Repudiation/moratorium
• Restructuring.
The exact definitions of these conditions are not important here, it is sufficient to recognise that there are a variety of credit events that can be considered to constitute a default. However, even these definitions are specific to the CDS market and do not necessarily reflect the practicalities of the default of a derivative counterparty and hence the impact on CVA calculation and the operation of a CVA desk. For a major international corporate or financial with traded CDS contracts it is likely that the CDS contract definition and trigger event will coincide with the failure of the derivative contract and this was certainly the case with the collapse of Lehman Brothers. However, for smaller entities the default process may be less clear cut. If there are no CDS contracts the CDS definitions are irrelevant. The event of default may be due to the restructuring of a counterparty portfolio in response to difficulties faced by the counterparty. The restructuring may be enacted by a group of creditors if there is more than one or the single bank counterparty if the defaulted entity only had a single banking relationship. In such cases it is not even clear if a credit event on one part of the portfolio automatically means that a default has occurred on all of the portfolio of transactions. So for example, an impairment may be taken on a loan by the lending bank but not on derivatives with the same counterparty. The key point to take away is that what constitutes a default is not always certain and that a CVA desk faces a range of different counterparties with a range of different possible credit events.
A second key question is when does default occur? Again this can vary, depending on the circumstances of the default. A failure to pay, for example, can be accompanied by a grace period which can vary from a few days up to a month. This is intended to ensure that issues such as IT system failure do not cause a technical default. Nevertheless, default cannot be confirmed until the grace period has passed. A counterparty could be placed in a workout process by its bank or bankers before impairments are taken. Restructuring may be inevitable but no actual credit event has occurred. From a CVA perspective the time that default is recognised depends on both external factors and internal management processes. For large counterparties with liquid CDS contracts, recognition of the default will tally closely with external market action and the close-out process for CDS contracts. For smaller illiquid counterparties the process will be governed by internal management process and will link with the internal impairment and workout process. Nevertheless, a CVA management function will typically be forced to recognise the loss and make good the derivatives trading desk long before any workout process has been concluded.
2.3.1 Example Default: The Collapse of Lehman Brothers
The most significant default in recent years was the collapse of the investment bank Lehman Brothers in 2008, at the height of the credit crisis. The collapse of the US subprime mortgage market led to significant losses on transactions linked to pools of mortgages, including mortgage and asset-backed securities and credit derivatives such as CDOs. This had already led to the collapse of Bear Stearns and its subsequent rescue by J.P. Morgan (Winnett and Arlidge, 2008). The problems of Lehman Brothers became visible with the publication of a second quarter loss of $2.8bn, coupled with $17bn of write downs on assets including mortgage and asset-backed securities, commercial mortgages and leveraged loans in June 2008 (Quinn, 2008d). On 9 September, negotiations around the sale of a stake in the bank to Korean Development Bank collapsed, prompting a 30 % fall in the share price on a single day (Onaran, 2008). On 11 September the Lehman share price fell as much as 46 %, while Lehman Brothers began exploring the possibility of selling itself to Bank of America (Quinn, 2008b). On 13 September Barclays Bank engaged in takeover talks, but subsequently pulled out on 14 September (Quinn, 2008c). With no rescue options left, Lehman Brothers filed for bankruptcy on the morning of 15 September 2008 (Quinn, 2008a).
When Lehman Brothers Holding Incorporated filed for bankruptcy, the court appointed PricewaterhouseCoopers (PWC) as administrators of the four main legal entities that comprised Lehman Brothers: Lehman Brothers Limited, Lehman Brothers Holdings plc, Lehman Brothers International (Europe) and LB UK RE Holdings Ltd (PWC, 2011). Clearing houses such as LCH.Clearnet acted swiftly to close out Lehman Brothers exchange-traded instrument positions in the weeks following the default (LCH, 2012d). Significant parts of the Lehman Brothers business were sold off rapidly after the bankruptcy with Barclays purchasing the New York investment banking and capital markets business on 16 September 2008 (Teather, Clark and Treanor, 2008) and Nomura purchasing Lehman Brother’s European and Middle East businesses on 22 September 2008 (Telegraph Staff, 2008). The CDS market auction process to determine the payout on Lehman Brothers took place on 10 October 2008 and set a recovery rate of 8.625 % (Barr, 2008), a relatively low figure in historical terms. The final recovery rate is now expected to be around 18 % (Carmiel, 2012). A year after the bankruptcy, Tony Lomas of PWC suggested the administration process could take 10–20 years to complete (Ebrahimi, 2009), because of the complexity of the business. Nevertheless, unsecured creditors have now started to receive payments (Rushton, 2014).
2.4 Credit Risk Mitigants
There are a number of ways of reducing counterparty credit risk and these can be placed into six categories; netting, collateral/security, clearing, capital, break clauses and purchasing credit protection.
2.4.1 Netting
A close-out netting agreement provides the legal framework for assets and liabilities to be netted together when closing out a portfolio of derivatives in the event of a default of one of the counterparties. Close-out netting significantly reduces credit exposure, with research by ISDA suggesting a reduction of 85 % (Mengle, 2010). To see how this works consider the following example where A and B have two derivatives transactions between them, one with a value of £1m and the second with a value of −£0.5m as seen by A. B then defaults and A recovers 40 % of the claim value. If the two derivatives net then the credit exposure at default is £0.5m and A will recover £0.2m, a net loss of £0.3m. However, if the trades do not net each trade will be treated separately with A recovering £0.4m on the trade with a value of £1m but having to pay £0.5m back to the administrators of B on the second transaction with a negative value. A’s net position is −£0.1m with no netting, a net loss of £0.6m. This is illustrated in Figure 2.2.
Figure 2.2 The impact of close-out netting reducing overall credit exposure.
Netting is enshrined in the ISDA Master Agreement which is the bilateral agreement between counterparties that provides the legal framework for OTC derivative trading. Netting is enshrined in English law but in some other jurisdictions separate legislation has been needed to allow close-out netting to be implemented. The legal enforceability of netting remains a concern for market participants and the use of netting has faced challenges in the aftermath of the 2008 financial crisis (Mengle, 2010).
2.4.2 Collateral/Security
Credit risk can be mitigated or eliminated entirely if the counterparty provides some form of security to cover the value of the liability which will be returned when the liability is repaid. Examples of this type of secured transaction are repos and reverse repos. A repo or repurchase agreement is a trade in which one counterparty sells bonds to another counterparty and agrees to repurchase them at a fixed price at an agreed date in the future.16 Repo transactions are a type of secured lending. If the bonds decline in value during the period of the repo additional collateral must be supplied, either more of the same bond, a higher quality bond, or cash.
Figure 2.3 The repo/reverse repo transaction flows.
Derivative
