On March 22-23 Federal Reserve held a conference on credit derivatives in Washington.


Federal Reserve Board vice-chairman Donald Kohn speech from this conference highlights few issues:

“At the Federal Reserve, we have considerable interest in credit risk and credit derivatives. As these markets develop and become more complete, they facilitate risk transfer and diversification, thereby increasing the resilience of our financial system. With participants coming to rely more on these markets to manage risk, we have focused increasingly on their liquidity and structure. We have worked closely with the private sector to strengthen the clearing and settlement infrastructure and to understand how these markets will function under stress.

But my emphasis today will be not the structure or mechanics of credit markets but rather the information contained in the prices we observe in these markets. We at the Federal Reserve use this information in nearly every area of our responsibility. For example, in our roles as bank supervisors and protectors of financial stability, we monitor the credit spreads of financial institutions as early warning signs of possible financial stress. In our role as monetary policy makers, we analyze information from credit-risk markets to get readings on the cost of capital to businesses and on forward-looking indicators of the health of the corporate sector that can have implications for future macroeconomic developments.


“In addition to these well-known puzzles [… equity premium, credit spread, behavior of financial volatility, term-premium…], are also a large number of puzzles across all asset markets that I will group under the common theme of risk harmonization. Risk-harmonization puzzles concern whether a given risk is priced the same way in all markets in which that risk is traded. In the absence of transaction costs, broadly defined, the law of one price should hold–there should be no risk-free arbitrage–and all risks should be priced the same way in all markets.”


“In the bad old days, about ten years ago, the best way to infer credit risk was from the prices of corporate bonds, but bond prices are contaminated by differences in coupons, taxes, option-like features, bond covenants, and the illiquidity of the corporate bond market itself. All of these features meant that the modeling error involved in the process resulted in credit-risk measures that were noisy and potentially biased.

Now, instead of looking to the bond market to measure default risk, we are increasingly turning to the market for credit default swaps, or CDS. CDS are more standardized than corporate bonds, and, over time, they have also become more liquid. They therefore provide us with new, and in many cases more precise, measures of credit risk. These measures in turn can sharpen our measures of the pricing puzzles. In addition, because the CDS market helps us to strip out the credit-risk component from bond prices, that market also gives us a clearer picture of how important non-credit-risk components of bond prices, such as liquidity, are priced.”

“ndency of firms to default at the same time. Suppose a bank makes a set of loans that appear to be safe when looked at individually. Whether the loans are likely to default at nearly the same time can represent the difference between whether the bank remains healthy or has the potential to become insolvent. For this reason, the modeling of default correlations, and how correlations change with economic conditions, is one of the most important inputs into measures of portfolio credit risk at banks. Default correlations and how they are modeled are also important to bank regulators and are heavily emphasized within the Basel II capital standards.

Collateralized debt obligations, or CDOs, are one of a number of financial instruments whose prices are sensitive to the pattern of default correlations. As a result, the prices of these instruments provide us with a forward-looking picture of the market’s perception of default correlations and an indication of how the risks of changes in correlation are priced. Of course, as some of the papers in the conference demonstrate, the pricing of correlation-sensitive instruments is, putting it generously, somewhat less than straightforward. For that reason, there is substantial model risk involved in making inferences from these prices. Nevertheless, the prices of these instruments provide a blurry view of default correlations that I expect will improve through time as credit derivatives markets continue to grow and mature.

Credit derivatives, like all derivatives, are in zero net supply, and, abstracting from the very important issue of counterparty credit risk, they neither add to nor subtract from the stock of financial risk in the economy. They do, however, provide new and more-efficient ways for sharing and hedging the risks that do exist, and they facilitate the transfer of those risks to those who are most willing to evaluate and bear them.”

” My message to you today has been that the Federal Reserve places a lot of emphasis on understanding financial asset prices to help it meet its public policy objectives. But in doing so, we are handicapped by the extent to which we do not understand important aspects of how financial assets are priced. Your work as researchers in this field–a portion of which is show-cased at this conference–has been helpful in beginning to explain some of the puzzles, and more recent techniques and ideas together with the data series being generated in new markets hold the promise of more progress in the future.

So, I will not keep you from your work any longer. Your contributions are important to the nation’s central bank. Please, go solve some puzzles.”

  • On the same day Fed Governor Randall Kroszner spoke in Richmond on innovations in credit markets.

Few quotes follow:

“The evolution of the credit markets has been spurred by the astonishing growth of new credit instruments, particularly credit derivatives. The notional amount of credit derivatives outstanding has doubled each year for the past five years; it totaled $20 trillion at the end of June 2006, according to statistics compiled by the Bank for International Settlements (BIS).”

“The bulk of credit derivatives outstanding consist of single-name credit default swaps, or single-name CDS, which reference the obligations of a single obligor. Derivatives are sometimes faulted for their complexity, but that charge cannot be leveled against single-name CDS: The risk of a single-name CDS is essentially that of simply buying or selling short a bond. Single-name CDS make up 70 percent of all credit derivatives, according to the BIS. The bulk of CDS trading is in the investment-grade segment of the corporate credit market, although CDS trading involving high-yield names has been expanding quickly. Most recently, CDS that reference asset-backed securities have been a high-growth part of the market.”


“Credit derivative indexes are currently the fastest-growing and most liquid area of the credit markets. They were created first in the most actively traded market segments: investment-grade and high-yield names in both North America and Europe. Recently, newer indexes have been created in other market segments, including securities backed by commercial mortgages, subprime residential mortgages, and European leveraged loans “


“Another instrument in the credit markets, similar to a credit index tranche, is the collateralized debt obligation, or CDO. A CDO pools a portfolio of fixed-income assets into a tranched liability structure that is familiar from other securitization markets. For example, banks have long used a similar liability structure to fund their credit card loans to consumers. The most common types of collateral for CDOs are asset-backed and corporate securities and syndicated loans. CDOs backed by loans are referred to as collateralized loan obligations, or CLOs. “

“The growth of CLOs has certainly had an effect on the market for syndicated loans. Of course, syndicated loans are not a new instrument. They have been around since the 1970s. But recently, the secondary-market liquidity of syndicated loans has improved dramatically, in part because of the demand for loans by CLOs. This improved liquidity has transformed loans from buy-and-hold investments into traded assets. Market participants are now working to standardize documentation for trading credit default swaps referencing loans. These so-called loan CDS have already started to trade in small amounts.”


“More recently, identifying the ultimate sources of institutional demand has become more difficult. For example, from 2001 through 2006, about two-thirds of institutional term loans were purchased as collateral for the issuance of CLOs. Although institutional investors undoubtedly are the predominant investors in CLOs, little is known about the holdings of the various types of institutions. Also, while much is being made of the increasingly important role of hedge funds in credit markets, hedge funds, in turn, are increasingly managing assets on behalf of endowments, pension funds, and other institutional investors”


“The new instruments, markets, and participants I just described have brought some important benefits to credit markets. I will touch on three of these benefits: enhanced liquidity and transparency, the availability of new tools for managing credit risk, and a greater dispersion of credit risk.”


“Some have expressed concern about the transfer of risk by banks and other heavily regulated depository institutions to more lightly regulated or unregulated entities. Some specific concerns are quite legitimate. For example, as I will discuss in a few moments, if banks transfer credit risk to other entities through mechanisms that expose the banks to counterparty risks to those entities, the transfer is fully effective only if the banks manage those counterparty risks prudently. “


“… while many focus on the dangers of risk transfer to highly leveraged entities that might be vulnerable to a sharp widening of credit spreads, a significant portion of the risks that are being transferred outside the banking system are being transferred to institutional investors that are far less leveraged than banks. “


“The benefits from the development of new instruments and markets that I have described will be fully realized only if market participants address various risk-management challenges posed by the use of these instruments. I will discuss three challenges: limiting counterparty credit risk, modeling default correlation, and improving the infrastructure for clearing and settling credit derivative trades.”

Banks commonly rely on collateral to mitigate counterparty credit risk on over-the-counter derivatives. Credit derivatives are no exception. Also, banks universally require their hedge fund counterparties to post collateral to cover current exposures and, with some exceptions, to cover potential exposures from future market movements. But given the growing role of hedge funds in credit markets, it is appropriate to ask whether dealer banks have enough collateral to protect them against a stress scenario that goes well beyond the recent benign experience in credit markets.

Default correlation is a distinctly new aspect of credit risk. The value of credit index tranches and CDO tranches is sensitive not only to the number of defaults among a set of issuers but also to the correlation of defaults. The more senior tranches suffer losses only in a scenario with many correlated defaults. The value of these senior tranches falls when default correlation rises. The value of a first-loss tranche rises when default correlation rises. And somewhere in the middle of the capital structure is a tranche whose value is roughly insensitive to correlation. The mathematical relationship between tranche value and correlation depends on the particular model that is used to forecast defaults. This dependency exposes dealers and investors to so-called correlation risk if their models or forecasts of default correlation turn out to be incorrect.”


“The third and final challenge I will discuss is that of infrastructure. The very rapid growth of trading credit derivatives had until recently outpaced the development of the infrastructure necessary to clear and settle those trades. Post-trade processes were largely manual, with attendant inefficiencies and risks. By early 2005, credit derivatives dealers had huge backlogs of unconfirmed trades, even though they had greatly increased their back-office resources. Unconfirmed trades increase the potential for material inaccuracies in trade records, which can cause mismeasurement and mismanagement of market risks and counterparty credit risks.”