you are worthy of credit, your credit is already gone.
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Credit Risk (3)Again, it may be said that we need not be alarmed at the magnitude of our credit system or at its refinement, for that we have learned by experience the way of controlling it, and always manage it with discretion. But we do not always manage it with discretion. There is the astounding instance of Overend, Gurney, and Co. to the contrary. Ten years ago that house stood next to the Bank of England in the City of London; it was better known abroad than any similar firm known, perhaps, better than any purely English firm. The partners had great estates, which had mostly been made in the business. They still derived an immense income from it. Yet in six years they lost all their own wealth, sold the business to the company, and then lost a large part of the company's capital. And these losses were made in a manner so reckless and so foolish, that one would think a child who had lent money in the City of London would have lent it better. After this example, we must not confide too surely in long-established credit, or in firmly-rooted traditions of business. We must examine the system on which these great masses of money are manipulated, and assure ourselves that it is safe and right.Walter Bagehot, “The Lombard Street,” London 1873
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Credit Risk (4)Most energy companies have specialized units responsible for management of credit risk at the corporate levelCredit risk management is particularly important to energy trading operationsManagement of credit risk requires cooperation of professionals with multiple skills, using different conceptual frameworks and languages
LawyersRisk analystsQuantitative modelers
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Credit Group’s Responsibility Development of systems and procedures for assessment and
management of credit risk Development of the counterparty data base Negotiation of credit agreements with trade counterparties Establishment and enforcement of credit lines and credit
limits Assessment of credit risk related to
Specific transactionsDifferent counterparties across all the transactionsOverall credit risk of the entire portfolio
Mitigation of credit risk
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Credit Risk Measurement
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Credit Risk Measurement Credit risk can be measured at the level of a single transaction
or the entire portfolio Credit risk of an individual transaction may be measured as
current + potential risk Current credit risk of a single transaction is the cost of
replacing the transaction in the market place in case of the counterparty default
Portfolio credit risk requires assessment of credit risk across a portfolio of Different transactions with the same counterparty
In case of transactions with the same counterparty netting may apply (assets and liabilities netted)
A portfolio of original transactions with many counterparties, possibly supplemented with risk mitigation instruments
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Credit Exposure
Source: Jones School, Rice University
Credit Exposure
Current PotentialAccountsReceivable
Current UnbilledExposure
Current MTM
Potential MTM
Provisional UnbilledExposure
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Potential MTM Exposure
CurrentMTM
1 Year
Exposure“Maximum” Potential Forward Exposure
95 % Confidence Interval
50 % Confidence Interval
1 Year Swap
3 Months
Threshold
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Bilateral Credit Risk Management
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Credit AgreementsCredit Limits and Credit ThresholdsCollateralization of Credit RiskNettingCredit Risk Hedging
Credit DerivativesCredit Insurance
Credit Risk Mitigation
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Master Agreements
Master credit agreements cover netting, set-off, cross-default and collateral arrangements
The templates are provided by a number of standardized documents: International Swap Derivatives Association Inc. ― Master
Agreement (ISDA) Edison Electric Institute ― Master Purchase & Sale
Agreement (EEI) Western Systems Power Pool ― Western Systems Power
Pool Agreement (WSPP) North American Energy Standards Board ― Base
Contract for Sale and Purchase of Natural Gas ― (NAESB)
Gas Industry Standards Board ― Base Contract for Short-Term Sale and Purchase of Natural Gas (GISB)
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Master Netting Agreements Benefits. Master netting agreements:
Reduce credit risk Free up cash and corporate guarantees Facilitate integration of risk management systems and allow
for development of Enterprise-Wide Risk Management System Reduce legal overhead requirements
Master credit agreements should address the issues of netting Across different product lines Across physical and financial transactions Across different jurisdictions
Many provisions of the credit agreements have not been tested in bankruptcy
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Credit Thresholds and Credit Limits
Bilateral credit risk is managed primarily through the establishment of the credit limits and credit thresholds Credit limits define the maximum credit exposure with
respect to a given counterparty Additional transactions require approval of the credit
department Credit thresholds define maximum credit exposure
that does not require posting collateral Once credit exposure exceeds the credit limit, the
excess credit exposure will be collateralized Credit thresholds can be adjusted based on the credit
ratings changes or the so-called MAC clauses in credit agreements
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Setting Collateral Requirements Collateral provides a level of assurance regarding counter-party
performance – “bankruptcy safe” Once credit threshold is set, collateral is normally required for
transactions that exceed this threshold Example, counter-party has been extended $20MM of credit
based upon its BBB+ investment grade rating and certain financial characteristics
Transaction with counter-party is now marked-to-market at $25MM
Counter-party must provide $5MM of collateral Counter-parties below investment grade
Collateral is usually 100% (or more) of the marked-to-market amount of the transactionFrequent use of over collateralization (O/C) for these
counter-parties (>100%)Counter-parties prefer O/C over contract termination
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Threshold Example
S&P Rating Moody’s Rating Threshold
AA- or above Aa3 or above $30,000,000
A+ A1 $20,000,000
A A2 $17,500,000
A- A3 $15,000,000
BBB+ Baa1 $12,500,000
BBB Baa2 $10,000,000
BBB- Baa3 $ 5,000,000
BB+ or below (or unrated)
Ba1 or below (or unrated)
Zero
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Setting Collateral Requirements Material adverse change in financial conditions (MAC)
language allows either party to increase its collateral requirements or terminate contract
If financial conditions imply performance impairment:Counter-party must post-adequate assuranceThresholds may be reduced (possibly to zero)Reduction of credit thresholds may start a death
spiral Credit downgrade below investment grade has similar
consequences The potential for death spiral
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Problems with Using Collateral Requirements
Differences in transaction valuation between counter-parties Illiquid markets Often a negotiated value is used by the counter-parties
Valuation differences are often split 50-50 – potential collateral shortfall may result
Disturbing trend – credit personnel negotiating contracts lacking experience in financial valuation techniques
Time lag of transaction valuation vs. receipt of collateral (2 - 5 days)
Linking a subsidiary with the parent company (establishing parent-child relationship) is a challenging task
Many financial firms offer hedging instruments combined with automatic credit lines (secured with physical assets) that can be used to post collateral
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Problems with Using Collateral Requirements (2)
Major risk: re-hypothecation This is a critical risk that has no been recognized
by the industryComingling of collateral with the firm’s own fund
and using it for general corporate purposesRe-hypothecation is the mechanism behind the
growth of shadow bankingDifferences between the US and UK laws
governing re-hypothecation
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Central Clearing Counterparties
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Central Clearing Counterparties
Clearinghouse mechanicsA bilateral transaction is broken up through a
process called novation into two transactionsA clearinghouse is inserted between two
original counterpartiesThe concept of a clearinghouse was developed
in FranceCaisse de Liquidation des Affaires en
Marchandise (1882)Predecessors
Dojima: rice futures market in Osaka, Japan, in the 18th century
Coffee Exchange in New York City
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2
3
45
1
Bilateral Clearing
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2
3
45
1 CCP
Central Clearing
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Central Clearing Counterparties (2)
Two CCP designs used in practiceVertical, integrated structure: a clearinghouse
owned by/associated with an exchangeAn example: The CME
A horizontal structure: a CCP accepting for clearing transactions executed on multiple exchanges
An example: London ClearinghouseA trend towards establishment of vertical
structures
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Mechanics of Clearing
NovationBoth counterparties post an initial margin
(performance bond)The positions are marked-to-market (usually
twice a day)If the equity in the account of a counterparty
falls below the so-called maintenance margin, variation margin has to be posted
The failure to post variation margin triggers liquidation of positions
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Central Clearing Counterparties (3)
CCPs have a number of safeguards to protect against a default by a clearing member, other members and their clients
Such measures include (in addition to marking-to-market and margining)Defining financial strength thresholds for clearing
members Audits of clearing membersStrict governance rules for the CCP and clearing
membersThe right to liquidate and/or transfer positions of
clearing members and their customersDefault fund and additional insurance
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FCMFCM (Futures Commission Merchant)
Executes orders to buy or sell futures or options on futures
Collects from customers funds or other assets to support these orders
Funds collected from the customers remain their property and cannot be comingled with the FCM’s own assets
There are currently 65 FCMs in the USTop 30 FCMs held over $163 billion of customer
funds as of March 2011An FCM typically collects more funds than the
minimum required by a clearing organization
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FCM (2)The CEA and CFTC regulations require that the
customer collateral received by FCMs be segregated
An FCM is allowed to invest funds held in the customers accounts
CFTC Rule 1.25 determines what are allowed investments
The value of customer account must remain intact all the times
FCM are subject to the CFTC regulations which are enforced by DSROs (Designated Self Regulatory Organizations)Regulation 1.10Regulation 1.16
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FCM (3)Regulation 1.10
The CFTC Regulation 1.10 requires FCMs to file monthly unaudited financial reports with the Commission and the DSRO
Segregation and net capital schedules details
“Further material information as may be necessary to make the required statements and schedules not misleading.”
Reports are filed under oath (CEO or CFO)
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FCM (4)Regulation 1.16
The CFTC requires FCMs to file annual certified financial reports with the Commission and the DSRO
Audits requirements include: Information about disagreements with
statements made in reports prepared by prior auditors
Inadequacy tests for internal controls that may inhibit an FCM from effectively protecting customers’ assets or result in violation of the CFTC’s segregation requirements
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Lessons Learned
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Recent Developments: DF
Dodd-Frank requires mandatory clearing of standardized derivatives Exemption for the end-users of derivativesA likely outcome: proliferation of clearing
houses“As long as the clearinghouse is well capitalized and
manages its risks well, there is no material counterparty risk with the clearinghouse. This fact explains the widely-held belief that requiring clearing for over-the-counter derivatives will significantly reduce systemic risk. It is important, however, to understand that we have much experience with exchange clearinghouses and little experience with over-the-counter clearinghouses. Over-the-counter clearinghouses have not been tested in a financial crisis.” “Testimony of René M. Stulz to The House Committee on Financial Services”
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Recent Developments: DF (2)
Potential for concentration of credit risk in a small number of clearinghouses
Clearinghouses may become a source of systemic risk Solution:
Access to central bank liquidityRestrictions on clearinghouse membership
Minimum capitalization levels for clearing members
Higher assessments and fees to build up a default fund
Additional insurance
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Lessons Learned – MF GlobalBankruptcy of MF Global and the curious case of
missing funds in segregated accountsBalkanization of the regulatory infrastructure
The CFTC regulates FCMs but lacks resource to implement effective oversight infrastructure
The day-to-day oversight responsibilities are delegated to the DSROs
The trend towards demutualization of exchanges creates profit pressures
The CFTC rules covering FCMs will be rewrittenThe CFTC is likely to receive additional funding to
enhance oversight of FCMs
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Lessons Learned – MF Global (2)Consequences and potential remedies:
An adverse impact on the efficiency of the US economy
Risk management principles should be revisitedAre risk managers truly independent?
Changes in management of relationships with brokers
More proactive management and monitoring of the financial conditions of a broker
More effective cash managementUsing several FCMs to reduce potential
exposure to any single broker