First American Bank Credit Default Swaps

9-203-033 J U L Y 1 7 , 2 0 0 2 ________________________________________________________________________________________________________________ Research Associate Eli Peter Strick prepared this case under the supervision of Professor George Chacko using published sources. Certain details are fictional. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Copyright © 2002 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School. G E O R G E C H A C K O E L I P E T E R S T R I C K First American Bank: Credit Default Swaps It was approaching 8 p.m. on a Wednesday in April 2002 when Chris Kittal received an urgent call from a contact at Charles Bank International (CBI). Kittal was a managing director in First American Bank’s credit derivatives unit in New York City. CBI, a medium-sized U.S. commercial bank based on the East Coast, had recently been approached by one of its corporate clients in need of additional funding. The client, CapEx Unlimited (CEU), a rapidly growing telecommunications company, had been a loyal banking customer with CBI for over five years and had used the bank in some lucrative transactions during that time. CEU was in the middle of an industry shakeout and required $50 million to finance the expansion of its network. The company had already accumulated $100 million in previous loans from CBI and was depending on their relationship with the bank for the additional funding. While reasonable by itself, the new loan, when added to CBI’s existing loans to CEU, would put CBI over its credit exposure limit with respect to a single client. In compliance with its internal lending statutes, CBI was unable to extend the additional loan to CEU and faced the possibility of damaging their banking relationship. Taking steps to prevent this, CBI’s management called on Kittal to see if CBI could use credit derivatives to their advantage. Kittal envisioned helping CBI mitigate the credit risk exposure to the additional loan using a single-name credit default swap. First American Bank First American Bank was one of the largest financial services firms in the United States. With more than 7,500 employees and over $50 billion in assets as of December 31, 2001, the bank served more than 10 million customers in more than 50 countries. (See Exhibits 1, 2, and 3 for First American Bank’s financial statements.) First American Credit Derivatives (FACD) was an independent business unit housed within First Amerian’s structured products branch. This group’s business model was essentially to utilize First American Banks’s capital base and expertise in risk management and financial engineering to provide clients with risk management and investment products. First American Bank’s efforts in the area of credit derivatives had been recognized in the banking community and given FACD a reputation as an emerging leader in its field. For the exclusive use of C. WANG This document is authorized for use only by Chao Wang in Global Risk Management - Fall 2012 taught by N. K. CHIDAMBARAN from September 2012 to December 2012. 203-033 First American Bank: Credit Default Swaps 2 CapEx Unlimited CapEx Unlimited was formed in 1996. The company focused primarily on the communication needs in less competitive markets of Northeast and Midwest United States. Originally established as a voice-only provider, CapEx had continuously upgraded and expanded its infrastructure in order to keep pace with the growing customer demand for new features and services. In 2001, its services included high-speed Internet access, Web hosting, data networking, voice communication, and video-/tele-conferencing. As a full-facility long-distance provider, CapEx possessed over 15,000 miles of fiber and over 20 advanced switching systems (for rerouting information). The company had over 100 co-location and interconnecting agreements with all the major carriers. (Exhibits 4, 5, and 6 show CEU’s financial statements while Exhibit 7 gives the company’s historic stock performance.) Applying Credit Default Swaps to the Situation Kittal knew he was in a position to help CBI. In this particular situation, he thought it best to use a credit default swap. A credit default swap was appealing because it made the credit risk accessible to a broad range of investors in a way that was simple and, more importantly, confidential. The default swap added flexibility to the situation because it could also be combined with another risk transfer mechanism, such as loan syndication, to separate the loan into different portions. Using a credit default swap, CBI would make a periodic fee payment to First American in exchange for receiving credit protection. First American would assume the credit risk of the additional loan to CEU by guaranteeing a payment to CBI if CEU defaulted on its debt. Even though a credit default swap was unfunded (meaning that it was unsecured by collateral), the counterparty risk for CBI was low. The low counterparty risk was a result of First American Bank being a highly rated entity and the low probability of First American defaulting at the same time as CEU. Using the credit default swap, CBI could preserve its banking relationship with CEU without violating its internal credit limits. From the client’s perspective, CBI would just be lending its client money in a normal manner. However, without the client’s knowledge, CBI would have passed the credit risk of the loan on to First American Bank1. Essentially, CBI would be acting as an intermediary between CEU and First American. (See Exhibit 8 for yields on U.S. Treasury STRIPS. Exhibit 9 shows credit spreads for bonds of firms in the telecommunications industry and Exhibits 10a and 10b show historic default rates for certain industries and credit ratings.) Credit Default Swap Overview The market for credit default swaps was the most liquid credit derivatives market. Through a single name credit default swap2, a party could have bought protection from another party with respect to various predefined credit events occurring to a certain reference entity/obligation. The party buying the protection (equivalently going short the credit) was called the “protection buyer.” The party selling the protection (or equivalently going long the credit event risk) was called the “protection seller.” 1 The actual loan stays on CBI’s accounting books, but may receive different treatment under regulations due to the risk hedge. 2 Single name refers to a contract written on a single entity/debtor rather than a group or portfolio. For the exclusive use of C. WANG This document is authorized for use only by Chao Wang in Global Risk Management - Fall 2012 taught by N. K. CHIDAMBARAN from September 2012 to December 2012. First American Bank: Credit Default Swaps 203-033 3 In exchange for receiving credit protection, the protection buyer paid a periodic fee to the protection seller until the contract expired or a credit event occurred. The credit protection consisted of a payment made by the protection seller to the protection buyer, contingent on the occurrence of one or more predetermined credit events. In exchange for the contingent payment, the protection seller either received the underlying asset (“physical settlement”) or the determined market value of the asset in cash (“cash settlement”), which netted out against the contingent payment The two swap counterparties could have defined the credit event(s) as they saw fit. However, in 1999, the International Swaps and Derivatives Association (ISDA) developed standard definitions and documentation to simplify the use of these instruments. Standardization allowed for faster execution of deals and minimized “documentation risk” by promoting a common understanding of the precise definitions of standard credit events. As a result, the standardization of credit default swap contracts facilitated the netting of contracts and resulted in enhanced liquidity in the market. In simple terms, the credit default swap contract was written for the event that the entity defaulted on its obligations. Therefore, an investor could have assumed an entity’s default risk, among other defined risks, without having taken on the other risks of the debt itself (i.e., interest rate risk). Moreover, on an ongoing basis throughout the life of the contract, the value of a credit default swap reflected the market credit spread of the entity. Thus, through a credit default swap, an investor could have gained exposure to (or hedge) an entity’s credit spread risk, as well as default risk. The flexibility in specifying the length of the life of the swap contract meant that an investor could have specified the desirable maturity exposure to the entity. It was possible that no other market could have provided the investor with this preferred maturity exposure to the particular entity. For example, an investor may have wished to take on five-year exposure to a company that did not have a five-year bond outstanding. However, by selling five-year protection on the company, the investor could have achieved the credit exposure he desired. (Exhibits 11a and 11b show the historic growth of the interest rate swap and credit derivative markets and Exhibit 12 shows the primary protection buyers and protection sellers of protection through credit default swaps.) Isolating Credit Risk To properly transfer the credit risk from CBI to First American Bank, a model was needed to isolate and value the credit portion of CEU’s risky debt. It was necessary to decompose the risky debt into different elements, value them separately and then decide how much the protection seller should be compensated for in the form of a swap premium. Kittal gathered the information he needed to complete the deal. CEU would receive the additional loan from CBI for $50 million, bringing their total long-term debt to approximately $5 billion; however, CBI was only looking for credit protection for the additional $50 million in principle. CEU’s publicly traded debt was already below investment grade (with a B2 rating from Moody’s) and the additional loans were not expected to have much impact on the market value of the existing debt. The terms of this new loan included a coupon rate of approximately 9.8% and a maturity of two years. CEU’s existing debt had an average maturity of five years, with an average semi-annual coupon of $130 million. This debt had a total market value of approximately $4.1 billion, representing an average yield of 9.6%. At the time of the deal, the five-year risk-free rate was approximately 4.5%. An analyst presented Kittal with information on traded long-term options on a For the exclusive use of C. WANG This document is authorized for use only by Chao Wang in Global Risk Management - Fall 2012 taught by N. K. CHIDAMBARAN from September 2012 to December 2012. 203-033 First American Bank: Credit Default Swaps 4 comparable firm with no debt3. (See Exhibit 13 for the comparable’s option data.) CEU’s equity had a current market value of $6.8 billion (the firm had recently announced the cessation of all dividend payments on all of its stock) and, using statistics from a Moody’s report, Kittal could project the dollar amount CBI would recover from its loan if CEU were to enter default. (Exhibit 14 shows Moody’s average defaulted values.) In exchange for protection against a CEU credit event, CBI would make semiannual swap fee payments to First American Bank that coincided with the interest payments it received on the CEU loan. Credit Risk Seekers Once CBI agreed to the swap premium and credit event definitions stated in the contract, the bank would have the protection it needed to make the loan while observing internal credit rules. On the other hand, Kittal knew he would have only completed half the transaction from First American Bank’s perspective. Before the CBI transaction had been completed, Kittal would be on the phone to potential investors, gauging their risk appetites. Unless First American wanted to keep the risk “in- house,” Kittal would have to find investors interested in taking on CEU credit risk. Instead of investing in the credit risk itself, First American would make a fee by acting as an intermediary and passing the credit risk from its source to the appropriate investors, or perhaps by hedging the credit risk using some set of market transactions. In the back of his mind, Kittal already had a list of prospective investors to contact. Kittal thought the most likely investors would be two relatively low-rated banks and a hedge fund and, as a result, he was aware that a credit default swap would probably not work for the back end of the deal. Credit Default Swap Boundaries A default swap was not feasible as a mechanism for transferring the CEU credit risk to the potential investors since a credit default swap was an unfunded contract and these protection sellers presented high counterparty risk for First American Bank, the protection buyer. The low credit quality of these entities meant that they might default during the life of the contract and not be able to make contingent payments if a CEU credit event took place. In addition, there was a considerable risk that both these protection sellers would default at the same time. In order for First American to protect itself from losses, it would have to require the protection sellers to post large amounts of collateral. These potential investors would be forced to tie up significant portions of their capital as collateral and have to forego other investment opportunities. Since collateral earned a low return, it would significantly lower each firm’s overall return on capital. This made an unfunded structure unattractive for them. In other words, the size of collateral that First American required resulted in high opportunity costs for their investors, which would make the default swap structure prohibitively “expensive” for these investors. Therefore, Kittal needed to find a funded solution that would be attractive to a broader investor group. One possibility was to use a credit-linked note. By repackaging the risk in note form it could be marketed to investment managers and other investors as a product competitive to other bonds and asset-backed securities with similar characteristics. 3 Long-term Equity AnticiPation Securities (LEAPS) typically have maturities from two to three years. For the exclusive use of C. WANG This document is authorized for use only by Chao Wang in Global Risk Management - Fall 2012 taught by N. K. CHIDAMBARAN from September 2012 to December 2012. First American Bank: Credit Default Swaps 203-033 5 Conclusion Kittal had two tasks left. First and foremost, he had to determine the semi-annual fee to be charged to CBI for the default swap. Second, Kittal needed to ensure that First American Bank could hedge its end of the default swap by selling off the credit exposure in the form of another default swap or through another means. For the exclusive use of C. WANG This document is authorized for use only by Chao Wang in Global Risk Management - Fall 2012 taught by N. K. CHIDAMBARAN from September 2012 to December 2012. 203-033 First American Bank: Credit Default Swaps 6 Exhibit 1 First American Bank’s Balance Sheet In $ Millions for Period Ended December 31, 2001 12/31/01 12/31/00 Cash and due from banks 1,662 1,763 Deposits with banks 937 613 Federal funds sold and securities purchased under resale agreements 4,686 5,108 Securities borrowed 2,690 2,380 Trading assets: Debt and equity instruments 8,695 10,239 Derivative receivables 5,232 5,616 Securities: Available-for-sale 4,359 5,375 Held-to-maturity 35 43 Loans 15,656 15,617 Private equity investments 676 840 Accrued interest and accounts receivable 1,088 1,516 Premises and equipment 463 521 Goodwill and other intangibles 1129 1165 Other assets 3,692 1,804 Total assets $51,000 $52,600 Total deposits 21,592 20,542 Federal funds purchased and securities sold under repurchase agreements 9,445 9,687 Commercial paper 1,361 1,827 Other borrowed funds 797 1,459 Debt and equity instruments 3,896 3,835 Derivative payables 4,122 5,626 Accounts payable, accrued expenses and other liabilities 3,516 2,997 Long-term debt 2,881 3,184 Firm's junior subordinated deferrable interest debentures 326 290 Total liabilities $47,936 $49,447 Preferred stock of subsidiary 40 40 Preferred stock 76 111 Common stock 147 143 Capital surplus 919 853 Retained earnings 1,985 2,066 Accumulated other comprehensive income (loss) (33) (18) Treasury stock, at cost (70) (42) Total stockholders' equity 3,064 3,153 Total liabilities, preferred stock of subsidiary and stockholders' equity $51,000 $52,600 Source: Created by casewriter. For the exclusive use of C. WANG This document is authorized for use only by Chao Wang in Global Risk Management - Fall 2012 taught by N. K. CHIDAMBARAN from September 2012 to December 2012. First American Bank: Credit Default Swaps 203-033 7 Exhibit 2 First American Bank’s Income Statement In $ Millions Except Per Share Amounts for Period Ended December 31, 2001 12/31/01 12/31/00 12/31/99 Revenue Investment banking fees 266 321 259 Trading revenue 362 463 386 Fees and commissions 677 679 579 Private equity—realized gains 48 151 124 Private equity—unrealized gains (losses) (139) (76) 107 Securities gains (losses) 64 17 (14) Other revenue 65 168 77 Total noninterest revenue $1,342 $1,722 $1,518 Interest income 2,366 2,694 2,295 Interest expense 1,572 1,995 1,538 Net interest income $ 794 $ 699 $ 756 Revenue before provision for loan losses 2,136 2,421 2,274 Provision for loan losses 234 101 106 Total net revenue $1,902 $2,320 $2,168 Expense Compensation expense 878 937 775 Occupancy expense 99 95 88 Technology and communications expense 194 180 160 Merger and restructuring costs 186 105 2 Amortization of intangibles 54 39 24 Other expense 303 321 275 Total noninterest expense $1,713 $1,678 $1,323 Income before income tax expense and effect of accounting change 189 642 845 Income tax expense 62 221 293 Income before effect of accounting change 126 421 552 Net effect of change in accounting principle (2) 0 0 Net income $ 125 $ 421 $ 552 Net income applicable to common stock $ 120 $ 414 $ 544 Source: Created by casewriter. For the exclusive use of C. WANG This document is authorized for use only by Chao Wang in Global Risk Management - Fall 2012 taught by N. K. CHIDAMBARAN from September 2012 to December 2012. 203-033 First American Bank: Credit Default Swaps 8 Exhibit 3 First American Bank’s Cash Flow Statement In $ Millions for Period Ended December 31, 2001 12/31/01 12/31/00 12/31/99 Operating activities Net income 125 421 552 Provision for loan losses 234 101 106 Merger and restructuring costs 186 105 2 Depreciation and amortization 213 187 143 Private equity unrealized losses (gains) and write-offs 139 76 (107) Trading-related assets 1,928 (2,556) (641) Securities borrowed (310) 232 (289) Accrued interest and accounts receivable 428 (5) (193) Other assets (1,967) (302) (500) Trading-related liabilities (1,481) 712 722 Accounts payable and