How does CLN issuer make money?

[ajsa]

Hi David,

If bond does not default, CLN issuer pays higher coupon. If bond default, it passes the recovery rate to the buyer. if downgrade, it pays lower rate.. It seems CLN issuer is betting that the bond will be downgraded but will not default?

Why does the CLN issuer want to issue CLN? to protect itself or to make money? is it normally a dealer?

Also could you show me how CDS is embedded in CLN?


BTW, I looked up online. http://en.wikipedia.org/wiki/Credit-linked_note
It seems there is a trust between issuer and buyer.. It also says "The CLNs themselves are typically backed by very highly-rated collateral, such as U.S. Treasury securities." What does it mean?
Also it gives an example: "A bank lends money to a company, XYZ, and at the time of loan issues credit-linked notes bought by investors. The interest rate on the notes is determined by the credit risk of the company XYZ. The funds the bank raises by issuing notes to investors are invested in bonds with low probability of default. If company XYZ is solvent, the bank is obligated to pay the notes in full. If company XYZ goes bankrupt, the note-holders/investors become the creditor of the company XYZ and receive the company XYZ loan. The bank in turn gets compensated by the returns on less-risky bond investments funded by issuing credit linked notes."

I am confused..

Thanks.

 

[David Harper CFA FRM]

Hi asja,

The motive of CLN issuer is: *funded* credit (default) risk transfer. The key is *funding*
(the CLN buyer has the "make money" motivation)

Culp says, CLN = funded CDS.

If that's true, we can say motive of issuer is similiar to motive of CDS (protection) buyer *except* unlike the CDS (where the protection buyer is not funded; i.e., incurs the counterparty risk that the seller [think AIG] will not make the *payoff* in credit event), the CLN issuer does not have the counterparty concern: the notes were are purchased (funded) so it only a matter of withholding from investors...

See synthetic CDO below

on the right, the tranched notes issued to investors are essentially CLN: junior tranche invests (*funds* with cash!), those funds go into high-quality collateral, but investor may not receive full par back if default. (I realize our readings don't call them CLNs but I am just illustrating they functionally are CLNs)

on the left, the orignator buys *unfunded* credit protection from SPE (hence, synthetic CDO). However, this risk tranfsfer (from originator to SPE) could instead be achieved via CLN instead: if CLN instead of CDS, SPE then would use investor funds to purchase CLN from originator. Risk transfer (from originator to SPE to investors) would be similarly achieved, but originator receives funds so does not have the counteparty risk with SPE (this would be a structured CDO vs synthetic CDO) (and, the disadvantage of this versus CDS is exactly due to the funding: it's easier for the SPE to write CDS than buy CLN)

see similarity? two credit transfers. on left, with unfunded derivatives only (CDS). On right, with funded note + embedded credit derivative (CLN).

is it normally a dealer? I think issuer can various entities and intermediaries, incl. corporation. CLN is very broad class with many flavors

so, i think the key points are:

primary issuer motivation: credit risk transfer to the investor/buyer
funded status: CLN implies issuer is receiving cash (to your point, that can be immediately invested in high-quality collateral)
and, importantly, counterparty risk: for CDS almost all the counterparty risk incurred by CDS buyer; for CLN, counterparty risk incurred by investor.

Re: "It seems CLN issuer is betting that the bond will be downgraded but will not default?"
This is *exactly* what Meissner says (Ch 3 was assigned last year): although "making a bet" not cited as issuer motivation (i.e., Meissner cites CLN buyer's motivation as yield enhancement. So, again you see the basic trade: credit transfer in exchange for yield enhancement), he does say best case for issuer is "downgrade but not default"

hope this helps...David

http://learn.bionicturtle.com/images/forum/0911_scdo.png

 

[ajsa]

Hi David,

Thank you so much for the detailed explainations! that makes more sense now..

why does CLN issuer need to put the received cash in a high quality asset as collateral? to fund the yield spread when there is no downgrade/default? is the collateral mandatory?

Thanks.

 

[rahul.goyl]

Hi David/Ajsa,

Thanks for the excellent explanation.

Take it as below Example
A CLN buyer is buying exposure of SPV in the Example thru issued Notes, So the payoff will be below
CLN Buyer Payoff - % of Regular Coupon (5%) + (Short) CDS Spread (200bps) + % Yields from Collateral (Invested in High Quality) (2.5%) = Total % 9.5%

Now why a CLN will issue such notes, the motivation for CLN is to make Risk Free return without any investment...
Payoff CLN Issuer - Investment in High Quality T Bills (4% - 2.5%(Paid to Investors) = 1.5% Risk Free without any Investment).
If Credit Rating remains constant then the CLN issuers have to will end up paying 9.5% . In that case the CLN issuer may end up making 200bps.

David what I understood is SPV (If Independent & not an Originator) does not make any investment from their pocket & make money invested by CLN buyer (Who are the sole risk taker in this position {Credit + Counterparty + Market (% Returns Decreases on Upgrading)}.

The CDS embedded into the the CLN issued is already collateralize by getting funded from CLN buyer & invested the proceeding into T Bills, So CLN issuer has No Credit & Counterparty Risk. So the CLN buyer will be getting Recovery incase of default, If not then the CLN are redeemed at the Face Value.

Correct if am wrong in getting this right.
Thanks
Rahul

 

[bpdulog]

Hi asja,

The motive of CLN issuer is: *funded* credit (default) risk transfer. The key is *funding*
(the CLN buyer has the "make money" motivation)

Culp says, CLN = funded CDS.

If that's true, we can say motive of issuer is similiar to motive of CDS (protection) buyer *except* unlike the CDS (where the protection buyer is not funded; i.e., incurs the counterparty risk that the seller [think AIG] will not make the *payoff* in credit event), the CLN issuer does not have the counterparty concern: the notes were are purchased (funded) so it only a matter of withholding from investors...

See synthetic CDO below

on the right, the tranched notes issued to investors are essentially CLN: junior tranche invests (*funds* with cash!), those funds go into high-quality collateral, but investor may not receive full par back if default. (I realize our readings don't call them CLNs but I am just illustrating they functionally are CLNs)

on the left, the orignator buys *unfunded* credit protection from SPE (hence, synthetic CDO). However, this risk tranfsfer (from originator to SPE) could instead be achieved via CLN instead: if CLN instead of CDS, SPE then would use investor funds to purchase CLN from originator. Risk transfer (from originator to SPE to investors) would be similarly achieved, but originator receives funds so does not have the counteparty risk with SPE (this would be a structured CDO vs synthetic CDO) (and, the disadvantage of this versus CDS is exactly due to the funding: it's easier for the SPE to write CDS than buy CLN)

see similarity? two credit transfers. on left, with unfunded derivatives only (CDS). On right, with funded note + embedded credit derivative (CLN).

is it normally a dealer? I think issuer can various entities and intermediaries, incl. corporation. CLN is very broad class with many flavors

so, i think the key points are:

primary issuer motivation: credit risk transfer to the investor/buyer
funded status: CLN implies issuer is receiving cash (to your point, that can be immediately invested in high-quality collateral)
and, importantly, counterparty risk: for CDS almost all the counterparty risk incurred by CDS buyer; for CLN, counterparty risk incurred by investor.

Re: "It seems CLN issuer is betting that the bond will be downgraded but will not default?"
This is *exactly* what Meissner says (Ch 3 was assigned last year): although "making a bet" not cited as issuer motivation (i.e., Meissner cites CLN buyer's motivation as yield enhancement. So, again you see the basic trade: credit transfer in exchange for yield enhancement), he does say best case for issuer is "downgrade but not default"

hope this helps...David

http://learn.bionicturtle.com/images/forum/0911_scdo.png

Is the funding motivation due to the fact that the bank uses the funding to originate more loans and issue more CLNs? Funding is great and all, but absent some kind of liquidity crisis what is driving the funding need?