This article summarizes an interview with Joe Walsh, president of Amherst Securities, about the firm's role in the securitization space and outlook. Key points: - Amherst is a leading broker-dealer specializing in mortgage-backed securities, serving institutional investors in new issue and secondary markets. - The firm has expanded into ABS and CMBS, seeing these as natural extensions of its RMBS expertise. It aims to provide better data, analysis and market understanding. - Walsh sees opportunities in the second half of 2020 as market volatility has increased uncertainty over the economic recovery trajectory and asset performance. - Fundamental performance may differ from expectations due to economic, political and regulatory factors, creating both

1. Issue 3 August 2010
Vanilla structures return
Less complex rate products in vogue
Focusing on ILS issuance RMBS and Structured CDS
risk chemistry expectations bank ratings credit ideas clearing

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3. Issue 3 August 2010
Contents
2 The Interview
Navigating changing markets
Joe Walsh, president of Amherst Securities, shares his views on
2
the ABS and MBS markets and the future strategy of his firm
6 Wholesale Structured Products
Vanilla structures return
Suddenly mundane is popular again. As Kathy Fitzpatrick
Hoffelder discovers, complicated rate product strategies that have
Editor been marketed as ‘too sophisticated to fail’ are out. Institutional
Mark Pelham investors instead are contemplating ways to offset an ever
6
+44 (0) 20 7438 1126 steepening yield curve and find a little bit of yield along the way
mp@structuredcreditinvestor.com
Design and Production
Andy Peat
11 Structured Credit
andy@andypeatdesign.co.uk Risk chemistry
Contributors The relationship between credit trading and risk management is
Jillian Ambrose attracting more attention in today’s plain vanilla, post-crisis world.
Madhur Duggar, Batur Bicer, Matthew Many institutions are putting a greater focus on CVA and reserve
11
Leeming, Søren Willemann and Rob models, while others are moving credit risk managers up the
Hagemans of Barclays Capital Credit hierarchy. Rachael Horsewood reports
Research
6 ILS
1
Kathy Fitzpatrick Hoffelder
Rachael Horsewood
James Linacre
Richard Lorenzo and Patrick Winsbury of
Greater expectations
Moody’s Investors Service Insurance-linked securities are typically thought of as a specialist
Corinne Smith asset class. However, as Jillian Ambrose explains, catastrophe
bonds are generating increasing interest from non-insurance
16
Managing Director investors, which in turn could be met by increased new issuance
John-Owen Waller volumes
+44 (0) 20 7061 6335
jow@structuredcreditinvestor.com
Sales Associate
Grace O’Dwyer Smith
1 ABS
2
+44 (0) 20 7061 6397
gos@structuredcreditinvestor.com
RMBS, bank ratings and risk
Richard Lorenzo, vp structured finance, and Patrick Winsbury,
svp financial institutions, at Moody’s Investors Service look at the
21
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is prohibited without the written permission of the
publisher.
ISSN: 2043-7900
Although every effort has been made to ensure 5 Structured Credit
2
the accuracy of the information contained in this
publication, the publishers can accept no liabilities for
inaccuracies that may appear. No statement made in
Simplicity is key
this magazine is to be construed as a recommendation Madhur Duggar, Batur Bicer, Matthew Leeming, Søren
to buy or sell securities. The views expressed in this
publication by external contributors are not necessarily
Willemann and Rob Hagemans of Barclays Capital Credit
those of the publisher. Research take a look at the potential for structured credit products
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Clearing consensus
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three months
www.structuredcreditinvestor.com 1

4. The Interview
Navigating
Joe Walsh, president of Amherst Securities,
shares his views on the ABS and MBS
markets and the future strategy of his firm
Q: How would you characterise Amherst Securities’ role in the Q: How would you differentiate yourselves from other similar
securitisation space? firms that have launched in the securitisation sector over
A: Amherst is one of the leading US broker-dealers specialising the past few years?
in the mortgage-backed securities space. We serve institutional A: Amherst has been around since 1993, so the first differentia-
investors and actively work in both the new issue and second- tion really is our experience and significant track record of
ary markets. success. We have helped our clients navigate several economic
Our approach has always been to ensure we have a solid cycles, including the most recent one which resulted in many
grasp on the market fundamentals by balancing our proprietary of our competitors dissolving or significantly scaling back their
data and analytics with a deep understanding of the technical services.
aspects of what moves the market. Our analytics and data serve The other real distinctions that separate our firm from
as our strategic advantage over other firms and are highly others are the quality of our proprietary data and analytics,
valued by our customer base. the quality of our people, and the fact that we have significant
2 SCI August 2010

5. The Interview
changing
markets
capital behind our operations, includ- form. As a firm, we are committed to in the space. The addition of these two
ing capital from our employees and the looking at opportunities where access products will also diversify our rev-
additional capital raised in 2008 from to fundamental performance data and enue stream and should make us even
a group of institutional investors led by thorough and thoughtful analytics more meaningful to our customers.
Stone Point Capital. can add value and we believe that the
ABS and CMBS markets provide this Q: How does this affect your established
Q: Over the past six months you’ve opportunity. RMBS business?
made some major hires in ABS and Our aim is to succeed with the same A: Our expansion into ABS and CMBS is
CMBS – what are your aims for strategy we’ve successfully deployed in a completely natural and complemen-
these two asset classes in particular? the residential sector – providing better tary extension of our RMBS business,
A: ABS and CMBS are natural exten- data, analysis and understanding of the which will continue to be a major focal
sions of our leading residential plat- market fundamentals than anyone else point for our firm. There is significant
www.structuredcreditinvestor.com 3

6. The Interview
“Recently we have seen confidence in a steady,
upward-sloping recovery erode and volatility
re-introduced into the marketplace”
amount of customer overlap between Q: Where do you see the bulk of your Q: Which factors do you need to con-
the different sectors and many of the business and/or market opportuni- sider in adapting to these changes?
lessons we’ve learned over the years ties coming from in the second half A: There are a lot of economic, politi-
in the RMBS space can be naturally of 2010 and why? cal and regulatory issues that are
applied to these categories as well. A: Recently we have seen confidence in a impacting consumer and borrower
steady, upward-sloping recovery erode behaviour. We believe it is critical
Q: What are the lessons you have and volatility re-introduced into the to appreciate the potential impact on
learned in the RMBS space? marketplace. In addition, the funda- fundamental performance that these
A: There were really multiple conflicts in mental performance of residential issues create.
the securitisation business model lead- and commercial mortgages and other In addition it is likely that we will
ing up to the recent crisis and in large consumer and corporate assets contin- see a technical response from the
part they are still being sorted out. The ues to evolve in the face of economic market to the extent the performance
level of faulty analysis and decision- pressures and regulatory reform. differs from expectations. We pride
making that went on in terms of select- These factors are going to lead ourselves on understanding the poten-
ing which loans were securitised and investors to more actively seek out tial outcomes and factoring those into
which weren’t was much higher than the expertise and analytical edge that a thoughtful view of risk and opportu-
people anticipated. Amherst provides. People want a firm nity. We’ve been extremely focused on
The origination and loan underwrit- they can trust, particularly in this type those things, as evidenced by some of
ing standards that were applied in the of volatile market. our published strategy reports show-
process were severely compromised We believe the market dynamics ing our early positions on things like
and massively underestimated by the are going to provide some interesting loan modifications, second liens in the
market. To navigate through the mess trading opportunities in the second half residential MBS market.
that was left over you really need to of 2010. Investors will need to react to
have access to great data and dynamic these changing conditions and we’re Q: Which specific impacts could those
analytics to see through the carnage going to be there to help people form economic, political and regulatory
and find opportunities. those reactions and opinions. issues have on performance?
4 SCI August 2010

7. The Interview
“Fundamental performance is going to continue
to evolve and it’s likely going to end up being
different than the market expects”
A: Ultimately all of those factors could We think we’ll ultimately be better A: If the economy is going to make a
have a very large impact because they positioned than others, but it’s going to substantial recovery, then you have
all can change fundamental perform- evolve over a very long period of time. to believe the securitisation markets,
ance. For example, there was a lot of which were such a big piece of provid-
regulatory rule changing that went on Q: What sort of technical response ing the capital for the vibrant and
when Bear Stearns essentially went do you anticipate from the market growing consumer-based economy last
bankrupt and that changed the outcome if performance does differ from decade, are going to make a recovery
allowing their debt to get paid 100 cents expectations? as well. But in general, those involved
on the dollar. But it’s clear these factors A: I suspect there could be a series of knee in the securitisation market are going
can have a real impact on actual per- jerk reactions, especially in situations to be very focused on making sure we
formance. You have to understand the where people don’t truly understand can use securitisation to fuel growth
potential of those impacts and under- why performance differs from expecta- while eliminating the obvious conflicts
stand how exposed you are to them. tions. We could elicit some uninformed which historically dominated the new
Political and regulatory pressures responses and that could be good or issue structured finance markets and
become extremely influential on issues bad for market participants. resulted many failed transactions. I
like loan modifications, so while you suspect what you will see in 2011 is
may not be able to predict them, you Q: What is your position on loan the new issue market trying to address
had better understand what various modifications and second liens in the those concerns and convince investors
scenarios mean to you and factor that RMBS market? that they are adequately protected from
into your strategy and make sure you A: Put simply, the second liens are stand- the mistakes that fuelled the recent
are getting paid for that risk. Knowing ing in the way of a lot of loan modifica- credit crisis.
what can happen to you, being able to tions. We believe the most effective
see it happening and seeing it first it loan modifications involve principal Q: Beyond ABS and CMBS, does
could create some very real and profit- reduction and it’s really difficult to do Amherst have plans to grow its busi-
able opportunities. that when the second lien holder is the ness into other securitisation areas?
servicer or is unwilling to have his debt A: Not at this time. We think there are
Q: In general, what are the types reduced or written off at that point in plenty of opportunities in the RMBS,
of trading opportunities you’ve the modification. As a result, use of CMBS and ABS space. We’re poised to
mentioned? principal reductions in loan modifica- provide more knowledge, insight and
A: Fundamental performance is going tions has yet to have a meaningful reliable data on the entire mortgage
to continue to evolve and it’s likely impact. industry than any other broker-dealer.
going to end up being different than the We may ultimately look to expand
market expects. It’s hard to predict how Q: Longer-term, how do you see the beyond those products, but right now
we will ultimately end up and why, securitisation market landscape in we are focused on building those exist-
which is the challenge for us all, and 2011 and beyond? ing businesses.
ultimately will separate the winners
from the losers in this space.
For instance, how loan modifica- About the interviewee
tions or foreclosures ultimately play Joe Walsh, president of Amherst Securities, co-manages the business and
out when the moratoriums are lifted operations of the Amherst Companies. He has been in the mortgage-backed
will create outcomes that are likely to securities business for almost 25 years.
be different than what people expect Walsh previously served as an md in the private equity business at Fortress
at the moment. So companies that can Investment Group specialising in financial institutions. He also served for nine years
see through that and see it first will as an md and head of mortgage and asset-backed origination, finance and trading at
have an advantage. Everyone who is RBS Greenwich Capital.
trading today has some opinion on how He earned his B.A. in Biology at Princeton University.
and when these things will play out.
www.structuredcreditinvestor.com 5

8. Wholesale Structured Products
Vanilla
structures
return
Suddenly mundane is popular again. As Kathy Fitzpatrick
Hoffelder discovers, complicated rate product strategies
that have been marketed as ‘too sophisticated to fail’ are
out. Institutional investors instead are contemplating ways to
offset an ever steepening yield curve and find a little bit of
yield along the way
6 SCI August 2010

9. Wholesale Structured Products
Chart 1
The BAML MOVE Index – three-year performance
300
250
200
150
100
0
Oct 2008 Apr Jul Oct 2009 Apr Jul Oct 2010 Apr
Source: Bloomberg.com/Bank of America Merrill Lynch
MOVE is the Merrill Option Volatility Estimate. This is a yield curve weighted index of the
normalised implied volatility on 1-month treasury options. It is the weighted average of
volatilities on the CT2, CT5, CT10, and CT30. `MOVE’ is a trademark product of Bank of
America Merrill Lynch.
puts it: “Most people are into preserva- currency concerns, he says, noting capital
tion of capital but they are concerned preservation did not help European-based
about exactly how you do that when your investors much since the euro has depre-
historic risk free is now full of risk.” Fur- ciated against all major currencies.
ther he says: “Everything has basically It is not all doom and gloom out there,
become a credit including government however. A Goldman Sachs research
bonds and that makes it very difficult. report in June notes the current macro
That’s why you are seeing the kind of and regulatory backdrop is much better
yields you are seeing on treasuries and than two years ago. For instance, private
bunds.” sector imbalances are much smaller,
Indeed, global bond markets have been having moved into surplus in the major
rocked by a range of events from Lehman economies. “This means balance sheets
and the start of the crisis, to sovereign are stronger and there are more savings
debt issues with a few government bail- available to fund the deficits,” the report
T
outs and periodic support thrown in for notes.
good measure. Bank of America Merrill But try convincing institutional
he landscape has changed for Lynch’s Option Volatility Estimate investors of that and one gets a myriad of
creating interest rate deriva- (MOVE) Index, which measures option responses. “There’s so much risk, volatil-
tives products that protect volatility on US treasuries, has seen dra- ity and uncertainty, it’s hard to turn the
principal and offer attractive matic swings from its widest levels seen table and say you have to do this for 100%
yields. First, the very amount in 2008 when it topped more than 260 to of your portfolio,” says Gary Pollack, md
of principal to protect has vastly dimin- the 70s currently (see chart). The 10-year and head of fixed income research and
ished for many investors and what kind of bund yield has dropped to 2.67%, in from trading for private wealth management at
protection is on offer is also up for grabs. a little over 3% last summer, while the Deutsche Bank Securities.
Gone are the days when so-called liquid 10-year treasury yield has slid to 3.19% However volatile government securi-
and transparent index based transactions from 3.5% at this time last year. ties and related products have been lately,
promised ‘expected’ anything. Not much Capital preservation itself has also investors generally agree one has to put
is expected anymore in this post credit altered in meaning and scope, according money to work somewhere. Everyone
crisis environment except uncertainty and to John Brynjolfsson, md at investment realises the natural rate for the 10-year
volatility. management firm Armored Wolf. Capital treasury is not 3% but something higher,
As Gary Jenkins, head of fixed income preservation is taking on a new defini- notes Walter Schmidt, svp and manager
research at Evolution Securities aptly tion where people are more sensitive to of structured product strategies at FTN
www.structuredcreditinvestor.com 7

10. Wholesale Structured Products
asset side to match your liabilities,” notes
Jochen Felsenheimer, co-head of credit at
Assenagon Asset Management.
Investors in general are a bit more
sophisticated than prior years and demand
at least a minimum return. This is the
case with steepener trades put on between
the 10-year and 30-year government bond
curves, in which one sells CDS protection
on the short end and buys protection on
the long end.
Along with the trades, some investors
favour having a cap and a floor, which
was not the case five years ago, adds
Felsenheimer. One caveat is “if interest
rates stay low, you probably just earn the
minimum on the interest rate structure,
but normally you do not have dramatic
problems on the rest of the risky part of
your portfolio,” he says.
Walter Schmidt, FTN Financial Jochen Felsenheimer, Assenagon
Capital Markets Seeking yield at the right cost Asset Management
Since loan demand is very low, deposito-
Financial Capital Markets. “People are ries continue to reach for yield in the port- Bill Gross, md at Pimco, reiterated
concerned we might be in a bubble for folio, says Schmidt. “Right now for most the changed landscape for investors in
bonds now. It’s just that we might be index based customers, and to a lesser his firm’s June commentary. “No longer
here for quite awhile so if we are here extent, even liability based customers like will ‘two get you three’ in the investment
for a while and sitting in cash, you are depositories and insurance companies, world. Not 1,000%, but 4-6% annual-
going to underperform and underperform everyone’s looking for some return in this ised returns for a diversified portfolio of
severely,” he says. environment,” he notes. stocks and bonds is the likely outcome,”
There is still a tremendous amount However, with the exception of the he writes.
of liquidity in this system, Schmidt corporate bond market, it’s very dif- But where to get even that yield is up
observes. “We’ve been in this environ- ficult to continue to add assets without for debate. The high yield corporate bond
ment for almost two years now where the the overall market overpricing itself, he market in the US is the favoured segment
market is liquidity rich and capital poor. notes. “This is exactly this deflationary or of the market, says one US-based asset
What the Fed is obviously trying to do is at least disinflationary environment that management firm’s research head. “When
offset the tremendous capital burden and Bernanke is quite concerned about.” you have a great year in high yield, it
tremendous write-downs that still need to Schmidt adds: “Those that are ratings- leads to good years to follow and default
take place,” he explains. constrained are reaching a bit for yield rates come in,” he says. He also sees the
Insurance companies, for one, are because they have to. The fact of the mat- sector as somewhat removed from the
still looking at interest rate structures ter is if you look at a state pension or cor- sovereign debt crisis in Europe. Returns
since they regularly need to match their porate pension, most of them have their often are in the 9% range, he says.
liabilities. “A lot of insurance compa- returns at 6-10% but no one’s earning SocGen’s quantitative strategist Marc
nies have probably blown through their 6-10% in any market, including equities. Teyssier adds that those investors that are
reserve levels. It becomes harder and The reach for yield is very, very powerful, more bullish on the economy are willing
harder to generate enough return on the very strong.” to invest in the high yield market –
something that only has occurred in rapid
pace since the beginning of the year. “You
“On the one side, there’s a very have all non-financial companies that
have very good results so far,” he says.
bearish focus on sovereign “On the one side, there’s a very bearish
focus on sovereign risk and on the other
side, there’s more focus on what’s hap-
risk and on the other side, pening on corporates,” Teyssier says. The
result has led to a compression of credit
there’s more focus on what’s spreads. “Hedging credit portfolios is the
hottest topic right now among investors.”
happening on corporates” But for Pollack, he views the invest-
ment grade bond market as a better bet in
8 SCI August 2010

11. Wholesale Structured Products
this post credit crisis environment. “We
think this is a good opportunity to pick
up some additional yield without really
“We would expect a large
picking up that much increased risk as a
way to capture higher returns in the fixed
amount of issuance from the
income markets,” he says.
Pollack is underweight in treasury Treasury in the 30-year sector
not just to finance existing
holdings since he used that money to
increase exposure to corporate bonds. He
believes rates are likely to stay lower a
little longer than originally believed.
deficits but to finance the rollover
Factoring in steepening
Investors right now are also trying to take shorter maturity treasuries”
advantage of the steep yield curve so they
are bidding up the price of fixed income
assets, adds Schmidt. For the most part, good trade opportunities in the long end The Treasury recently extended its tar-
they are focusing on the front end of the of the euro swap curve, but people tend to get maturity for federal debt to 84 months
curve as opposed to the long end, he stay away from it since it’s a “pain trade” or 7 years from as low as 48 months
explains. The yield curve between the US due to the uncertainty in the market, says during 2009, which makes it more likely
two-year treasury and the 10-year treas- Ungari. “If everything goes wrong, it’s to issue out the curve. At a Treasury Bor-
ury stands at about 248bp, which is in the kind of trade you cannot get away rowing Advisory Committee meeting in
from 290bp earlier this year. Years earlier, from,” she adds. May, the Treasury said it believes its over-
say in 2002, for example, the yield curve The 30-year maturity is also subject to all debt issuance schedule is appropriate.
was closer to the 2% level at 220bp. huge volatility due to some flows coming “Consistent with the desire to increase
While historically steep yield curves from pension funds, Ungari says. The the average maturity of outstanding debt,
can be inflationary, they can also be a flows are not predictable and bring lots the Committee recommends that issuance
step in the right direction economically. of volatility in the 10s/30s sector of the sizes in two-year, three-year and five-year
“Steepening trades are attractive because curve, she notes, adding that the segment maturities be reduced meaningfully, with
they pay good carry. People will try to also sees constant maturity swap hedging smaller reductions in seven-year, ten-year
find trades which pay good carry over the flows as well. and thirty-year maturities.”
short term,” says Sandrine Ungari, quan- To others, the key right now is to The Treasury also decided last May to
titative strategist at SocGen, noting the avoid the long end at any cost. Particu- increase the frequency of Treasury Infla-
trades make more sense in euros currently larly if interest rates rise, the US-based tion Protected Securities (TIPS) auctions
than in US dollars. asset management firm’s research head by having a second reopening to 10-year
But further out along the curve, inves- is turning away from bonds with a high TIPs offerings. It brings the total to six
tors start to get skittish. There are really duration. He is also advising clients to 10-year TIPS auctions per year. The new
seek out maturities 5-years and under.
“Most bonds even with a 10-year duration
are getting called,” he adds.
Some hedge funds and money manag-
ers are, however, buying long-term US
treasuries, and even have large mandates
in place, but according to Brynjolfsson,
the curve is still expected to be steep.
“There are buyers of these long term
treasuries, but I think the very steep yield
curve is here to stay and possibly get
steeper,” he says.
Three large sellers of long-term treas-
ures are likely to keep the curve steep, he
explains. The Treasury, Federal Reserve
and China all have their reasons to unload
or sell the securities, says Brynjolfsson.
“We would expect a large amount of
issuance from the Treasury in the 30-year
sector not just to finance existing deficits
but to finance the rollover shorter matu-
Marc Teyssier, SocGen rity treasuries.” Sandrine Ungari, SocGen
www.structuredcreditinvestor.com 9

12. Wholesale Structured Products
“More and more traditional really know how the new regulation is
going to affect them,” says Teyssier.
The tranche market is still, however,
money accounts are now an outlet to hedge the volatility of mark
to market. Lots of people buy protection
looking to create different risk on senior index tranches, he adds, noting
that the combination of systemic risk and
return profiles by moving into
regulatory risk is why spreads in this area
have widened so far, especially in Europe.
What is occurring more often, though,
new asset classes” is a variety of hidden correlation offers,
such as when banks are trying to hedge
their exposure by selling part and by
change begins with the July new issue continues to monetise the fiscal deficits, keeping some correlation risk, notes
10-year TIPs offering. explains Brynjolfsson. “I would expect Felsenheimer. But problems still exist
The Fed’s decision last year to curtail that would cause the bond market to in selling the paper. “They need to find
its planned US$300bn buying programme remain sceptical – both of inflationary a buyer for this stuff. Except for hedge
similarly is still having an effect on the impact of those policies and the solvency funds I don’t see any trades,” he adds.
curve. “The Fed is examining very care- impact of those policies increasing Credit index options, however, are prov-
fully the possibility of selling their exist- amounts of federal liabilities,” he says. ing they are able to withstand the credit
ing holdings rather than let them mature,” crisis a bit more than other structured
says Brynjolfsson. Seeking alternatives products. Options trading on iTraxx Main
The existing plan was to hold onto Other investors are venturing a little bit and on CDX have been popular lately.
their long-term treasuries and allow them beyond their comfort zone for yields – if “They [CDS index options] don’t suf-
to mature through the natural seasoning ever so slightly. More and more tradi- fer from the bad reputation of tranches.
process rather than sell them, he notes. The tional money accounts are now looking There are more clients willing to invest in
process would still put selling pressure on to create different risk return profiles that kind of instrument against a spread
the long-end, however, due to the Fed’s by moving into new asset classes, says widening,” says Teyssier. “An out-of-the-
overweight position of long-term treasuries. Felsenheimer. But more often than not money option does not cost a lot but is
Globally government issuance will it means implementing new strategies an efficient hedge against a spread blow
remain high with net issuance in the cur- within traditional asset classes, or in out. Credit options are a very interest-
rent financial year expected to be about a sense, creating a new definition for ing product for clients that want to hedge
US$1.9trn in the US, €300bn in the euro what alternative investment means, he their credit exposure.”
area and £150bn in the UK, according to explains. Whether or not rate products are the
a report by Morgan Stanley analysts last Indeed, more exotic correlation trades panacea for investors right now remains
March. are not as popular as they once were with to be seen, but one thing is certain. Inves-
A likely scenario going forward is investors, especially due to regulatory tors are not going to sit around and wait
that the Fed continues to keep short end measures to be implemented under Basel for the next bubble to appear – whether in
rates low, below the inflation rate, and 3 in Europe. “Market participants don’t bonds or not.
10 SCI August 2010

13. Structured Credit
The relationship between credit trading and risk management is
attracting more attention in today’s plain vanilla, post-crisis world.
Many institutions are putting a greater focus on CVA and reserve
models, while others are moving credit risk managers up the
hierarchy. Rachael Horsewood reports
Risk
chemistry
C
redit risk management and trading are working “It is fair to say that the credit risk manager role has moved
together more than ever before. Some sources say up a notch now. When you consider that credit risk is being
this is how it should have always been. Others transferred from an originating desk to a credit risk management
believe it is only perception given the market’s risk- group, it is only natural for the risk managers and traders to work
averse mood since the crisis. “Credit risk manage- more closely. We see them working together more when it comes
ment is definitely experiencing a new evolution – it is viewed to valuation and pricing too. But traders are still the top dogs
more as a value-added function now,” asserts David Kelly, the when it comes to pay packages since they are the ones generating
director of credit product development at Quantifi, a specialist revenue,” Kelly notes.
software company. A portfolio manager in London adds: “Traders are more
He agrees credit risk management has distinguished itself more aware of credit risk and capital charges but not as much as they
from other types of risk management since the crisis. Market would if these things impacted their bonuses.” He says a lot of
risk managers, for example, are still viewed as more of a middle- risk management heads at banks are trying to push credit risk
office, support function. Their main responsibility is to make sure management down to the desk level, but trading desks don’t want
traders trade within the limits and report numbers accurately. it. They see it as a firm-wide responsibility.
www.structuredcreditinvestor.com 11

14. Structured Credit
majority of institutions it is a game of hot
potato right now,” he explains.
Some sources argue that trading desks
were well-aware of their counterparty
exposures during the crisis. “Systems
used to monitor credit risk at the desk
level were reasonably well-established
and working before the crisis. Most of
the focus on the sell-side has been on the
big drive towards centralised clearing,”
explains Kevin Gould, a co-founder of
Markit. He says he has seen some subtle
organisational changes due to pending
regulation, but that the bigger story is the
greater focus on data quality and liquidity
risk monitoring all around the market.
The lack of liquidity in credit has
made it much more difficult to trade.
One head of credit trading from a French
bank says this is another reason why
David Kelly, Quantifi you see risk managers coming in to help Kevin Gould, Markit
optimise the return on capital. “You can
This is a sell-side trend since most hedge interest rate risk and, on a macro CVA move
buy-side exposures are heavily collateral- basis, you can hedge your credit risk. In Some sources say banks are also looking
ised, according to the portfolio manager. Europe, we have sector indexes to help us at Credit Valuation Adjustment (CVA)
“It was less of a priority before the crisis even hedge our funding risk, and because more than before because of the pressure
when there were fewer defaults,” he adds. these products are so granular, we are to preserve capital and assess liquidity
Marc Loomis, a credit product man- able to fine-tune the hedges. But there risks. “CVA is primarily an accounting
ager at Calypso, says the relationship is one thing none of us can hedge and requirement, b ut we are seeing more
between trading and risk management that is liquidity risk.” He says the ability crossovers between credit risk manage-
is “cyclical like most other things in the to execute transactions (at a reasonable ment and capital optimisation,” Kelly says.
financial world. At the end of the day risk price) has worsened since 2007. He was previously a senior credit trader
managers are paid to mitigate risk and A credit strategist from another on the global portfolio optimisation desk
traders are paid to take it on – a bit like European bank adds that idiosyncratic at Citigroup. There he actively managed
yin and yang.” risks are more specific to credit. “This the credit risk in derivatives positions and
One London-based credit strategist also makes credit much less resilient than also established a CVA business.
says that although some banks try to other assets. When you think of Greece CVA is a valuation of the credit risk
make it look like risk management is in and what has happened there as well, of all contracts an institution has with a
charge of their capital, traders really are you realise there are so many more lay- given counterparty – the aggregate risks
the ones who own the risk. “Everyone is ers of risk within the credit market that of all counterparties. It is nothing new.
putting more resources into credit risk we didn’t see a few years ago,” he says. The first ones became known back in the
management, but it is a mixed bag when “Many banks are now trying to combine 90s, when fair value accounting emerged
it comes to how they organise it. Several all the talent they have in the structured and the chief risk manager position
of the larger banks have established, cen- credit space to create a more industrial- became norm. Back then, credit default
tralised top-down approaches, but for the ised credit department.” swap (CDS) pioneers on Wall Street
were also emphasising the importance of
counterparty risk management and how
it and trading desks should work together
“Everyone is putting more to optimise capital, especially after the
repeal of Glass Steagall in 1999.
resources into credit risk Jonathan Di Giambattista, md at Fitch
Solutions in New York, agrees CVA has
become a more topical subject. He says
management, but it is a mixed it is also because of the greater focus on
derivatives counterparty risk. He explains
bag when it comes to how they that CVA managers buy credit protection
as part of their mandate to level out risks,
organise it” especially concentration risks created
from trading desks.
12 SCI August 2010

15. Structured Credit
“You can say that the CVA function is Figure 1
there to capitalise on the compensation of
Elements of pricing and valuation infrastructure and operations
risks since profit is relative to the risk that
is taken. But it really is meant to ensure Cash Instruments Flow OTC Structured Derivatives
e.g. Credit Derivatives e.g. Structured Credit
risk is accounted for. It is a centralised e.g. Corporate Bonds
risk control discipline for all asset classes Front Hardware/software Front-to-Back
Excel-based Structuring/ Excel-based
Illustrative Only
(Bloomberg, Trading / Risk Portfolio
within an institution. We believe most of Office
Reuters) Systems
‘Pricers’
Mgmt Apps
‘Pricers’
the top-tier international banks have a
Market data Market data (e.g. Market data (e.g.
CVA function in place, but we have not (e.g Bloomberg, Bloomberg, Markit, Bloomberg, Markit,
seen any on the buy-side,” Di Giambattista Reuters) CMA, BQuotes) CMA, BQuotes)
says. Risk and Risk and Risk and
Analytics are
Product control Product control Product control
He continues: “We find that apart from
portfolio risk, accounting, etc.
etc.
portfolio risk, accounting, etc.
portfolio risk, accounting, etc.
Risk control, collateral mgmt,
Risk control, collateral mgmt,
Risk control, collateral mgmt,
required and
Middle
often ‘embedded
a few of the biggest international institu- Office • Deal level and
portfolio IPV
• Deal level and
portfolio IPV
• Deal level and
portfolio IPV in these systems
tional investors most buy-side firms really • P&L risk control • P&L risk control • P&L risk control and processes
• In-house • In-house • In-house
do not hedge counterparty risk exposures. • Independent • Independent • Independent
This is an expensive proposition for them 3rd party 3rd party 3rd party
valuations valuations valuations
generally due to the transaction costs of
Back
hedging. The economies of scale are not Office
there if it is only five names you are wor- Recurring Recurring Recurring
valuations valuations valuations
ried about. Smaller players might put on a
bilateral trade every once in a while when
it makes economic sense, but they tend to Related to Front Office Related to Middle/Back Other users of pricing or
rely more on internal controls, limit set- price discovery Office valuation of positions valuation data
ting and the monitoring of counterparty Source: Celent
relationships.”
However, a number of hedge funds and
other large institutional investors have
been hiring seasoned traders and risk Ed James, a senior consultant in the Salary increase
managers that used to work on the credit risk management group at Joslin Rowe According to recruiters, salaries for risk
desks at investment banks. “Former struc- Associates in London, confirms that a lot management roles in general are increas-
tured credit traders could be valuable in of new credit risk management positions ing by around 15% from last year. Some
many other areas of trading and managing have been created this year. “We see banks are increasing salaries 25% or
credit risk. If you look at the composition demand across all types of risk manage- more in order to attract the best, most
of credit risk there is a securitisation ele- ment, and not just from banks but also experienced candidates. Consultants
ment in transactions that are not cleared asset management firms.” say that some senior risk management
so their skills could be applied to any of He adds: “Many of these roles were salaries might look larger because their
those,” Kelly adds. considered part of the finance or opera- pay is normally not tied to performance or
tions groups four or five years ago. But risk profitability, it is fixed.
management has become more high-profile Loomis agrees that while risk manag-
and is now a bigger group in its own right ers’ influence might be increasing, they
at most financial institutions. On the credit are never going to be paid as revenue
side, the risk manager’s opinions matter a generators. “Pay packages are unlikely to
lot more than they used to.” change. Giving risk managers a bonus for
“You can say that the CVA
function is there to capitalise on
the compensation of risks since
profit is relative to the risk that
is taken. But it really is meant to
Jonathan Di Giambattista, Fitch Solutions ensure risk is accounted for”
www.structuredcreditinvestor.com 13

16. Structured Credit
Figure 2 sight of the shadow banking system and
off-balance sheet entities is necessary.
Total lifecycle costs for derivatives analytics (Shadow banking institutions are typi-
USD$million cally intermediaries between investors
Total Cost of Derivatives Analytics
? ? and borrowers – e.g. hedge funds, SIVs,
50
Unknown costs
conduits, investment banks and other
45 ? Represents the non-bank financial institutions. By
cost of complexity
and a drag on the definition, shadow institutions do not
40 Ranges between
$11-$22m Integration costs
competitiveness
of the firm
accept deposits like a depository bank
with internal &
35
external systems and therefore are not subject to the same
30 •Enhancements
• Inefficiencies & regulations.)
‘drag’due to 22.5
25
•Upgrades
fragmented data, Acharya explains how the cycli-
analytics, platforms
cal nature of credit means there can be
20 • If there are silos,
data disparities & 11.3 Known costs a significant amount of aggregate and
$4.5m over 5 years
15 quality issues will
Between ~$25 liquidity risks when trading in this asset
•Bug Fixes continue to exist 4.5
10
$9m •Support
• In an ideal world,
to $36 million class and that many financial institutions
Initial this would be zero.
9.0
underestimated both. “This is where the
5 specification,
build and test importance of capital adequacy comes in
0
Development Support / Evolve / Indirect 3rd party apps/ Total
because if there is not sufficient capital
Maintenance Enhance costs integration to absorb losses then people outside of
the financial sector become affected. So,
One-off, Recurring costs totaled over one key issue is whether regulators can
initial costs a 5-year production lifecycle
address such socio-economic risks that
Source: Celent have not shown up before,” he asserts.
Regulatory spirit
Kelly agrees that the spirit of most of the
catching a certain type of risk is unlikely managers might even be gaining more new regulations is to make sure securiti-
too. A risk manager is not paid to discover power to curtail trades. But the point is sation and the product engineering around
where the bank should take risk. That that risk management means a lot more it has some socio-economic benefit. “It
is what a trader does. Traders look for a than it did before this crisis, partly due is pretty clear that the securitisations of
cheap asset and then hope that the value to all of the pending regulation. Risk mortgages, student loans and credit cards,
of it goes up. The risk manager is there to management is not just credit-related and for example, are beneficial to economies
make sure the bank doesn’t over-expose it is not just about calculating your delta. as long as the risk is transferred to people
itself,” he adds. It is also about transparency and suitabil- who want it. I think regulators are a lot
Sources say compliance is behind a lot ity. It is about digging deeper and looking more on the ball when it comes to credit
of the new risk roles and Europe’s sover- not only at the counterparties more but
eign debt crisis is definitely accelerating also the motivation behind each trade,”
the regulatory effects on banks’ organi- explains Loomis.
sation structures and risk management Viral Acharya, a professor of finance
practices. “The risk manager’s statue at New York University’s Stern School of
might be increasing a bit more now. Risk Business, says this is why some over-
“This is where the importance
of capital adequacy comes in
because if there is not sufficient
capital to absorb losses then
people outside of the financial
sector become affected” Viral Acharya, New York University Stern
School of Business
14 SCI August 2010

17. Structured Credit
trading and risk management, but I would
not say they are providing a guiding
light for big international banks. These
“Valuation is definitely what links
institutions know what they need to do,”
he asserts. trading and risk management.
When it comes to the credit side,
It is clear that banks continue to invest
heavily in the credit risk management
area, partly due to Basel III. But some
sources say that if these regulations push
more transactions onto exchanges, some
pricing and risk management are
of the credit risk management functions
could become extinct. “A lot of the coun- instrumental in getting any deal
terparty risks will be mitigated by central
clearing and standardised CDS contracts
will have daily margining like futures
off the ground right now”
contracts,” Kelly notes.
Even so, sources do not expect central
clearing will actually replace risk man-
agement roles. “Central clearing is one the International Swaps and Derivatives written by Anton Valukas, an examiner
of the main focuses of change right now Association introduced last year are help- who was hired by a US court to probe
but I don’t believe it will diffuse coun- ing to improve transparency in the OTC Lehman Brothers’ failure, also explained
terparty risk management and I don’t market. “The modelling for bespoke deals how the bank’s product control team was
believe it will cover every type of CDS. is long and complicated. That is part of too small to be an effective independent
Banks have been trying to price counter- the reason why that market remains so check on business desks.
party risk for years. It is a dark science. illiquid.” Inadequate product control has been
In other words it is not just about the pure Sources say that although the market cited in the financial markets many times
credit worthiness of your counterparty. for bespoke credit deals (cash and syn- since the crisis. The UK’s Financial Serv-
It is also about your risk profile and the thetic) is very thin, interest has not totally ices Authority (FSA) has taken action
exposures you have to that counterparty,” disappeared. “The secondary credit against a number of institutions over
says Loomis. market is extremely fragmented and the the past couple of years. In its write-up
Di Giambattista adds that central lack of price transparency is what is keep- against one American investment bank
clearing for OTC derivatives would ing investors from participating or acting last year the FSA said: “Whilst junior
not reduce the effectiveness of a CVA. regularly. The basis risk is so volatile that global product control staff understood
Sources believe there will always be you cannot really use CDS the way they that their role was to ensure P&L was
demand for bi-lateral contracts whether are meant to in the fixed income world,” fully attributed, reconciled and explained
they are plain vanilla or the complex and the French dealer says. in accordance with the firm’s systems,
esoteric type. He also says corporates “Valuation is definitely what links senior product controllers expected that
will continue to use the OTC market for trading and risk management. When it juniors would undertake analysis of
customised hedges. “There will always be comes to the credit side, pricing and risk P&L and whether it was consistent with
a need to mitigate counterparty risk when management are instrumental in getting changes in risk and market movement. In
you are dealing with different counterpar- any deal off the ground right now,” the particular there was a lack of understand-
ties around the world. Most CDS trades European credit strategist adds. ing among junior controllers of volatility
are still executed bilaterally anyway,” he as a driver for the P&L.”
says. Lessons learned? Last year, McKinsey & Company
Greater standardisation will no doubt This close relationship with new issuance also addressed this issue in a paper titled
help make pricing more transparent and is driving greater reflection on lessons ‘Turning Risk Management into a True
bid-offer spreads tighter. Loomis adds: from the past and there is no shortage of Competitive Advantage: Lessons from
“Valuation has always been a job for information being published to examine. the Recent Crisis’. It states: “In some
traders and I do not expect that to change. For example, a new report explains that cases, revenue producers are clearly in
What will continue to change is the Lehman Brothers’ use of ‘inconsistent charge and tend not to involve the risk
information that goes into models. People, and highly subjective’ valuation methods management function in their decisions.
mainly buy-side players, thought they did was what brought the bank down. In best-in-class organisations, the risk
not need to understand the model because Released in March, the report said that management function is seen as a key
the credit rating was all that mattered. while there is always some subjectivity enabler of profitable growth. Problems
That got a lot of them into trouble during in assigning prices to complex securities, can arise when the risk function is
the crisis.” Lehman Brothers’ used differing valua- viewed by quickly evolving businesses as
Loomis says open source initiatives tion methods for trading desks that were a cop or a goalie trying to catch the bad
such as the standardised pricing model that even of the same asset class. The report, shots.”
www.structuredcreditinvestor.com 15

18. ILS
Insurance-linked securities are typically thought of as
a specialist asset class. However, as Jillian Ambrose
explains, catastrophe bonds are generating increasing
interest from non-insurance investors, which in turn
could be met by increased new issuance volumes
Greater
A
s the 2009 global market rally falters to a limp in Those involved in the space are quick to point out that while
2010 due to the European sovereign debt situation, other fixed income asset classes buckled under credit pressures,
catastrophe bonds are enjoying a new-found popu- ILS remained largely uncorrelated, with the exception of those
larity. While it is unlikely that insurance-linked bonds affected by the Lehman bankruptcy. “Cat bonds have
securities (ILS) will become as mainstream as posted strong performance throughout the crisis,” points out
other structured finance asset classes, investors are increasingly Christophe Fritsch, head of ILS at AXA Investment Managers.
interested in adding diversification to their portfolios and those “Investors have real positive elements from which they can judge
in the ILS space are eager to encourage this, which should also the main reasons they should be investing in cat bonds: such as
encourage great volumes of new issuance. their low correlation and their resilience in the midst of strong
In a post financial-crisis context, investing in ILS seems to financial tensions on the markets.”
be an increasingly appealing prospect for investors. Speaking As a result, adding ILS instruments to an investment portfo-
at the 2nd Insurance Linked Securities Summit held in London lio is emerging as a promising new diversification play. “When
at the end of April, ceo of Hanover Re, Ulrich Wallin painted a people look back on the financial crisis this is the one area of
bright picture for the future of the ILS industry. In particular he the fixed income market that still had liquidity because it’s truly
explained that while the Lehman bankruptcy led to a total return diversified,” explains md and head of ILS distribution for Swiss
swap default on four cat bonds, this consequence was an indirect Re, Judy Klugman. “Our investors still had cash and we were
one. Structural problems within the market have since been trading bonds. The basic tenants of this sector were really vali-
addressed, according to Wallin. dated during the crisis and as a result, investors value the diver-
16 SCI August 2010

19. ILS
expectations
sification that these assets have to offer. one-year agreement. As a result, sponsors
Although further developments need to be are increasingly interested in exploring
made within the space, those within the the benefits of ILS.
sector are now calling for a greater inves- However, despite many ILS market
tor involvement in the market in order to participants bordering on the evangelical
bring ILS into the mainstream. in their calls for greater investment in the
Historically an insurer would seek sector, the vast majority of investors have
to transfer risk through a reinsurance remained indifferent until now. “So far,
agreement in order to remain solvent in there have not been that many institu-
the event of a large-scale natural catas- tional investors that have taken the cat
trophe. Although ILS does not seek to bond leap,” confirms Fritsch.
replace reinsurance, it is being touted as But Henning Ludolphs, director of
a complement to the traditional reinsur- Hanover Re’s ILS unit, adds that he is
ance sector. From the point of view of the currently seeing an increase in interest
sponsors, ILS offers the added benefit of from institutional investors. “We believe
a multi-year transaction with exposure to that there are a lot of investors, pension
the capacity of the capital markets, while funds for example, who are starting to
reinsurance transactions are typically a look at allocating a small portion of their Judy Klugman, Swiss Re
www.storminvestor.com 17

20. ILS
problem may have to do with the overall going to hit Los Angeles in the next two
perception of the market. years. Using hundreds of years of science,
“It needs to be more widely looked at independent firms assess the risk for
as a mainstream asset class, rather than an investors,” she explains.
‘esoteric asset class’ which scares some Klugman adds that the models used
investors off,” says Klugman. “Really are not created specifically for the ILS
it should be part of everyone’s diversi- markets, but are developed within the
fication strategy. The sector needs to be scientific community and used by third-
demystified.” party firms in analysing securitisations.
Any enthusiasm that non-insurance This, she says, adds a degree of subjectiv-
specialist investors have for ILS can be ity to the process. “When I look at credit
dampened by confusion regarding the and what can go wrong in terms of fraud
underlying data, market processes and the and misunderstanding, I think there are
structures of the cat bonds themselves. more variables in credit than there is in
Participants in the space simultaneously analysing the risk in a catastrophe bond.”
argue that the market is not as complex as
it may initially appear and point to recent Increasing transparency
developments and innovations within In order to attract a wider investment base
the market as evidence of its increasing into the market, greater calls have come
Christophe Fritsch, AXA accessibility. for increased transparency in the market.
Investment Managers Concerns regarding the performance “Transparency and liquidity is good for
indicators used are perhaps justifiable any market, and cat bonds are no excep-
funds to ILS,” he says. “A small portion for investors unfamiliar with the market, tion,” says Fritsch.
of a large fund would be a huge amount of especially in light of the persistent con- Ludolphs believes that various steps
money coming into the ILS market.” troversy and distrust surrounding rating could be taken to make the market more
Fritsch predicts that as new investors agencies in the broader credit markets. transparent and easily understood by new
enter the space, development within the Those involved in ILS insist that the mod- investors to the space. “The market needs
market will increase. “As large inves- els used in analysing the securitisations to be open with underlying exposure data
tors such as pension funds and insurance offer investors a non-subjective means of and underlying investment data,” he says.
companies start investing more heavily understanding the underlying risks. Further, Ludolphs suggests that under-
in this sector, a new market dynamic will Rupert Flatscher, head of Munich Re’s lying data could be posted on websites in
be created,” he says. “This obviously goes risk trading unit, says: “New investors the same way as regulation now requires
hand in hand with a larger number of need to understand that ILS are based on mainstream structured finance deals to
sponsors as well as an increased diversifi- models which are used in the insurance do. “We need to share information and
cation of perils.” industry sometimes for decades. It is not make underlying information transpar-
only investors relying on such models but ent,” he stresses.
Mainstream option? also a far bigger industry.” Ludolphs also advocates the greater
However, ILS is still far from being Furthermore, Klugman argues that use of indices and parameters which
accepted as a mainstream investment assessing risks in ILS may be more reli-
option and current participants believe able than methods used in other credit
that it’s vital to make the necessary markets. “We don’t expect an investor to
changes to the market in order to develop be able to analyse what the probability
ILS beyond a niche market. Part of the is that a magnitude seven earthquake is
“When I look at credit and what
can go wrong in terms of fraud
and misunderstanding, I think
there are more variables in
credit than there is in analysing
the risk in a catastrophe bond” Rupert Flatscher, Munich Re
18 SCI August 2010

21. ILS
will naturally lead to greater transpar- Chart 1
ency within the market. “For example, if
Catastrophe bond issuance year-by-year to 1 June 2010
investors know that a bond is triggered by
an earthquake with a magnitude of 8 or 7,000
higher then immediately an investor can
read in a newspaper whether they have 6,000
lost money or not,” he explains.
Ultimately, he believes that transparency 5,000
will remove much of the complexity which
Issuance volume ($M)
deters investors in the first place. “We need
4,000
to make the structures easy to understand.
The more complex it becomes the more
3,000
expert knowledge one needs to have.”
However, Fritsch adds that investors
are not satisfied by an explanation of 2,000
the underlying perils alone and sug-
gests a need for the structures of the cat 1,000
bonds themselves to be more transpar-
ent. “Transparent, easy-to-understand 0
structures are needed,” he says. “For a 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
market to grow, it needs transparency, and Year
it can currently be very difficult to get Source: 2009/10 - STORM; 2000-2008 - GC Securities
information on transactions. Investment
opportunities can sometimes be jeop-
ardised because of that; you don’t want
to invest in a transaction you don’t fully She notes though that the structures these innovations offer both a solution
understand.” need to appeal to both investors and spon- and a potential drawback for the investor.
sors in order to result in development for She suggests that money could be put into
Significant challenges the market as a whole. Whereas indem- treasury money market accounts, but adds
Although most ILS participants agree nity structures are more opaque from an that in this way investors would lose the
unanimously with the idea that greater investor viewpoint they offer the safest Libor-based rate.
transparency in structures is required, option for sponsors. “In today’s environment to get a
and should be developed in a standardised Moving forward a fine line will need Libor-return implies that you actually
format to maintain as much simplicity as to be walked in order to appease both have to take some measure of credit risk
possible, the implementation of these ide- camps. Klugman says: “If an issuer does a with your assets,” Klugman says. “So
als is not without significant challenges. transaction based on anything other than that’s what we’re grappling with moving
Currently investors are faced with nego- their actual losses then that means that forward: how much credit risk are inves-
tiating a multitude of potential cat bond they’re taking a measure of basis risk. tors prepared to take on to get a Libor-
trigger mechanisms which could result We need structures that meet the widest based rate, or are they fine taking very
in the investor losing money. Parametric appetite for investors and sponsors.” little credit risk and having a treasury
measurements – such as the physical Furthermore, Klugman explains that money market return?” While Klugman
measurement of wind speeds or an earth- steps have been taken to minimise the acknowledges that this is not a major
quake – can be used, as can industry loss potential risk for investors, but that again hurdle for the industry as a whole, it is an
triggers based on the insurance company
losses across the industry.
While these triggers are relatively
simple processes for an investor to gauge,
indemnity triggers also exist whereby the
“Transparent, easy-to-
trigger is based on the losses incurred by
the original sponsor. This can raise the
understand structures are
kind of questions which act as a deter-
rent to prospective investors, but which is needed. For a market to grow, it
favoured by the sponsors themselves.
“We do believe that indemnity struc-
tures have a place in the market,” says
needs transparency, and it can
Klugman. “But for this market to really
grow we believe that one shouldn’t feel currently be very difficult to get
that they need to be an underwriting cat
expert in order to analyse the bond.” information on transactions”
www.storminvestor.com 19