Credit protection

The heart of the credit protection in a RMBS transaction is governed by rules that determine how the cash flow in the transaction is allocated. Exhibit 11.7 illustrates a generic cash flow allocation scheme (the cash flow waterfall). 

Credit derivative transactions involve both a protection buyer and protection seller. Banks currently act as either buyers or sellers of credit protection in a transaction. Insurance companies are also active in the credit derivatives market as sellers of credit protection. 

The credit curves (or default swap curves) reflect the term structure of spreads by maturity (or tenor) in the credit default swap markets. The shape of the credit curves are influenced by the demand and supply for credit protection in the credit default swaps market and reflect the credit quality of the reference entities (both specific and systematic risk). The changing levels of credit curves provide traders and arbitragers with the opportunity to measure relative value and establish credit positions. 

Sell credit protection Buy credit protection Positive basis Negative basis Long-basis trade Short-basis trade ... 

For example, the change in profit and loss as a result of bumping the credit curve by 1 bp, assuming we have a short credit (i.e., bought credit protection) that is... 

Note that the haircut is the amount of the bond value that is not handed over in the loan proceeds—it acts as a credit protection to the provider of funds in the event that the bond, which is in effect the collateral for the loan, drops in value during the term of the swap. For ease of illustration the haircut in this example is 0 percent so the loan is the full value of the bond collateral. 

SPV usually enters into an interest rate swap. The swap counterparty may also sell the SPV other derivative instruments, such as interest rate caps, to manage possible cash flow risk. Such risk-exposure management requires careful attention, since the SPV s risk profile can have a significant impact on the credit risk of the notes issued to investors. In an unleveraged transaction, the size of the issue is equivalent to the credit protection the SPV offers on the reference pool of assets. For example, if the credit default swap is on a nominal of 300,000, the nominal value of the notes issued will be 300,000. 

The contingent payments under any credit-default swap used to transfer credit risk from the originator to another party, such as the SPV or an OECD bank. Under Basel 1 rules, if an investor takes out credit protection on a loan, and the protection is provided by a OECD bank, his capital charge changes from 100 percent to 20 percent. 

Garnishment of employee wages by employers is regulated under the Consumer Credit Protection Act (CPCA) which is administered by the Waee and Hour Division,... 

To diversify their credit portfolios. Banks may wish to take on additional credit exposure by selling credit protection on assets they own to other banks or investors, thus enhancing their portfolio tetutns. They may sell derivatives to non-bank clients who don t want to buy the associated assets directly but do want exposute to the ctedit tisk of the assets. In such a transaction, the bank acts as a credit intermediary. 

Banks tried to hedge their exposure to super senior ABS CDO by buying credit protection from monoline insurers. The typical transaction involved a negative basis trade in which the bank would hold the super senior ABS CDO position, typically rated AAA and also buy credit protection from a monoline insurer. However, these hedges suffered from wrong way exposure of the monoline counterparty. The wrong way exposure exists because the counterparty s creditworthiness is lowest when the exposure is largest. 

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