Simone Westerfeld

The Impact of Counterparty Risk on Credit Default Swap Pricing Dynamics

As observed throughout the financial crisis in 2008 CDS contracts are not only exposed to the credit risk of the underlying reference entity but also to the counterparty risk of the protection seller. Conducting a panel regression analysis based on CDS contracts from 2004 to 2009 in Europe and North America for 198 reference entities we find that market-oriented counterparty risk measures are reflected in the pricing of CDS contracts. The impact of counterparty risk is decreasing with a higher creditworthiness of the underlying reference entity. We show that counterparty risk has been incorporated in the CDS spreads for North American reference entities already prior to the financial crisis, whereas for European reference entities the pricing impact only intensified with the outbreak of the financial crisis in September 2008. Market-based counterparty risk measures have a higher impact on the pricing of CDS contracts as compared to measures relying on the correlation structures of asset returns of reference entities and CDS counterparties.

Information or Insurance? On the Role of Loan Officer Discretion in Credit Assessment

We employ a unique dataset of 6,669 credit assessments for 3,542 small businesses by nine banks using an identical rating model over the period 2006-2011 to examine (i) to what extent loan officers use their discretion to smooth credit ratings of their clients, and (ii) to assess whether this use of discretion is driven by information about the creditworthiness of the borrower or by the insurance of clients against fluctuations in lending conditions. Our results show that loan officers make extensive use of their discretion to smooth clients’ credit ratings: One in five rating shocks induced by changes in the quantitative assessment of a client is reversed by the loan officer. This smoothing of credit ratings is prevalent across all rating classes, is independent of whether the borrower experiences a positive or a negative rating shock, and is independent of whether the shock is firm-specific or market-related. We find that discretionary rating changes have limited power in predicting future loan performance, indicating that the smoothing of credit ratings is only partially driven by information about creditworthiness. Instead, in line with the implicit contract view of credit relationships loan officers are more likely to smooth ratings when rating shocks have stronger implications for interest rates.

Internal Control and Strategic Communication within Firms – Evidence from Bank Lending

The allocation of authority affects the communication of information about clients within banks. We document that in small business lending internal control leads loan officers to propose inflated credit ratings for their clients. Inflated ratings are, however, anticipated and partly reversed by the credit officers responsible for approving credit assessments. More experienced loan officers inflate those parameters of a credit rating which are least likely to be corrected by credit officers. Our analysis covers 10,568 internal ratings for 3,661 small business clients at six retail banks. We provide empirical support to theories suggesting that internal control can induce strategic communication within organizations when senders and receivers of information have diverging interests. Our findings also point to the limits of the four-eyes principle as a risk-management tool in financial institutions.

Sovereign Risk and the Pricing of Corporate Credit Default Swaps

Based on an empirical analysis of European corporations, we investigate the impact of sovereign risk on the pricing of corporate credit risk. In our paper, we show that sovereign credit default swaps (CDS) are positively correlated with corresponding corporate CDS spreads and are a significant factor for corporate CDS pricing models. We also find that this impact in-creases throughout the sovereign debt crisis in 2010-2011 and is more distinctive for Euro-zone countries that were more exposed to the sovereign debt crisis than others. We further observe that this effect is particularly pronounced for corporations with a high dependency on their domestic market.

E-Business Tools for Active Credit Risk Management A Market Analysis

This paper analyses the impact of ICT on the value creation system of loans and its respective business models and focuses on credit risk management of commercial banks. Whereas ICT impact on loan origination has been studied already in earlier papers there are no in-depth studies available mainly focused at credit risk management, which reaches beyond mere origination. After presenting a general analysis about ICT impact on value creation in the financial industry, this paper provides a state-of-the-art analysis of e-business tools for credit risk management emphasizing their value proposition with respect to credit risk management. The analysis is based on the hypothesis that only by innovative e-business solutions traditional loan business can convert into active credit risk management. As a result the research comes up with three categories of tools which are valuation platforms, rating tools, and trading platforms. It can be shown that ICT leads to the deconstruction of the traditional loan business model.

Rating Agencies and Information Efficiency: Do Multiple Credit Ratings Pay Off?

We empirically investigate the benefits of multiple ratings not only at issuance of debt instruments but also during the subsequent monitoring phase. Using a record of monthly credit rating migration data on all U.S. residential mortgage-backed securities rated by Standard & Poors, Moodys, and Fitch between 1985 and 2012 (154,600 tranches), our results provide empirical evidence that rating agencies put more effort in rating and outlook revisions when tranches have assigned multiple ratings. Furthermore, we see that in the case of multiple ratings, agencies do a better job in discriminating tranches with respect to default risk. On the downside, we observe a shift in collateral towards senior tranches and incentives for issuers to engage in rating shopping activities, but find no evidence that rating agencies exploit such behavior to attract more rating business. Our results contribute to the literature on information production of credit ratings and extend the perspective to the monitoring period after issuance.

The Liquidity Dynamics of Bank Defaults

We compare liquidity patterns of 10,979 failed and non-failed US banks from 2001 to mid-2010 and detect diverging capital structures: failing banks distinctively change their liquidity position about three to five years prior to default by increasing liquid assets and decreasing liquid liabilities. The build-up of liquid assets is primarily driven by short term loans, whereas long term loan positions are significantly reduced. By abandoning (positive) term transformation throughout the intermediate period prior to a default, failing banks drift away from the traditional banking business model. We show that this liquidity shift is induced by window dressing activities towards bondholders and money market investors as well as a bad client base.

Impact of Multiple CDO Ratings on Credit Spreads

The authors analyze whether multiple ratings for CDO tranches have an impact on credit spreads and examine the various effects with regard to the number of rating agencies involved. Based on a data set of more than 5,000 CDO tranches, the authors calculate index-adjusted credit spreads to isolate the specific credit risk per CDO tranche and find a negative correlation between number of ratings and credit spreads per CDO tranche—i.e., additional ratings are accompanied by lower credit spreads. On the basis of a valuation model, the authors show that multiple ratings are a significant pricing factor and conclude that investors demand an extra risk premium due to information asymmetries between CDO issuers and investors. Any additional rating reveals incremental information to the market and increases transparency with regard to the underlying portfolio’s credit risk. However, the study does not find empirical support for the hypothesis that marginal tranche spread reduction decreases when additional rating agencies are added. Finally, the study finds evidence that second or third ratings by Fitch on average are higher when directly compared with Moody’s and/or S&P ratings per CDO tranche. This finding is in line with existing literature on corporate bonds and indicates a bias also on CDO ratings due to their solicited character.

Selecting credit portfolios for collateralized loan obligation transactions : A heuristic Algorithm

We investigate the optimization of a securitized asset pool for collateralized loan obligation (CLO) transactions. Defining economic risk transfer as the objective function for optimization and the crucial underlying motivation for banks to engage in balance-sheet CLOs, we present the mathematical description of this optimization problem. The criteria applied by rating agencies to CLO transactions add both linear and non-linear constraints to this optimization task. As such problems may not be solved in closed form, we develop a heuristic algorithm and test it with realistic credit portfolio data. The application of this algorithm could support banks as originators when selecting an optimal securitized portfolio from an eligible asset pool. The algorithm becomes particularly relevant when considering the current credit crisis and the subsequent need for liquidity in banking: retained CLO tranches could be used as collateral in repo transactions with central banks and establish an alternative source of funding.