2.3 presentation slides
- 1. 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 (᷇ᰕ䖹 ঊ༛) 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 Outline † Credit default swaps † Credit linked notes † Collateralized debt obligations † Sales and marketing † Regulatory requirements † Credit structuring in mainland China 3 4
- 2. 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 1,000 1,000 1,000 1,000 1,000+100,000 1 2 3 11 12 100,000 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 30 30 30 30 30+1,000 1 2 3 9 10 950 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
- 3. 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
- 4. 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 15 Outline † Credit default swaps † Credit linked notes † Collateralized debt obligations † Sales and marketing † Regulatory requirements † Credit structuring in mainland China 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
- 5. 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 Single name CDS Premiums Steady cash flows Bank Single name CLN
- 6. 21 Synthetic CLN † An investment bank, e.g. HSBC „ Establishes a SPE independent of HSBC „ Grants a short term loan to the SPE † 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 „ Uses the proceeds from selling the notes to settle the short term loan † 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
- 7. 25 Basket CLN SPE Investors Top quality assets Basket CDS Premiums Steady cash flows Bank Basket CLN 26 Basket CLN † An investment bank, e.g. HSBC „ Establishes a SPE independent of HSBC „ Grants a short term loan to the SPE † 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 „ 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 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 Basket CDS Premiums Steady cash flows Bank Basket CLN Active trading portfolio
- 8. 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 † Credit default swaps † Credit linked notes † Collateralized debt obligations † Sales and marketing † Regulatory requirements † Credit structuring in mainland China 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 Principal = HKD 40 mn Mezzanine tranche Principal = HKD 10 mn Equity tranche Principal = HKD 10 mn
- 9. 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 Ultra senior 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 † Mezzanine tranche 2 † Mezzanine tranche 1 † Equity tranche
- 10. 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 Portfolio CDS Premiums Steady cash flows Bank CDO 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 Ultra senior tranche Principal = HKD 40 mn Senior tranche Principal = HKD 36 mn Mezzanine tranche Principal = HKD 12 mn Equity tranche Principal = HKD 12 mn Active trading portfolio
- 11. 41 Market value CDO SPE Investors Top quality assets Portfolio CDS Premiums Steady cash flows Bank CDO 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) Rating Description AAA 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. AA 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. A 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.
- 12. 45 Agency rating (2) Rating Description BBB 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. BB 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. B 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. 46 Agency rating (3) Rating Description CCC 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. CC A CDO tranche rated CC is currently highly vulnerable to violation of payment schedule. C 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. 47 Outline † Credit default swaps † Credit linked notes † Collateralized debt obligations † Sales and marketing † Regulatory requirements † Credit structuring in mainland China 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/lehma n_structure_products.html
- 13. 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 ³hedging´ purpose
- 14. 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? † %DQN¶VRZQLQYHVWPHQWV „ 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 † Credit default swaps † Credit linked notes † Collateralized debt obligations † Sales and marketing † Regulatory requirements † Credit structuring in mainland China
- 15. 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 6)2¶VLQYHVWRUSURWHFWLRQUHJLPH † 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 † Credit default swaps † Credit linked notes † Collateralized debt obligations † Sales and marketing † Regulatory requirements † Credit structuring in mainland China
- 16. 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 62 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
- 17. 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: education@ifphk.org Website: www.ifphk.org