credit linked structured products

ZB06

Credit Linked Structured Products for

Wealth Management Services

in Greater China

3 IFPHK CE credits

3 SFC CPT hours

3 MPFA non-core CPD hours

Speaker: Dr. LAM Yat Fai (林日辉博士)

Doctor of Business Administration (Finance)

CFA CAIA FRM PRM MCSE MCNE

6:30pm to 9:30pm Wednesday 11th December 2013

2

What is credit linked

structured product?

� Very complex cash flows

� Lengthily prospectus difficult to understand

� No risk disclosure

� Small print in contract

� High yield

� Mass destructive weapon

4

� Credit default swaps

� Credit linked notes

� Collateralized debt obligations

� Sales and marketing

� Regulatory requirements

� Credit structuring in mainland China

Outline

5

Term loan

� Lending amount – HKD 100,000� Your bank pays the borrower HKD 100,000 today

� Maturity – one year� The borrower will pay your bank at most HKD 100,000 after one

year

� Interest frequency – monthly� The borrower will pay your bank interest on monthly basis

� Interest rate – 12 %� The borrower will pay your bank at most

HKD 100,000 × 12% / 12= HKD 1,000 monthly

11 22 33

1,0001,000 1,0001,000 1,0001,000 1,0001,000 1,0001,000+100,000+100,000

12121111

100,000100,000

6

Coupon bond

� Market price – 95%� Your bank pays the corporation HKD 950 today

� Principal value – HKD 1,000� The corporation will pay your bank at most HKD 1,000 at maturity

� Maturity – 5 years� The corporation will pay your bank at most HKD 1,000 in 5 years

� Coupon frequency – semi-annual� The corporation will pay your bank interest every 6 month

� Coupon rate – 6 %� The corporation will pay your bank at most HKD 30 every 6

months

11 22 33

3030 3030 3030 3030 30+1,00030+1,000

101099

950950

7

Single name CDS

Protection

buyer

Protection

seller

Principal × 30 bps

every quarter

Payoff at default

= Principal × LGD

Reference debt + Single name CDS Risk-free security

- Single name CDS Reference debt - Risk-free security

≈

≈

8

Single name CDS

� Protection buyer – risk adverse investor

� If the reference debt survives, pays premium regularly

� If the reference debt defaults, receives default loss of

principal

� Protection seller – risk tolerant investor

� If the reference debt survives, receive premium

regularly

� If the reference debt defaults, pays default loss of

principal

9

Application of CDS

� Hedging

� Protection buyer – long position

� To mitigate credit risk

� Investment

� Protection seller – short position

� To invest in a debt without upfront cash

outflow

� Regular cash inflows (premiums)

� Subject to credit risk of the reference debt

10

Three single name CDSs

� My portfolio� HKD 100mn GM US 3-year senior secured bond

� HKD 100mn Three Deer China 3-year senior secured bond

� HKD 100mn Northern Rock UK 3-year senior secured bond

� Hedging strategy� Single name CDS on GM US 3-year senior secured bond with

principal HKD 100mn

� Single name CDS on Three Deer China 3-year senior secured bond with principal HKD 100mn

� Single name CDS on Northern Rock UK 3-year senior secured bond with principal HKD 100mn

� Advantages vs disadvantages� Largely perfect hedge

� Expensive

11

1st-to-default CDS

� Cash outflows� Protection buyer pays a regular premium

� Cash inflows� If GM US defaults first, protection buyer pays the accrued premium and

receives a payoff as if the 1TD CDS is a single name CDS with GM US as the reference debt

� If Three Deer China defaults first, protection buyer pays the accrued premium and receives a payoff as if the 1TD CDS is a single name CDS with Three Deer China as the reference debt

� If Northern Rock UK defaults first, protection buyer pays the accrued premium and receives a payoff as if the 1TD CDS is a single name CDS with Northern Rock UK as the reference debt

� Advantages vs disadvantages� Protection to the first out of three potential defaults

� No protection to the second and third defaults

� Less expensive than three single name CDSs

12

A less uniform portfolio

� My portfolio� HKD 100mn GM US 3-year senior secured bond

� HKD 120mn Three Deer China 2+11/12-year senior unsecured bond

� HKD 80mn Northern Rock UK 2+10/12-year senior unsecured bond

� Hedging strategy� Single name CDS on HKD 100mn GM US 3-year senior secured

bond

� Single name CDS on HKD 110mn Three Deer China 2+11/12-year senior unsecured bond

� Single name CDS on HKD 90mn Northern Rock UK 2+10/12-year senior unsecured bond

� Advantages vs disadvantages� Perfect hedge

� Expensive

13

Portfolio CDS

– First HKD 100mn principal

� Cash outflows� If no debt defaults, protection buyer pays a regular premium

� Cash inflows� If GM US defaults first, protection buyer pays the accrued premium and receives

a payoff as if the portfolio CDS is a single name CDS of principal HKD 100mn with GM US as the reference debt. The portfolio CDS terminates after the protection payment

� If Three Deer China defaults first, protection buyer pays the accrued premium and receives a payoff as if the portfolio CDS is a single name CDS of principal HKD 100mn with Three Deer China as the reference debt. The portfolio CDS terminates after the protection payment

� If Northern Rock UK defaults first, protection buyer pays the accrued premium and receives a payoff as if the portfolio CDS is a single name CDS of principal HKD 90mn with Northern Rock UK as the reference debt. The portfolio CDS continues to works as a HKD 10mn portfolio CDS with a smaller premium

� Advantages vs disadvantages� Protection to a fixed amount of principal

� No protection beyond the fixed amount of principal

� Less expensive than three single name CDSs

14

Tranching of

a debt portfolio

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Outline

16

Single name CLN

� Investments in BYD� Any investor can invest in BYD equity shares

� Only institutional investors can invest in BYD bonds

� An investment bank, e.g. HSBC� Purchases HKD 100 mn principal of BYD bonds

� Issues 1,000 notes, each with cash flows 100% tracking the cash flows of HKD 10,000 principal of BYD bonds

� Sells the notes to many individual investors and charges commissions

� Individual investors subject to credit risk of both BYD and HSBC

17

Special purpose entity

� A shell company

� Established by a financial institution, usually

incorporated in tax heaven, e.g. Cayman

Island

� Bankruptcy remote

� Financially independent, not to be affected by

the credit quality of the parent institution

� Primary function

� To issue single name CLN

18

Single name CLN

issued under SPE

� An investment bank, e.g. HSBC� Establishes a SPE independent of HSBC

� Grants a short term loan to the SPE

� The SPE� Purchases HKD 100 mn principal of BYD bonds

� Issues 1,000 notes, each with cash flows 100% matching those of BYD bonds

� Uses the proceeds from selling the notes to settle the short term loan

� HSBC, as an agent, charges commission on selling the notes to many individual investors

� SPE, a liabilities free shell company, has no credit risk

� Individual investors subject to credit risk of BYD only

19

Synthetic CLN

� Existing BYD bonds may not match the LGD,

maturity, interest rate and interest payment dates

of the requirements from investors

Reference debt + Single name CDS Risk-free security

Single name CLN - Single name CDS + Risk-free security

≈

≈

20

Synthetic CLN

SPE Investors

Top quality

assets

Premiums

Single name

CDS

Steady cash flows

Bank

Single name

CLN

21

Synthetic CLN



� The SPE� Issues to HSBC single name CDSs with HKD 100 mn principal of

hypothetical BYD bonds with LGD, maturity, interest rate and interest payment dates matching the requirements of investors

� Invests in HKD 100 mn principal top quality assets (AAA)

� Issues 1,000 notes, each with cash flows 100% matching those of HKD 10,000 principal of the hypothetical BYD bonds


� HSBC, as an agent, charges commission on selling the notes many individual investors

� SPE, a liabilities free shell company, has no credit risk

� Individual investors subject to credit risk of BYD only

22

Cash flows

� Cash outflow

� An initial amount to acquire a single name

CLN

� Cash inflows

� Reference debt survives

� Scheduled interests and principal

� Reference debt defaults

� Recovered amount of the reference debt

23

Yield enhancement

� One shared principal

� Reference to a basket of identical debts

from different issuers

� Track the cash flows of the 1TD reference

debt

� Higher credit risk => higher return

24

Basket CLN

� A basket of identical reference debts seldom

exists physically

� To synthesize with 1TD CDS

Basket CLN + 1TD CDS Risk-free security

Basket CLN - Basket CDS + Risk-free security

≈

≈

25

Basket CLN

SPE Investors

Top quality

assets

Premiums

Basket CDS

Steady cash flows

BankBasket CLN

26

Basket CLN



� The SPE� Issue a 1TD CDS of HKD 100 mn principal on three identical

hypothetical bonds issued by BYD, Tencent and Tsing Tao Beer

� Invests in HKD 100 mn principal top quality assets (AAA)

� Issues 1,000 notes, each with cash flows 100% matching those of the 1TD reference bonds


� HSBC, as an agent, charges commission on selling the notes to many individual investors

� SPE has no credit risk

� Individual investors subject to credit risk of the 1TD reference bond only

27

Cash flows

� Cash outflow

� An initial amount to acquire a basket CLN

� Cash inflows

� All reference debt survives

� Scheduled interests and principal

� Either one reference debt defaults

� Recovered amount of the debt defaulted

28

Market value CLN

SPE Investors

Top quality

assets

Premiums

Basket CDS

Steady cash flows

BankBasket CLN

Active trading portfolio

29

Market value CLN

� Top quality assets

� Sell high

� Buy low

� Trading profit to offset part of default loss

� Risk

� Credit risk of reference debts

� Trading risk of top quality assets

30







Outline

31

Illiquid secondary market

of credit risky debts

� Mis-match of demand and supply

� High demand of high quality debts

� Limited supply of high quality debts

� Information asymmetry

� Owner with more understanding demands a

higher ask price

� Investor with less understanding offers a lower

bid price

32

Traditional CDOs

Debt 1

Debt 2

Debt 3

�

Debt N

Principal =

HKD100 mn

SPE

Ultra senior tranche

Principal = HKD 40 mn

Senior tranche


Mezzanine tranche


Equity tranche


33

Cash waterfall

� Cash inflows (interests and principal) are collected from a debt portfolio

� Cash is first paid to the ultra senior tranche as much as possible according to the specifications of the ultra senior tranche

� If residual cash is available, then paid to the senior tranche as much as possible according to the specifications of the senor tranche

� If residual cash is available, then paid to the mezzanine tranche as much as possible according to the specifications of the subordinated tranche

� If residual cash is available, then paid to the equity tranche according to the specifications of the equity tranche

34

Cash waterfall

Equity tranche


Mezzanine tranche

Cash inflows from

debt portfolio

Senior tranche

35

Tranching

� Attachment point� The percentage of defaulted portfolio principal from which the

CDO tranche starts to suffer from loss

� Detachment point� The percentage of defaulted portfolio principal starting from which

the CDO tranche will suffer from total loss

� Thickness = Detachment point - Attachment point

� Ultra senior tranche� 100% attachment point and no detachment point

� Equity tranche� 0% attachment point

36

Tranching

� Ultra senior tranche

� Senior tranche

� Mezzanine tranche

� Equity tranche

� Senior tranche

� Mezzanine tranche 3



� Equity tranche

37

Synthetic CDO

� Similar to synthetic basket CLN

� Using portfolio CDS and top quality assets to

replicate the cash flows of a CDO tranche

CDO Tranche + Portfolio CDS Risk-free security

CDO Tranche - Portfolio CDS + Risk-free security

≈

≈

38

Synthetic CDO

SPE Investors

Top quality

assets

Premiums

Portfolio CDS

Steady cash flows

BankCDO tranche

39

Market value CDO

� Collaterals

� Traditional CDO – debt portfolio

� Synthetic CDO – top quality assets

� To push up the value

� Sell high

� Buy low

� Trading profit to offset default loss

40

Market value CDOs

Debt 1

Debt 2

Debt 3

�

Debt N

Principal =

HKD100 mn

SPE



Senior tranche


Mezzanine tranche


Equity tranche


Active

trading

portfolio

41

Market value CDO

SPE Investors

Top quality

assets

Premiums

Portfolio CDS

Steady cash flows

BankCDO tranche

Active trading portfolio

42

Cash flows

� Cash outflow

� An initial amount to acquire a CDO tranche

� Cash inflows

� Tranche principal survives� Scheduled interests and principal

� Tranche principal defaults partially� Interests and principal in proportion

� Tranche principal defaults completely� No interests and principal

43

Functional purpose

� Broadening of credit market� Producing higher quality debts from lower quality raw

material

� Default dependency as a new investment class

� Credit risk mitigation� Selling debt portfolio to other investors

� Cash flow CDO

44

Agency rating (1)

A CDO tranche rated A is somewhat more susceptible to the adverse

effects of changes in circumstances and economic conditions than the

CDO tranches in higher rated categories. However, the capacity of the

debt portfolio and tranche structure to meet the interests and principal to

the CDO tranche is still strong.

A

A CDO tranche rated AA differs from the highest rated CDO tranches

only to a small degree. The capacity of the debt portfolio and tranche

structure to meet the interests and principal to the CDO tranche is very

strong.

AA

A CDO tranche rated AAA has the highest quality. The capacity of the

debt portfolio and tranche structure to meet the interests and principal to

the CDO tranche is extremely strong.

AAA

DescriptionRating

45

Agency rating (2)

A CDO tranche rated B is more vulnerable to violation of payment

schedule than the CDO tranches rated BB, but the debt portfolio and

tranche structure currently has the capacity to meet the interests and

principal to the CDO tranche. Adverse business, financial, or

economic conditions will likely impair the capacity of the debt portfolio

to meet the interests and principal to the CDO tranche.

B

A CDO tranche rated BB is less vulnerable to violation of payment

schedule than other speculative issues. However, it faces major

ongoing uncertainties or exposure to adverse business, financial, or

economic conditions which could lead to inadequate capacity of the

debt portfolio and tranche structure to meet the interests and principal

to the CDO tranche.

BB

A CDO tranche rated BBB is subject to adequate protection from the

debt portfolio. However, adverse economic conditions or changing

circumstances are more likely to lead to a weakened capacity of the

debt portfolio and tranche structure to meet the interests and principal

to the CDO tranche.

BBB

DescriptionRating

46

Agency rating (3)

A C rating is assigned to a CDO tranche that is currently highly

vulnerable to violation of payment schedule or has payment arrearages

allowed by the terms of the documents. Among others, the C rating may

be assigned to an equity tranche on which cash payments have been

suspended in accordance with the terms of the CDO contract.

C

A CDO tranche rated CC is currently highly vulnerable to violation of

payment schedule.

CC

A CDO tranche rated CCC is currently vulnerable to violation of payment

schedule, and is dependent upon favorable business, financial, and

economic conditions for the debt portfolio and tranche structure to meet

the interests and principal to the CDO tranche. In the event of adverse

business, financial, or economic conditions, the debt portfolio is not likely

to have the capacity to meet the interests and principal to the CDO

tranche.

CCC

DescriptionRating

47







Outline

48

From media

� Lehman Brothers minibonds� Very complex structured products

� Prospectus difficult to understand

� No risk disclosure

� Small print in contract

� High expected return at high risk

� Customers� Retail customers

� Old aged, less educated, mis-sold by banks

http://www.sfc.hk/sfc/html/EN/general/general/lehman/lehman_structure_products.html

49

Lehman Brothers

minibonds

50

Lehman Brothers

minibonds

� Market value CLN

� Linked to a few high credit quality

companies when the CLNs were first

issued

� Operating under a SPE

� Low risk investments before 2006

� Moderate nominal yield 3% to 7%

� No secondary market

51

Prospectus

� Well written documents

� A few pages of upfront summary

� Very clear disclosure

� 50 to 100 pages

� May reference to other program

prospectuses

52

Sales and marketing

� Marketing

� Nice features of a structured product

� Strong sales channels – the dominating

factor

� Sales channels

� Professional investors

� Financial institutions

� Private banking customers

� Corporations for “hedging” purpose

53

Why minibonds?

� Low interest income on regular fixed deposits

� Higher yield on minibonds

� Operating like deposits

� Confidence in commercial banks

� Attractive gifts on purchase of minibonds

54

Why credit linked

structured products?

� Bank’s own investments

� Earning interest income

� Higher yield at the same credit rating

� Products sold to corporate and private

banking customers

� Operating like deposits and bonds

� Customized in accordance with the preference

of customers in terms of return, risk and

horizon

55

Credit risk re-distribution

through CDO

56







Outline

57

Structured products

under the SFO

� A financial instrument with its payoff determined

by reference to one or more of

� the value, rate, level (or a range of value, rate, level)

of any type or combination of types of currency,

interest, equity, commodity, credit event or index

� the value, rate, level (or a range of value, rate, level)

of any basket of more than one type or combination of

types of currency, interest, equity, commodity, credit

event or index

� Excluding bonds, mutual funds and exchanged traded

products

58

Regulatory requirements

� After financial tsunami 2008

� Credit linked structured products can only be

sold to professional investors

� Professional investors are not covered by the

SFO’s investor protection regime

� Professional investors

� With sufficient knowledge and experience

� With at least USD 1 mn free cash

59

Investor protection

� Standardized legal documents

� Lawyers

� Civil litigation

� Experience with bankers

60







Outline

61

China market

� The largest debt markets

� Loans to government departments

� Loans to government owned corporations

� Municipal debts

� Wealth management

� Commercial bank

� Shadow banking

� Alibaba

63

Credit securitization

� Credit risk transfer

� Bank transfers lower quality debts to asset management company

� Asset management company forms many SPEs

� SPEs to issue single name CLNs and/or CDOs

� Circulation of funding supply

� Funds from selling CLNs/CDOs return to the bank and facilitates further lending

64

An emerging subprime

crisis in China

� Chinese investors has little understanding on credit securitization, in particular the risk

� Cash flows similar to deposits and bonds hide credit structuring behind the scene

� Banks position themselves as a commission earning intermediary only

� Credit rating agencies in China are solely profit driven

� Political risk dominates

65

Reference

https://sites.google.com/site/crmbasel

66

Q & A

67

Thank You

68

Upcoming IFPHK Continuing Education Programs:

http://www.ifphk.org/CEP/ce-calendar

Institute of Financial Planners of Hong Kong

13/F, Causeway Bay Plaza 2,

463 - 483 Lockhart Road, Hong Kong

Tel: 2982 7888

Fax: 2982 7777

Email: [email protected]

Website: www.ifphk.org

credit linked structured products

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