credit linked note

[Rajiv28]

Hi David,

Though I have unserstood this product from the buyer's point of view, I am still unable to figure out the math from note issuer viewpoint. How does the issuer make money by paying higher coupon than what it receives from the underlying? Especially when it is required to pay extra for corelation in case of a basket of assets?

Thanks,
Rajiv

 

[David Harper CFA FRM]

Culp helpfully says a CLN = bond + CDS. CLN means issuers sells note (bond) plus buys credit protection.
(so from investors viewpoint, it is a *funded* CDS: by buying the bond, they have up-front paid/funded the CDS, so unlike a typical CDS, no counterparty risk)

So, from angle of yield enhancement, you are right: under no downgrade/default, the issuer is losing by the CDS spread.
In de Servigny's example, reference bond has 8% coupon, and CLN pays a 10% coupon.
So, infer: CDS spread is 2% (that is the cost of purchasing credit protection)

So, the motive would be here the same motive to buy CDS: transfer credit risk. If no default, issuer (to your point) is worse off. But if downgrade, then issuer is better off.

It is good to conduct this thought problem! Last year's FRM had +2 de servigny chapters on "the application of" credit derivatives. I think it was a bit of mistake to omit them, b/c questions will be about this sort of the thing (e.g., the MOTIVE of buyers/sellers, application)....I will put the math of some of these c.d. into EditGrid, if it helps, this is the topic for next Monday...thanks, David

 

[Swarnendu Pathak]

Hi David,
One basic fundamental concept is confusing me in understanding the concept of CLN. Whether the CLN issuer is a protection (CDS) buyer or seller?? as per my understanding CLN issuer is selling the CDS on some reference assets & getting the premium from protection buyer which in turn is used by the CLN issuer to pay to the CLN buyer/investor in terms of higher coupon, now if the CLN issuer is paying the higher coupon to CLN investor than what the issuer is earning from CDS premium - then how the CLN issuer is making profit out of the whole transaction?? Please make me understand the whole concept with your as usual lucid explanation.

Thanks

 

[ashanks]

Swarnendu,

You're mistaken here. CLN issuer is the protection BUYER, and the CLN buyer herself is the CDS/protection seller. To compensate the protection seller with the 'CDS' premium, CLN issuer pays a higher coupon to the CLN buyer. The buyer pays face value at inception. Now three things can happen

ONE:

If there is no credit down grade or no default on the reference bond, the CLN buyer walks away with enhanced coupon, and the principal at the end of the term. However, this exposes the CLN buyer to counterparty risk. THe CLN issuer may default. This is why the premium part of the CLN is higher than the premium of a CDS typically.​

​

TWO:

There is a credit downgrade on the reference bond: in this case, the CLN buyer receives a reduced coupon​

​

THREE:

There is a default on the reference bond: in this case, the CLN buyer only receives the (1-RR) (i.e. she is 'made whole')​

​

Anshuman

 

[ShaktiRathore]

hi, @Swarnendu Pathak
The investor buys CLNs from the issuer who receive face value of the issued CLNs, this face value amount is then deposited in high quality collateral which earns the collateral interest and this interest can be swapped with libor to earn high interest rate. this collateral interest is the source of income i think for the CLN issuer. refer http://www.lawrencedloeb.com/blog_documents/Structure.of.Abacus.Deal.from.GS.pitchbook.pdf
Investor will receive the LIBOR +spread equal to the default swap spread of the reference asset+ spread linked to the funding spread of the issuer. The funding spread of the issuer is smaller than CDS spread passed on to the investor. The issuer actually charges a admin cost for admin work of managing the credit linked note.

thanks

 

[bpdulog]

Hi @David Harper CFA FRM

Thanks for the explanation above, I don't really see why a bank would want to enter such a transaction unless the odds are the bonds will default or they want to maintain a client relatioinship.

 

[bpdulog]

Hi @David Harper CFA FRM

Going back to the reading, it seems like the bank is actually making 100bps off this transaction



However, I still don't understand it. The investor pays $15MM for the CLNs, then the trust stores that money in T-notes paying 6.5%. The bank purchases $105MM in non-inv grade loans paying L+250 financed by L. So the bank collects 250bps and pays out 150bps to the trust (not sure why).

In this scenario, the bank is making money and the investor is making money. Therefore , it looks like the trust is losing money? They are paying L+250 coupon to the bank and the T-note return + yield to the investor.

In your explanation above, is the bank losing money because they are issuing the CLN directly and not via a trust? Sorry for all the questions, this is confusing

 

[bpdulog]

Swarnendu,

You're mistaken here. CLN issuer is the protection BUYER, and the CLN buyer herself is the CDS/protection seller. To compensate the protection seller with the 'CDS' premium, CLN issuer pays a higher coupon to the CLN buyer. The buyer pays face value at inception. Now three things can happen

ONE:

If there is no credit down grade or no default on the reference bond, the CLN buyer walks away with enhanced coupon, and the principal at the end of the term. However, this exposes the CLN buyer to counterparty risk. THe CLN issuer may default. This is why the premium part of the CLN is higher than the premium of a CDS typically.
​

TWO:

There is a credit downgrade on the reference bond: in this case, the CLN buyer receives a reduced coupon
​

THREE:

There is a default on the reference bond: in this case, the CLN buyer only receives the (1-RR) (i.e. she is 'made whole')
​

Anshuman

Hi @ashanks

I think in your third point, the CLN buyer receives the RR not 1-RR

 

[David Harper CFA FRM]

@bpdulog In Crouhy's CLN, the trust is effectively just a vehicle for holding the collateral and issuing notes to the investors; the trust does not gain or lose any cashflow, economically everything "passes through" it, so I think of it as merely a vehicle that enables the CLN. The bank does not need the CLN. Presumably, the bank sets up the CLN (and the trust which enables the CLN) in order to transfer the credit risk on the "equity tranche" (i.e., the credit risk on the $15 mm which is the first loss position).

How I think of this situation, then, as simply as possible is:

• $105 in assets produce a yield of Libor + 250 bps. The baseline scenario is that the banks just buys them by borrowing at Libor and collects the full + 250 bps. However, apparently, the bank does not want all of that credit risk (e.g., perhaps as such, the position incurs too much risk weighted asset under Basel III)
• The trust enables the bank to issue a CLN to investors on the riskiest "equity" tranche ($15 mm). Their funded $15 mm is safely stored in risk-free assets. Now, rather than collecting the entire +250, the bank effectively diverts +150 to the investors and keeps + 100 (the price of insuring the riskiest $15 mm). The trust is just "running interference" here, it's like escrow for the investor's $15 mm: they get it back if there are no defaults, but they could lose it all, hence the legal construction of the trust. I hope that's helpful!

 

[bpdulog]

Thanks @David Harper CFA FRM this is very helpful

Now, if the bank wanted to transfer the entire $105MM in credit risk, the entire L + 250 would pass through the investors? If so, how is there any yield enhancement for the investors if they are purchasing the entire amount?

 

[David Harper CFA FRM]

Hi @bpdulog That's a good question that explores the dynamics. If the bank transfers the entire credit risk, the investors won't be leveraged and the best they can do is earn the 6.5% risk free (on treasury notes) plus the 2.50% "excess" that is inherent to the loan. The bank here acquires loan(s) that earn Libor + 250 bps and funds the purchase with libor, so there is +250 bps that can be shared. Specifically,

• If we keep this scenario and change only the investor's CLN purchase, and to your question, let's say the purchase the entire $105.00 (i.e., transfer of all credit risk), then their leverage = 1.0 = 105 CLN/105 assets and, if the bank still only pays them + 100 bps of the + 250, then the investors yield is only 8.0% = 6.50% + (1.50%* 1.0 leverage) = 8.00%. However, this is unrealistic: if they acquire all of the risk, they demand more proceeds. For example, if the bank pays all + 250, then the investor's yield goes up to 8.0% = 6.50% + (2.50%* 1.0 leverage) = 9.00%. But that's the max and there's no leverage.
• But the investors could pay (eg) $50 of the 105 for a leverage of 2.1, and maybe the bank pays them + 200 bps and keeps 50 bps, such that investors yield = 6.5% + (2.00% * 50/105) = 10.70%. I hope that clarifies!

 

[bpdulog]

Thanks @David Harper CFA FRM , this is extremely helpful!!!

I just noticed that the diagram is missing a key component: the payment on the CDS. So the 100bps the bank is technically receiving is actually less (or even negative) since they are buying credit protection on the CDS

 

[David Harper CFA FRM]

@bpdulog Great! ... but I don't think there is a "missing" CDS. We just say the CLN is analogous to a CDS except (whereas the CDS is unfunded), it is funded by protection seller. The 100 bps payment by the bank to the investors is analogous to the CDS premium (in exchange for protection, not on the entire 105 but rather, on the $15). Unless I am mistaken, I actually think the 100 bps is confusingly placed. Where a $15 CDS would payoff in the credit event, here the investors have funded (or "prepaid" to the trust) the payoff which might be used by the bank if there is a loss. So the mechanics of the CDS are embedded in the CLN. I hope that helps!

 

[bpdulog]

@bpdulog Great! ... but I don't think there is a "missing" CDS. We just say the CLN is analogous to a CDS except (whereas the CDS is unfunded), it is funded by protection seller. The 100 bps payment by the bank to the investors is analogous to the CDS premium (in exchange for protection, not on the entire 105 but rather, on the $15). Unless I am mistaken, I actually think the 100 bps is confusingly placed. Where a $15 CDS would payoff in the credit event, here the investors have funded (or "prepaid" to the trust) the payoff which might be used by the bank if there is a loss. So the mechanics of the CDS are embedded in the CLN. I hope that helps!

Thanks again @David Harper CFA FRM

It makes sense, but I ran into a diagram you created that shows a CDS payment being made. Is this a different structure?

 

[David Harper CFA FRM]

@bpdulog Right, that's my copy of Meissner's "more complex" CLN (on the right) wherein there the protection buyer explicitly is long a CDS with the CLN issuer. But notice that it's economically equivalent to Crouhy's above (although, in my haste switching between forum and notes, I confused myself re: the 100 bps. The 100 bps down-arrow is retained by the bank, so it doesn't confuse me too much, and the right-arrow 150 bps is effectively--or analagously--the CDS premium). The bank is paying to the trust 150 bps (after keeping 100 bps) and this is the implicit CDS premium (or maybe its explicit, Crouhy doesn't say. Its either an "actual CDS" with the trust, or "effectively" a CDS embedded in the CLN): this is going to the investors in exchange for a claim on the already-funded $15.00 if/when there are losses. It is effectively a CDS on $15 notional, except its $15 notional principal because the investors prepaid it (funded it into the trust). I hope that clarifies!

 

[bpdulog]

@bpdulog Right, that's my copy of Meissner's "more complex" CLN (on the right) wherein there the protection buyer explicitly is long a CDS with the CLN issuer. But notice that it's economically equivalent to Crouhy's above (although, in my haste switching between forum and notes, I confused myself re: the 100 bps. The 100 bps down-arrow is retained by the bank, so it doesn't confuse me too much, and the right-arrow 150 bps is effectively--or analagously--the CDS premium). The bank is paying to the trust 150 bps (after keeping 100 bps) and this is the implicit CDS premium (or maybe its explicit, Crouhy doesn't say. Its either an "actual CDS" with the trust, or "effectively" a CDS embedded in the CLN): this is going to the investors in exchange for a claim on the already-funded $15.00 if/when there are losses. It is effectively a CDS on $15 notional, except its $15 notional principal because the investors prepaid it (funded it into the trust). I hope that clarifies!

Thanks again @David Harper CFA FRM !

Another important insight gained where the text simply mentions CDS with no further detail - it is only for the $15 million equity piece as opposed to the entire portfolio of the bonds