Hi and welcome back to my YouTube channel. In today's video we're going to
learn about credit and we'll learn about what credit derivatives are. Welcome back
to my channel. Today's video is mostly about credit derivatives, but we're
firstly going to start out by defining what we mean by credit. This is the first
video I'm doing in a series on credit derivatives. I will put them all together
as a playlist which you can watch by clicking on my profile and then on
playlists. Hopefully you'll find them useful. All of these videos are based on
my book Trading and Pricing Financial Derivatives, which I've linked to in the
description below. OK so firstly what is credit credit is
the trust that allows one party to obtain goods or resources from another
party where that second party does not pay immediately but instead arranges to
either pay or return those resources at a later date
Credit encompasses any form of deferred payment, examples include home mortgages,
credit card debts, corporate borrowing and government borrowing. The concept of
credit is necessary whenever something is borrowed or lent. Credit risk then is
the risk that a deferred payment agreement may be reneged on at or before
the scheduled payment. This is the risk of default and credit risk is also known
as default risk or counterparty risk. Historically debt obligations were
entered into and the counterparties to the transaction did not change
throughout the life of the loan until the debt matured. Credit risk is most
thoroughly examined at the initiation of the loan and then monitored periodically
until maturity. Loans and bonds can however be traded throughout their lives
between a variety of market participants thus the concept of credit risk expands
to bring in credit deterioration or credit improvement and not just the
binary outcomes of borrower repays or borrower defaults considerable sums of
money can be made and lost by traders through these more subtle variation
in credit quality and pricing throughout the life of a bond. Credit risk is better
defined as the risk of gains or losses arising from changes in credit quality
credit rating agencies exist provide investors an independent measure of the
credit quality of issuing firms and the individual debt instruments the largest
credit rating agencies are S&P Moody's and Fitch these companies are paid a fee
by the debt issuing entity to provide an independent credit rating which is then
shared widely with public debt market participants I might do a separate video
on credit rating agencies at some point let me know in the comments section if
you'd be interested in seeing that credit ratings can have a tremendous
impact on the price of financial instruments prior to the existence of
rating agencies investors had difficulty obtaining and processing sufficient
information about creditworthiness to make informed credit risk decisions
unlike the equities market where typically a company would have only one
equity security outstanding in public markets a company could have a wide
range of debt instruments outstanding each with different maturities different
coupons varying legal covenants ranges of collateralization and seniority of
repayment in the event of default the fact that each issue was rated
separately reduce the confusion surrounding these instruments and
greatly increase the attractiveness to investors of investing in bonds
including small investors who previously would have found this research effort
prohibitive ratings information greatly enhanced liquidity in bond markets
historically banks made loans and mortgages to companies and individuals
and typically held that risk until the maturity of balloons they funded this
with their own client deposits this introduced a series of limitations on
the loan and mortgage markets a given bank might aim to have a diversified set
of outstanding loans to companies loaning to a portfolio of companies
across industry sectors and applying strict percentage caps on loans to
individual sectors should minimize losses in the event of a significant
downturn in one industry sector the bank might mandate a maximum 10% of its loan
portfolio to mining companies for example and insist that these amounts be
spread across a number of different companies to reduce the default risk of
exposure to one company these sector loan restrictions designed to make the
bank's portfolio safer from defaults would have reduced loan availability to
individual companies the former hold to maturity loan model
constrained the bank's portfolio composition the bank would only be able
to make limited numbers and sizes of loans to companies that they otherwise
might be very confident of lending more funds to companies received fewer loans
under this model due to the bank's constraints a further drawback was the
fact that a bank might have an industry or regional expertise that it could
profitably and successfully pursue but would be restrained by industry sector
weight constraints in the portfolio the bank might have a top tier mining
industry team one that measures mining credit risk with acute precision and has
extensive local relationships with the mining community. This proficiency could
not be used to its full capacity in the hold to maturity loan environment. At
the same time there were other investors in the broader financial world who were
interested in taking on these credit risk exposures a similar effect was seen
in bank lending for home mortgages credit cards and student loans markets
this mismatch of banks ability to underwrite a far greater number of loans
than they could feasibly hold combined with a broader investor appetite to hold
credit risk help to drive the credit derivatives market so what are credit
derivatives credit derivatives are financial instruments that have payoffs
that depend on corporate or sovereign bonds or on loan portfolios as the under
instruments they transfer the credit risk from one party to another without
transferring ownership of the underlying securities the underlying securities
need not be owned by either party in the transaction the most common types of
credit derivatives are asset backed securities credit default swaps and
collateralized debt obligations I'll do individual videos on each of these
credit derivatives over the next few days securitization was developed to
ameliorate the problem of banks ability to issue larger amounts of credit than
they could hold to maturity on their own balance sheets securitization is the
process of creating securities whose value and income payments are derived
from and collateralized by a specified pool of underlying assets what were the
effects of securitization well securitization brought about numerous
changes in debt markets it allowed originators to remove loan assets from
their balance sheets which increased overall lending much faster than deposit
growth alone would have banks competed for loan mortgage credit card and bond
origination business leading to decreased borrowing costs for companies
and individuals the increased availability of credit affects demand
fur and thus the price of real estate and other assets that can be purchased
on credit when a bank made a loan and kept that loan on its books the credit
risk of the loan mattered to the long-term profitability and survival of
the bank securitization allows financial institutions to make loans that they do
not intend to keep on their books when loans are made in this manner there
is less of an incentive to accurately measure and monitor credit risk.
Originators are instead incentivized to minimize the costs associated with
qualifying the borrower and monitoring their credit risk this can lead to a
decrease in overall credit quality well that's it for now over the next few days
I will put up videos on some of the biggest credit derivatives
I will assemble them all in a playlist at the end I'll put up a video about the
pros and cons of these products and how they've changed the world we'll talk
about the role of credit derivatives in the credit crunch - don't forget to hit
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below have a great day bye
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