Title: Integration of Credit Risk and Market Risk Financial Markets Research Center Conference Owen School
1Integration of Credit Risk and Market
RiskFinancial Markets Research Center
ConferenceOwen School
- Thomas S. Y. Ho
- THC
- April 17, 2008
- Tom.ho_at_thomasho.com
2Credit Risk and Market Risk
- Credit risk
- Reduced form model
- Probability of default, recovery ratio (actuarial
model) - Dynamic conditional default rate (hazard rates)
- Structural model
- Put options on a risky asset and the prob of
default - Market risk
- Interest rate risk, market risk, currency risk
- Arbitrage-free valuation
- Option-adjusted spreads
3Organizational Structure in Risk Management
- Market risk management
- Monte-Carlo simulations, greeks
- Credit risk management
- Concentration risk
- Basel II
- Internal model
- Relating economic capital to risk sources
- The silo approach to credit risk and market risk
4Purpose and Outline of the Presentationthe Need
for an Alternative to the Silo Approach
- The Silo Approach failed in the subprime crisis
- The securitization process from mortgage loans
to the collateralized debt obligations (CDO) - Discovering the market price of risk of a CDO
- Integration of credit risk and market risk
- Cashflow approach
- Significance of model risks and liquidity risks
- Policy issues
- Importance of securitization
- Regulatory roles in surveillance, supervision and
policy
5Subprime Crisis
- defects in the CDO securitization
- Lending practice
- Transparency of the practice
- Inadequate financial disclosures
- Credit rating of the securities
- Credit derivative swaps prevalent use
- Lacks regulatory oversights of the process
- Sales practice tight risk premia
6Transparency
- Transparency
- Risks of mortgage loans are not properly priced
creates demands - Asymmetric information results in illiquid
markets - Impacts of the demands on the securitization
process - Dominance of arbitrage CDOs
- 2006 balance sheet CDO (7) Arbitrage (93)
- Questions
- How were the CDO mispriced?
- What do we really mean by transparency?
- Necessary to take a closer look at a CDO
7An Illustrative Simple Example Cash CDO
- Mortgage loans
- Home equity loans, second liens
- option ARMs
- Negative amortization min payment, recourse
(trigger full amortization), reset - Asset backed securities (ABS)
- Attachment and detachment (options)
- ARMT 2006-3
- loans 683, 470 million
- Credit derivative swap
- Sell protection investments
8Cash CDO Structure
- Sharps CDO II Ltd
- Collaterals and the waterfall 187 ABS
collaterals - Classes OC and IC tests
- Over-collateralization test par amount of the
collateral available to cover a class - Interest coverage test
- Tranche priority
- A 1-3 (790mil),B (55mil), C(55mil), D 1-3
(58mil) - Equity call option
9Credit Analysis
- Concentration risks
- Correlation
- Ignoring the credit options and model risks
- Tests under 3 prepayment speeds
- Concentration of credit risks
10Option ARMs Valuation
- Prepayment default model (multinomial logit
model) - Estimating the competing risks
- Analytical results
- Base case CDR and CPR
- Price performance
- Embedded credit option
11Conditional Default Rate and Condition Prepayment
Rate
12ABS Valuation and Analysis
- Analysis of the attachment and detachment points
- Price performance
- Embedded credit option
- Call option limited liability shifting risks to
a senior tranche - Short put option Mertons option
- Fall in asset price being equivalent to the
increase in probability default
13Embedded Options in ABS
14CDO Valuation and Analysis
- Base case CDR and CPR
- Price performance of the tranches
- Embedded credit options
- Mortgagor loans Options (home price )
- ABS tranche Option ( mortgage loans) strike
attachment point - CDO tranche Option (ABS tranches) strike OC/IC
- Contrast with the credit model
- Sector, product types, geographic concentration
- Actuarial model that ignores embedded options
15CDO Price Performance
16CDO Risk Sharing Senior Tranche
17CDO Risk Sharing (D Tranches)
18CDO Risk Sharing (BC Tranches)
19CDO Risk Sharing (equity tranche)
- Slower prepay may lead to higher credit risk
- Higher credit tranches may benefit with slower
prepayment and higher defaults
20Conclusions
- Inseparable interest rate options and credit
options - Not additive
- Significant model risk behavior of the
mortgagors - A Unified (interest rate credit) Arbitrage-free
Model - Identify the option behavior
- Identify the impact of the model risks
- Defects of the silo approach to risk management
- Result in market failure because of asymmetric
information sellers lack capital and buyers lack
info
21Implications on Securitization
- Financial disintermediation has made significant
progress securitization is key - Financial system has evolved from a flow of funds
system to a risk sharing system - Potential benefits of securitization to the
economy are significant insurance
securitization, energy credits etc - Goal is to strengthen the securitization process
CMO market lessons learnt
22Market Disciplines on Securitization
- Many ABS and cash CDO are structured to diversify
risks, to provide liquidity and price discovery - Simplify structures and collateral pools
- Price transparency in different levels
- Mortgage loans, collaterals, ABS, CDOs
- Homogenous in classification of securities
- Model after the standardization of conforming
loans
23Implications on Regulatory Policies
- Price transparency- Model after National Market
System - mortgage loans, ABS, CDO, extends from CDX and
ABX (there are markets but no publicly available
prices) - price discovery is based on relative valuation
- Financial disclosure
- terms and conditions are more transparent
- quantitative risk exposure such as risk
accounting
24Implications on Regulatory Supervision
- Integration of risks to determine the economic
capital - Integration of risk management of the financial
institutions - Use financial models and appropriate data to
implement principles-based regulations and
internal model based supervision - Adjust Basel II requirements
- Measure systemic risks from the account level
information
25References
- Ho and Lee Generalized Ho-Lee Model A
Multi-Factor State-Time Dependent Implied
Volatility Function Approach Journal of Fixed
Income Winter 2007 - --- Unified Credit and Interest Rate
Arbitrage-free Model Working paper - Dunsky and Ho Valuing Fixed Rate Mortgage Loans
with Default and Prepayment Options Journal of
Fixed Income Spring 2007