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The first decade of the 21st Century...

has seen counterparty credit risk become the key element of financial risk management,

highlighted by the bankruptcy and failure of several high profile institutions. The sudden

realisation of extensive counterparty risks has severely compromised the health of global

financial markets.

This book is unique in being practically focused but also covering the more technical aspects. It

is an invaluable complete reference guide for any market practitioner, policy maker, academic or student with any responsibility or interest within

the area of counterparty credit risk and CVA.

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1

Counterparty credit riskA continuing challenge for global financial marketsJon Gregory9781118316672 • Cloth • 480 pages August 2012 • £60 / €71 / $100

1 Introduction“If history repeats itself, and the unexpected always happens, how incapable must

Man be of learning from experience.” - George Bernard Shaw (1856–1950)

Between 2004 and 2006, US interest rates rose from 1% to over 5%, triggering a slowdown in the US housing market. Many homeowners, who had been barely able to afford their payments when interest rates were low, began to default on their mortgages. Default rates on subprime loans (made to those with a poor or no credit history) hit record levels. US households had also become increasingly in debt, with the ratio of debt to disposable personal income rising. Many other countries (although not all) had ended up in a similar situation. Years of poor underwriting standards and cheap debt were about to catalyse a global financial crisis.

Many of the now toxic US subprime loans were held by US retail banks and mortgage providers such as Fannie Mae and Freddie Mac. However, the market had been allowed to spread due to the fact that the underlying mortgages had been packaged up into complex structures using financial engineering techniques, such as mortgage-backed securities (MBSs), which had been given good credit ratings from the rating agencies. As a result, the underlying mortgages ended up being held by institutions that did not originate them, such as investment banks and institutional investors outside the US. Financial engineering had created a global exposure to US mortgages.

In mid-2007, a credit crisis began, caused primarily by the systematic mispricing of US mortgages and MBSs. Whilst this caused excessive volatility in the credit markets (which had been quiet for a number of years), it was not believed to be a severe financial crisis (for example, the stock market did not react particular badly). The crisis, however, did not go away.

In July 2007, Bear Stearns informed investors they would get very little of their money back from two hedge funds due to losses in subprime mortgages. In August 2007, BNP Paribas told investors that they would be unable to take money out of two funds because the underlying assets could not be valued due to “a complete evaporation of liquidity in the market”. Basically, this meant that the assets could not be sold at any reasonable price. In September 2007, Northern Rock, a British Bank, sought emergency funding from the Bank of England as a “lender of last resort”. This prompted the first run on a bank for over a century. Northern Rock, in 2008, would be

taken into state ownership to save depositors and borrowers.

By the end of 2007, some insurance companies, known as “monolines”, were in serious trouble. Monolines provided insurance to banks on mortgage and other related debt. The Triple-A ratings of monolines had meant that banks were not concerned with a potential monoline default, despite the obvious misnomer that a monoline insurance company appeared to represent. Banks’ willingness to ignore the counterparty risk had led them to build up large monoline exposures without the requirement for monolines to post collateral, at least as long as they maintained their excellent Triple-A credit ratings. However, monolines were now reporting large losses and making it clear that any downgrading of their credit ratings may trigger collateral calls that they would not be able to make. Such downgrades began in December 2007 and banks were forced to take losses totalling billions of dollars due to the massive counterparty risk they now faced. This was a particularly bad form of counterparty risk, known as wrong-way risk, where the exposure to a counterparty and their default probability were inextricably linked.

By the end of 2007, although not yet known, the US economy was in recession and many other economies would follow. The crisis was now affecting the general public and yet this was only the tip of the iceberg.

In March 2008, Bear Stearns was purchased by JP Morgan Chase for just $2 a share, assisted by a loan of tens of billions of dollars from the Federal Reserve, who were essentially taking $30 billion of losses from the worst Bear Stearns assets to catalyse the sale. This clearly represented a form of bailout, with the US taxpayer essentially funding some of the purchase of Bear Stearns. The sale price of Bear Stearns was shocking, considering that it had been trading at $93 a share only a month previously. Something was clearly going very wrong. In early September 2008, mortgage lenders Fannie Mae and Freddie Mac, who combined accounted for over half the outstanding US mortgages, were placed into conservatorship (a sort of short-term nationalisation) by the US Treasury. Treasury secretary Henry Paulson stated that the combined debt levels posed a “systemic risk” to financial stability.

In September 2008 the unthinkable happened when Lehman Brothers, a global investment bank and the fourth largest investment bank in the US with a century-long tradition, filed for Chapter 11 bankruptcy protection, (the largest in history). This occurred after teams of bankers failed during the weekend spent in the Federal Reserve Building to agree any better solution, in particular with Barclays and Bank of America pulling out of buying Lehman. The US government was reluctant to rescue Lehman due to the moral hazard that such bailouts encourage. The bankruptcy of Lehman had not been anticipated, with all major rating agencies (Moody’s, Standard & Poor’s and Fitch) all giving at least a Single-A rating right up to the point of Lehman’s failure and the credit derivative market not pricing an actual default.

Saving Lehman’s would have cost the US taxpayer again and exasperated moral hazard problems since a bailout of Lehman’s would not punish their excessive risk

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taking (their exposure to the mortgage market and risky behaviour in understating the need for new funding). However, a Lehman default was not an especially pleasant prospect either. Firstly, there was estimated to be around $400 billion of credit default swap (CDS) insurance written on Lehman Brothers debt. Since the debt was now close to worthless, this would trigger massive payouts on the underlying CDS contracts and yet the opacity of the OTC derivatives market meant that it was not clear who actually owned most of the CDS referencing Lehman.

Another counterparty might now have financial problems due to suffering large losses because of providing CDS protection on Lehman. Secondly, Lehman had around one and a half million derivatives trades with around 8,000 different counterparties that all needed to be unwound, a process that would take years and lead to many legal proceedings. Most counterparties probably never considered that their counterparty risk to Lehman’s was a particular issue nor did they realise that the failure of counterparty risk mitigation methods such as collateral and special purpose vehicles (SPVs) would lead to legal problems.

On the same day as Lehman’s failed, Bank of America agreed a $50 billion rescue ofMerrill Lynch. Soon after the remaining two investment banks, Morgan Stanley and Goldman Sachs, opted to become commercial banks. Whilst this would subject them to more strict regulation, it allowed full access to the Federal Reserve’s lending facilities and prevented them suffering the same fate as the bankrupt Lehman Brothers or the sold Bear Stearns or Merrill Lynch.

In case September 2008 was not exciting enough, the US government provided American International Group (AIG) with loans of up to $85 billion in exchange for a four-fifths stake in AIG. Had AIG been allowed to fail through bankruptcy, not only would bondholders have suffered but also their derivative counterparties (the major banks) would have suffered significant losses. Prior to the crisis, the counterparty risk of AIG was typically considered minimal due to their size, excellent credit rating and the fact that (unlike monoline insurers) they did post collateral. The reason for the rescue of AIG and non-rescue of monolines was partly timing – the AIG situation occurred at the same time as the Lehman bankruptcy and immediately after the Fannie Mae and Freddie Mac rescues.

However, another important fact was that AIG had an exposure that was not dissimilar to the total exposure of the monoline insurers but concentrated within a single financial entity. AIG was “too big to fail”.

Three of the largest US investment banks had now either gone bankrupt (Lehman Brothers) or been sold at fire sale prices to other banks (Bear Stearns and Merrill Lynch).

The remaining two had given up their prized investment bank status to allow them to be bailed out. Later in September 2008 Washington Mutual, America’s biggest savings and loan company, was sold to JP Morgan for $1.9 billion and their parent company, Washington Mutual Inc., filed for Chapter 11 bankruptcy protection. A CDS contract purchased from any of the aforementioned US banks on any of the other US banks was now clearly seen to have enormous, almost comical amounts of wrong-way counterparty risk.

By now, trillions of dollars had simply vanished from the financial markets and

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therefore the global economy. Whilst this was related to the mispricing of mortgage risk, it was also significantly driven by the recognition of counterparty risk.

On October 6, the Dow Jones Industrial Average dropped more than 700 points and fell below 10,000 for the first time in four years. The systemic shockwaves arising from the failure of the US banking giants led to the Troubled Asset Relief Program (TARP) of not too much short of $1 trillion to purchase distressed assets and support failing banks. In November 2008, Citigroup, prior to the crisis the largest bank in the world but now reeling following a dramatic plunge in its share price, needed assistance via TARP, via a $20 billion cash injection and government backing for around $300 billion of loans.

The contagion had spread far beyond the US. In early 2009, the Royal Bank of Scotland (RBS) reported a loss of £24.1 billion, the biggest in British corporate history. The majority of this loss was borne by the British government, now the majority owner of RBS, having paid £45 billion to rescue RBS in October 2008. In November 2008 the International Monetary Fund (IMF), together with other European countries, approved a $4.6 billion loan for Iceland after the country’s banking system collapsed in October. This was the first IMF loan to a Western European nation since 1976.

From late 2009, fears of a sovereign debt crisis developed in Europe driven by high debt levels and a downgrading of government debt in some European states. In May 2010, Greece received a D110 billion bailout from Eurozone countries and the IMF. Greece was to be bailed out again and support was also given to other Eurozone sovereign entities, notably Portugal and Ireland. Banks again were heavily exposed to potential failures of European sovereign countries. Again, the counterparty risk of such entities had been considered low but was now extremely high and made worse by the fact that sovereign entities generally did not post collateral.

By now, it was clear that no counterparty (Triple-A entities, global investment banks, retail banks, sovereigns) could ever be regarded as risk-free. Counterparty risk, previously hidden via spurious credit ratings, collateral or legal assumptions, was now present throughout the global financial markets. CVA (credit value adjustment), which defined the price of counterparty risk, had gone from a rarely used technical term to a buzzword constantly associated with financial markets. The pricing of counterparty risk into trades (via a CVA charge) was now becoming the rule and not the exception. Whilst the largest investment banks had built trading desks and complex systems and models around managing CVA, all banks (and some other financial institutions and large derivatives users) were now focused on expanding their capabilities in this respect.

By 2009, new fast-tracked financial regulation was beginning to take shape around the practices of banks. The Basel III global regulatory standard (developed in direct response to the crisis) was introduced to strengthen bank capital bases and introduce new requirements on liquidity and leverage. The US Dodd–Frank Wall Street Reform and Consumer Protection Act 2009 and European Market Infrastructure Regulation (EMIR) were aimed at increasing the stability of the over-the-counter (OTC) derivative markets. Regulatory response to the global financial crisis (as it was now known) revolved very much around counterparty credit risk, with the volatility of CVA, collateral management and wrongway risk all receiving attention.

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The regulatory focus on CVA seemed to encourage active hedging of counterparty risk so as to obtain capital relief. However, the market that would be most important for such hedging, credit derivatives, was having its own problems. Whilst credit derivatives, such as single-name and index credit default swaps, allowed counterparty risk transfer, being OTC instruments, they also introduced their own form of counterparty risk, which was the wrongway type highlighted by the monoline failures. Indeed, the CDS market was almost seizing up due to this severe wrong-way risk. Counterparty risk was the principle linkage among participants in the CDS market that could cause systemic failures. Regulatory proposals to deal with this problem involved pushing heavily towards the central clearing of certain standard OTC derivatives, notably CDSs. Whilst, prior to the crisis, much of the interest rate swap market was already moving towards central clearing, without regulatory intervention the CDS market was arguably years away.

Whilst central counterparties (CCPs) provided advantages such as transparency that the OTC derivatives market clearly lacked, this also introduced the question of what would happen if a CCP ever failed. Since CCPs were likely to take over from the likes of Lehman, Citigroup and AIG as the hubs of the complex financial network, such a question was clearly key, and yet not particularly extensively discussed. Furthermore, other potential unintended consequences of increased regulation on counterparty risk could be seen as early as 2010 when, for example, the Bank of England commented that “CVA desks” hedging counterparty risk were causing European sovereign spreads to widen “away from levels solely reflecting the underlying probability of sovereign default”. Although the need to ensure investment banks were better capitalised for risk taking was not under debate, arguments developed over the correct level of capitalisation and the potential adverse and unintended consequences of new regulation.

At the same time as a renewed focus on counterparty risk, other changes in derivatives markets were taking place. A fundamental assumption in the pricing of derivative securities had always been that the risk-free rate could be appropriately proxied by LIBOR. However, practitioners realised that the OIS (overnight indexed spread) was actually a better proxy for the risk-free rate. The LIBOR–OIS spread had historically hovered around 10 basis points, showing a close linkage. However, this close relationship had broken down, even spiking to around 350 basis points around the Lehman bankruptcy. This showed that even the simplest types of derivative, which had been priced in the same way for decades, needed to be valued differently, in a more sophisticated way. Since CVA is an adjustment to the risk-free value of a transaction, this topic was clearly closely related to counterparty risk.

Another, almost inevitable dynamic was that the spreads of banks (i.e., where they could borrow unsecured cash on a longer term than in a typical LIBOR transaction) had increased. Historically, this borrowing cost of a bank was in the region of a few basis points but had now entered the realms of hundreds of basis points in most cases. It was clear that these now substantial funding costs should be quantified alongside CVA. The cost of funding was named FVA (funding value adjustment). Funding costs were also clearly linked to counterparty risk in terms of the calculation and also their similarity to something now known as DVA (debt value adjustment).

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DVA for some banks was the only silver lining of the counterparty risk cloud. DVA allowed banks to account for their own default in the value of transactions and therefore acted to counteract counterparty risk-related losses due to an increase in CVA driven by the widening credit spread environment. However, many commentators believed this to be nothing more than an accounting trick as banks reported billions of dollars of profits from DVA simply due to the fact that their own credit spread implied they were more likely to default in the future. Basel III capital rules moved to remove DVA benefits to avoid effects such as “an increase in a bank’s capital when its own creditworthiness deteriorates”.

The net result of the financial crisis and the impact of regulation led banks to consider the joint impact of risk-free valuation, counterparty risk and funding costs in the valuation of derivatives. Not surprisingly, the increase in funding costs and counterparty risk naturally led banks to tighten up collateral requirements. However, this created a knock-on effect for typical end-users of derivatives that historically had not been able or willing to enter into collateral agreement for liquidity and operational reasons. Some sovereign entities considered posting collateral, not only to avoid the otherwise large CVA and funding costs levied upon them, but also to avoid the issue that banks hedging their counterparty risk may buy CDS protection on them, driving their credit spread wider and potentially causing them more problems. A sovereign posting their own bonds in collateral would ease the problems but this would not be the ideal answer due to another manifestation of wrong-way risk. Furthermore, corporates other than non-collateral posting entities had issues, for example an airline predicted more volatile earnings “not because of unpredictable passenger numbers, interest rates or jet fuel prices, but because it does not post collateral in its derivatives transactions”. End-users of derivatives, although not responsible, were now being hit as badly as the orchestrators of the financial crisis.

Meanwhile, many taxpayers were experiencing poor economic conditions and counting the cost of bailouts via higher taxes and reduced government spending. Businesses and individuals were struggling to borrow money from the heavily capitalised banks. All of this was created by a crisis fuelled to a large extent by counterparty risk.

Because of the above, counterparty risk has become a major subject for global financial markets. It is necessary to consider how to define and quantify counterparty risk. Counterparty risk mitigation methods need to be understood, and their side-effects and any residual risks need to be defined. The question of the role of central counterparties must be examined, alongside the consideration of the risks they will represent. It is important to define how CVA can be quantified and managed, together with other related components such as DVA and FVA. Wrong-way risk must be understood and mitigated or avoided completely. The role and positioning of a CVA desk within a bank or other institution must be defined. The regulation around counterparty risk must be understood, together with the likely impact this will have on banks and the financial markets in which they operate. Finally, the consideration of how all of the above changes are likely to define counterparty risk practices in the future is important.

If any of the above are of interest, then please read on...

6

Counterparty credit risk Jon Gregory

“Jon Gregory is the acknowledged global expert on counterparty credit risk. This new edition of his definitive treatment of the

subject, fully updated and expanded, will remain the go-to source on counterparty risk management and valuation. The concepts

and examples are perfectly pitched to masters students, financial market participants, and regulators.”

- Darrell Duffie, Dean Witter Distinguished Professor of Finance, The Graduate School of Business, Stanford University

“Much has happened in financial markets since the first edition of Counterparty Credit Risk was published. With the second edition

Jon Gregory brings the reader right up to date. Much of the material has been rewritten or expanded. The book will continue

to be essential reading for anyone who works in derivatives.”

- Professor John Hull, Maple Financial Professor of Derivatives and Risk Management, Joseph L. Rotman School of Management,

University of Toronto

“Jon Gregory provides a comprehensive treatment of counterparty risk, including centralized clearing. His exposition

is clear and accessible, which is remarkable given the complexity of the topic. There are many practical examples, including

experiences from the recent credit crisis. His book should be required reading for risk managers, senior banking executives,

regulators, policy makers and scholars concerned about counterparty risk.”

- Stuart M. Turnbull, Bauer Chaired Professor, Bauer College of Business

“It is great to see a timely and extensive update to what has quickly become a classic text in a rapidly evolving field of

counterparty credit risk.”

- Vladimir V. Piterbarg, Global Head of Quantitative Analytics, Barclays