Loan Portfolio Hedging Under the Fair Value Option

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Loan Portfolio Hedging Under the Fair Value
Option
North Carolina State University Financial
Mathematics Workshop December 8, 2006
Randy Miller, SVP
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Credit Derivatives Market Evolution109 Growth
in 2006

• The credit derivative market is expected to grow
  to over 35 trillion by the end of 2006

Credit Derivatives Outstanding Notional1
Late 80s
1996
1997
2003
2004
Today
Development of Cash CDOs
Introduction of Moodys ratings model
First synthetic CDOs
Creation of Dow Jones Trac-X Development of
index tranche market
Development of investor and third party managed
transactions
Investors can choose between investor selected,
third party managed or index-based transaction
1 Source ISDA, BMA and the British Bankers
Association Credit Derivatives Report 2003/2004.
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Product Segmentation

• Within the tremendous growth of credit
  derivatives, index and portfolio products have
  continued to gain market share over single-names
  since 2003

Market Share and Estimated Product Growth1
1 Source British Bankers Association Credit
Derivatives Report 2003/2004 Standard and Poors
LCD Bond Market Association
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Market Participants

• Banks continue to maintain substantial market
  among buyers and sellers of credit protection
• Recent accounting changes have increased bespoke
  volumes among banks and insurance companies

Buyers of Credit Protection
Sellers of Credit Protection
Other includes corporations, mutual funds,
pension funds and government agencies
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Hedging ToolsCorporate Credit
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Hedging ToolsConsumer Credit
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Commercial Loan Portfolio HedgingFactors
Influencing Hedging Activity Analysis and
Decisions

• Portfolio Efficiency
• Risk Appetite
• Spread versus Default Risk
• Systematic versus Idiosyncratic Risk
• Basis and Convexity Risk
• Commercial Loan Embedded Options
• Qualitative Factors
• Accounting Regime
• Regulatory Capital
• Internal Risk Governance
• External Ratings
• Peer Comparisons

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Risk Appetite and Portfolio EfficiencyWhere do
you want to play? Whats your risk budget?
Dominated by Concentrated High Yield Portfolios
2,050
2,000
1,950
1,900
Expected Total Credit Return In USD mm
1,850
1,800
?
?
1,750
Current Portfolio
1,700
Minimum Risk Portfolio
1,650
700
900
1,100
1,300
Risk expressed as CVAR in USD mm
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Performance Objectives for Hedge Book

• Manage MTM Price Risk
• Maintain breakeven or better PL through the
  credit cycle?
• Limit downside PL risk?
• Retain some net upside potential from material
  spread widening?
• Manage Exposure Jump Risk Associated with
  downgrade and default
• Provide protection against material default loss
  and downgrade loss events?
• Retain some net upside potential from default
  events?

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Price Risk versus Exposure Jump Risk

• Hedge price risk at expected usage or slightly
  more

• Hedge exposure jump risk at usage given default
  exposure,

• Balanced Alternative
• Hedge at expected usage with balanced ramp up as
  downgrade/default risk Increases on a name

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Systematic Versus Idiosyncratic Risks

• The risk of a portfolio can be decomposed into
  systematic and idiosyncratic components
• 50 or more of credit risk is idiosyncratic
  i.e., default and high vol spread events are
  tough to predict
• Single name vs. index products vs. option
  products in hedging strategy?

IDIOSYNCRATIC vs. SYSTEMIC
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Embedded Options, Convexity Mismatch, Basis Risk

• Loans are short or long various embedded options
• Prepayment option
• Extension/Term-out option
• Utilization/UGD for Revolvers
• Pricing Grids
• Covenant Structures
• Embedded options are difficult to model and price
  as exercise patterns can be idiosyncratic and
  volatile
• Loans are negatively convex because of embedded
  options
• Hedges (CDS) are less convex than loans
• Basis Risk
• Different Reference Assets
• Risk Premiums
• Market Technicals
• Mark to Model/Mark to Market

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Peer Benchmarking and External Ratings

• The hedge ratio compares disclosed notional
  hedging levels vs. wholesale loan portfolio
• Focusing on the corporate loan portfolio, there
  are diverging philosophies on how much to hedge
  . and more importantly what

Source Company Annual Reports and Public
Filings Disclaimer Classification of B/S items
may not be 100 consistent across company filings
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Accounting Regimes
Credit Derivatives Book Fair Value Loan Book Mark
to Market Accounting
Hold to Maturity Loan Book Accrual Accounting
Accounting Asymmetry

• Objective
• Manage default and downgrade risk of credit risk
  concentrations
• Reduce earnings volatility through the credit
  cycle
• Improve portfolio efficiency
• Method
• Single name credit derivatives
• Credit Indices

• Objective
• Manage PL volatility
• Manage default risk
• Method
• Single name credit derivatives
• Credit indices

Additional CHALLENGES

• Limited liquidity
• Limited price discovery
• Limited time series

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Fair Value Option Summary

• Fair Value Option (FVO) permits fair value
  measurement treatment for certain financial
  assets and liabilities, with changes in fair
  value recognized in earnings as those changes
  occur, based on a contract-by-contract election.

• Allows us to mark loan positions to market,
  thereby eliminating a good deal of the accounting
  asymmetry associated with hedging.
• Option to elect either January 1, 2007 or January
  1, 2008.

• Other Features
• Irrevocable election must be made at inception of
  the contract (i.e. at origination)
• A one time election to move existing assets into
  MTM is available at adoption, with any cumulative
  unrealized gains and losses on existing contracts
  recorded as an adjustment to equity (no PL
  impact)
• Implementation is prospective and will not
  require financial restatements for prior periods.
  
• Definition of a contract to be decided. Contract
  could be defined as
• Entire loan agreement
• Tranches (Term A, Term B, Revolver, etc.)
• Minimum assignable amount (as mentioned in the
  loan agreement)

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FVO Strategic Objective
Maximize HTM Earnings Relative to Minimized and
Stable Risk Level

• Maximize earnings opportunities
• Transfer accrual positions to FVO to create
  capacity for additional business
• Pursue new diversifying credit exposure
  opportunities
• Minimize and stabilize risk
• Reduce unacceptably large risk concentrations
• Reduce positions where bank is not paid well for
  risk

Higher Earnings Same or Lower Risk
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Identify Best Loans to Move to FVO

• Portfolio Optimization Applications
• Identify undesirable risk concentrations that
  present material credit loss volatility or
  reputation risks
• Identify customers with poor total relationship
  return/risk ratios within the banks portfolio

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Construct Hedges that Neutralize Fair Value Book
PLHedging to address price (spread), embedded
option, and jump to default risk

• Portfolio Optimization Applications
• Construct optimal single name or credit index
  hedges for systematic price (spread) risk for
  expected, or minimal, drawn exposure amounts
• Construct optimal single name, credit index,
  spread option, equity option hedges for quantity
  (usage given credit downgrade or default) risk

Hedged Portfolio Return Distribution
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Quantitative Hedging ModelsA quantitative
modeling challenge and opportunity

• Hedge construction options
• Single Name Hedge Ratio (Spread DV01
  loan)/(Spread DV01 Single Name CDS)
• Index Hedge Ratio (Spread DVO1 loan
  portfolio)/(Spread DV01 Index) (Beta of
  Portfolio)
• Minimum Tracking Error Hedge Replicate
  simulated PL of FVO loan book as closely as
  possible with combination of index and/or single
  name hedge positions
• Static Hedging with Options, Tranche Product, etc.

• Considerations
• Liquidity
• Hedge effectiveness versus rebalancing cost

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Pro Forma Hedge Solution Examples
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Upside Downside Risk
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Some references
Felsenheimer, Gisdakis, and Zaiser, "Active
Credit Portfolio Management," (Wiley,
2006). Credit Derivatives Pricing Models Model,
Pricing and Implementation, by Philipp J.
Schönbucher, P.J. Schonbucher. Market Models A
Guide to Financial Data Analysis, by Carol
Alexander. Felsenheimer will be available soon
in HA 251. If you wish to request a book for the
FM library, contact Mrs. Bucklad.
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The Rebel Band in Action
GPS Rebel Band
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Our Fearless Leader Looks to the Investment
Horizon
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Rebalancing the Portfolio
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Providing Optimal Portfolio Hedging Solutions
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sails The Rebel Band