Wednesday, March 30, 2011

Wrong Way Risk: A Primer

This article appeared in The Edge, Malaysia (Derivatives World) on Mar 14 2011

Wrong Way Risk:  A Primer

Wrong Way Risk has now been an important subject in contemporary risk management circles.  Wrong Way Risk is a hazard that is always present in the credit world but usually brushed off as negligent and remote. It is surprisingly easy to understand but difficult to quantify. This article will introduce the risk as plainly as possible and gradually move towards some quantification and valuation issues.
If I were to borrow some money from you, you would be concerned about my ability to repay. What is the probability of me defaulting on the loan? Here you are trying to assess the default risk or the exposure of the loan. Now, if I got ABC to guarantee my loan to you, how would you assess the exposure? If I defaulted on the loan, ABC steps in to repay my loan. You will probably be more interested in ABC’s credibility because ABC is now the ultimate borrower. You will also have better comfort in valuing the loan since ABC is expected to have a better credit standing.
Nothing to worry so far, or is there? What if ABC defaults together with me? What if ABC defaults before I do? Consider the scenarios below:
a)      ABC is actually a company where I am the main shareholder. Here, the borrower and the guarantor are the same.
b)      ABC and I are closely related – spouses or business partners. If I were a company, ABC could be my holding company. Here you will see that some market or economic factors could affect both ABC and me simultaneously. There is a chance that both ABC and I will default together.
c)      ABC and I are not related but our businesses are in the same industry. Hence we are exposed to the same market factors. For example if we were in the airline industry, a sudden rise in fuel cost would increase my default risk and, at the same time, ABC’s credibility as a guarantor. The default risk that you hedged with a guarantee is now moving the wrong way.
d)      ABC guarantees a lot of borrowers in the same business as mine. Here the guarantor faces concentration risk. In an unfavourable market turn, ABC may not be able to take over all the loans at once and hence will default as well. Even if my business manages to withstand the adverse market event, ABC would have defaulted before I did.
e)      ABC’s guarantees could also be concentrated in a business or industry different than mine. Here, if a market event unrelated to my business occurs, there is again a chance that ABC defaults before me.
One would think that surely ABC has built in limits to manage concentration risk and the amount of loans guaranteed over its capital. In reality, everyone was happy with this assumption, even the rating agencies that continued with the AAA rating for MBIA and AMBAC in the U.S. in 2007. Both MBIA and AMBAC were at the brink of collapse as a result of the credit crisis. Their risk of these monolines (bond insurers in a specific industry) was concentrated in the mortgage industry. Moreover they underestimated the default risk of the loans that were being guaranteed which caused them to guarantee a huge amount of loans over and above their capital.
The monoline case has helped to highlight the ad hoc approach of many financial institutions in thinking about this risk. Some were unaware of the potential risk they were running while others chose to ignore it, assuming that the worst-case scenario would or could not occur.

What is a financial guarantee?
A financial guarantee is a traditional method of transferring risk. Parties can also transfer risk through a variety of other contractual mechanisms like credit default swaps, total return swaps and credit linked notes.
Let us consider a bond issued by a company which is guaranteed (or wrapped) by a guarantor. Here bond holders have made a loan to the company and obtained protection against default losses associated with that loan. Chart 1 illustrates this. As a result, the bond carries a higher credit rating. The borrower company would have to pay a fee to the guarantor (who must have very good credit standing) for this credit enhancement.

Chart 1:  A simple credit guarantee arrangement. Arrows show transfer of credit risk

Wrong Way Risk
ISDA’s (International Swaps and Derivatives Association) definition of Wrong Way Risk is a risk that occurs when an exposure to a counterparty is adversely correlated to the credit quality of that counterparty. To illustrate with an extreme example, Bank A enters into a reverse repo (essentially just a collateralised loan) with Bank B (the counterparty). The collateral that Bank B provides happens to be other bonds that are also issued by Bank B. If Bank B is unable to repay its loan, the collateral will not help either. Bank A should rightfully assign zero value to this guarantee.

The above is an example of specific Wrong Way Risk. There is also a more general form of Wrong Way Risk (referred to as General Conjectural Wrong Way Risk). This risk arises where the credit quality of the counterparty may, for non-specific reasons be correlated with other macroeconomic factors that may also impact the exposure of transactions. These transactions can range from a simple collateralised loan or bond to various types of over-the-counter derivatives such as forwards, swaps and options. The counterparty and the underlying issuer may be in a similar industry, or the same country or geographical region, for instance.

It is this general form of Wrong Way Risk which is of particular concern as it is both difficult to detect in the trading book, hard to measure and complex to resolve.

Quantifying Wrong Way Risk and Basel III
In practice, the exposure to a transaction and credit worthiness of counterparties are measured and modelled independently. Of recent, there is more pressure to assess this together.  In a transaction where wrong way risk occurs, this approach is not sufficient and ignores a significant source of potential loss.
To explain this, if I have a credit default swap (CDS) with Counterparty A, the Market Risk Management division measures the CDS exposure in relation to the various market factors and the Credit Risk Management would monitor the amounts owing in aggregate to Counterparty A. Say Counterparty A is a major bank and the underlying bond of the CDS is also a major bank. A crisis in the banking industry would significantly affect the value of the CDS. If I was the protection buyer of the CDS, I would profit from the change in value and Counterparty A will have to make a payment to me. But since Counterparty A is also in the banking industry, it would also be hit by the crisis and would not be able to pay. This was the classic horror that banks experienced when they had huge exposures with Lehman when it collapsed in 2007.
Basel has long recognised this source of risk and in its latest standard, both specific and general wrong way risk is attempted to be quantified. Specific wrong way risk involves mainly higher risk weights as an incentive for banks to move trades to central counterparties and away from over-the-counter trades. As for the general part of this risk, procedures involved are stress testing scenarios and simulations involving longer time periods.

The Valuation of Wrapped Bonds Predicament
In valuing an illiquid bond that is guaranteed by a Guarantor, the norm would be to take the credit curve of the guarantor (assuming that there is a CDS market for the guarantor) and use that as a discount rate to value the wrapped bond.
However this assumes that we are only looking at the probability of default of the guarantor. Actual default only occurs when both the issuer and guarantor defaults- i.e. the joint default probability, which is smaller. But in many cases, the bond issuer and the guarantor are not mutually exclusive which means that their probability of default is correlated with each other. This involves conditional probabilities. Here is where Wrong Way Risk must be seriously taken into account or the final estimated joint probability of default will be dangerously underestimated.

Bond Guarantees in Malaysia
Danajamin Nasional Berhad is Malaysia’s only official bond guarantee agency at present. It is in its early days and started with the moral obligation to ensure smaller corporations get the opportunity to assess debt capital markets. However, it is worth pointing out that various possibilities could occur along the time line as the numbers of guarantees grow and competition intensifies in the market place.

In a financial market that is increasingly getting fully globalised and losing its country borders, Wrong Way Risk will possibly grow to become more significant. Oversights may occur in quantifying this risk but ignoring it all together would be a bigger mistake.