Integration of Credit Risk and Market Risk Financial Markets Research Center Conference Owen School

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Integration of Credit Risk and Market
RiskFinancial Markets Research Center
ConferenceOwen School

• Thomas S. Y. Ho
• THC
• April 17, 2008
• Tom.ho_at_thomasho.com

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Credit 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

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Organizational 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

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Purpose 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

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Subprime 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

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Transparency

• 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

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An 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

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Cash 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

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Credit Analysis

• Concentration risks
• Correlation
• Ignoring the credit options and model risks
• Tests under 3 prepayment speeds
• Concentration of credit risks

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Option ARMs Valuation

• Prepayment default model (multinomial logit
  model)
• Estimating the competing risks
• Analytical results
• Base case CDR and CPR
• Price performance
• Embedded credit option

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Conditional Default Rate and Condition Prepayment
Rate
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ABS 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

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Embedded Options in ABS
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CDO 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

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CDO Price Performance
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CDO Risk Sharing Senior Tranche
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CDO Risk Sharing (D Tranches)
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CDO Risk Sharing (BC Tranches)
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CDO Risk Sharing (equity tranche)

• Slower prepay may lead to higher credit risk
• Higher credit tranches may benefit with slower
  prepayment and higher defaults

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Conclusions

• 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

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Implications 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

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Market 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

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Implications 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

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Implications 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

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References

• 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