Finance

1. ZB06
Credit Linked Structured Products for
Wealth Management Services
in Greater China
3 IFPHK CE credits
3 SFC CPT hours
3 MPFA non-core CPD hours
Speaker: Dr. LAM Yat Fai (林日辉 博士)
Doctor of Business Administration (Finance)
CFA CAIA FRM PRM MCSE MCNE
6:30pm to 9:30pm Wednesday 11th December 2013

2. 2
What is credit linked
structured product?
Very complex cash flows
Lengthily prospectus difficult to understand
No risk disclosure
Small print in contract
High yield
Mass destructive weapon

3. 3

4. 4
Credit default swaps
Credit linked notes
Collateralized debt obligations
Sales and marketing
Regulatory requirements
Credit structuring in mainland China
Outline

5. 5
Term loan
Lending amount – HKD 100,000
Your bank pays the borrower HKD 100,000 today
Maturity – one year
The borrower will pay your bank at most HKD 100,000 after one
year
Interest frequency – monthly
The borrower will pay your bank interest on monthly basis
Interest rate – 12 %
The borrower will pay your bank at most
HKD 100,000 × 12% / 12= HKD 1,000 monthly
11 22 33
1,0001,000 1,0001,000 1,0001,000 1,0001,000 1,0001,000+100,000+100,000
12121111
100,000100,000

6. 6
Coupon bond
Market price – 95%
Your bank pays the corporation HKD 950 today
Principal value – HKD 1,000
The corporation will pay your bank at most HKD 1,000 at maturity
Maturity – 5 years
The corporation will pay your bank at most HKD 1,000 in 5 years
Coupon frequency – semi-annual
The corporation will pay your bank interest every 6 month
Coupon rate – 6 %
The corporation will pay your bank at most HKD 30 every 6
months
11 22 33
3030 3030 3030 3030 30+1,00030+1,000
101099
950950

7. 7
Single name CDS
Protection
buyer
Protection
seller
Principal × 30 bps
every quarter
Payoff at default
= Principal × LGD
Reference debt + Single name CDS Risk-free security
- Single name CDS Reference debt - Risk-free security
≈
≈

8. 8
Single name CDS
Protection buyer – risk adverse investor
If the reference debt survives, pays premium regularly
If the reference debt defaults, receives default loss of
principal
Protection seller – risk tolerant investor
If the reference debt survives, receive premium
regularly
If the reference debt defaults, pays default loss of
principal

9. 9
Application of CDS
Hedging
Protection buyer – long position
To mitigate credit risk
Investment
Protection seller – short position
To invest in a debt without upfront cash
outflow
Regular cash inflows (premiums)
Subject to credit risk of the reference debt

10. 10
Three single name CDSs
My portfolio
HKD 100mn GM US 3-year senior secured bond
HKD 100mn Three Deer China 3-year senior secured bond
HKD 100mn Northern Rock UK 3-year senior secured bond
Hedging strategy
Single name CDS on GM US 3-year senior secured bond with
principal HKD 100mn
Single name CDS on Three Deer China 3-year senior secured
bond with principal HKD 100mn
Single name CDS on Northern Rock UK 3-year senior secured
bond with principal HKD 100mn
Advantages vs disadvantages
Largely perfect hedge
Expensive

11. 11
1st-to-default CDS
Cash outflows
Protection buyer pays a regular premium
Cash inflows
If GM US defaults first, protection buyer pays the accrued premium and
receives a payoff as if the 1TD CDS is a single name CDS with GM US
as the reference debt
If Three Deer China defaults first, protection buyer pays the accrued
premium and receives a payoff as if the 1TD CDS is a single name CDS
with Three Deer China as the reference debt
If Northern Rock UK defaults first, protection buyer pays the accrued
premium and receives a payoff as if the 1TD CDS is a single name CDS
with Northern Rock UK as the reference debt
Advantages vs disadvantages
Protection to the first out of three potential defaults
No protection to the second and third defaults
Less expensive than three single name CDSs

12. 12
A less uniform portfolio
My portfolio
HKD 100mn GM US 3-year senior secured bond
HKD 120mn Three Deer China 2+11/12-year senior unsecured
bond
HKD 80mn Northern Rock UK 2+10/12-year senior unsecured
bond
Hedging strategy
Single name CDS on HKD 100mn GM US 3-year senior secured
bond
Single name CDS on HKD 110mn Three Deer China 2+11/12-
year senior unsecured bond
Single name CDS on HKD 90mn Northern Rock UK 2+10/12-
year senior unsecured bond
Advantages vs disadvantages
Perfect hedge
Expensive

13. 13
Portfolio CDS
– First HKD 100mn principal
Cash outflows
If no debt defaults, protection buyer pays a regular premium
Cash inflows
If GM US defaults first, protection buyer pays the accrued premium and receives
a payoff as if the portfolio CDS is a single name CDS of principal HKD 100mn
with GM US as the reference debt. The portfolio CDS terminates after the
protection payment
If Three Deer China defaults first, protection buyer pays the accrued premium and
receives a payoff as if the portfolio CDS is a single name CDS of principal HKD
100mn with Three Deer China as the reference debt. The portfolio CDS
terminates after the protection payment
If Northern Rock UK defaults first, protection buyer pays the accrued premium
and receives a payoff as if the portfolio CDS is a single name CDS of principal
HKD 90mn with Northern Rock UK as the reference debt. The portfolio CDS
continues to works as a HKD 10mn portfolio CDS with a smaller premium
Advantages vs disadvantages
Protection to a fixed amount of principal
No protection beyond the fixed amount of principal
Less expensive than three single name CDSs

14. 14
Tranching of
a debt portfolio

15. 15
Credit default swaps
Credit linked notes
Collateralized debt obligations
Sales and marketing
Regulatory requirements
Credit structuring in mainland China
Outline

16. 16
Single name CLN
Investments in BYD
Any investor can invest in BYD equity shares
Only institutional investors can invest in BYD bonds
An investment bank, e.g. HSBC
Purchases HKD 100 mn principal of BYD bonds
Issues 1,000 notes, each with cash flows 100%
tracking the cash flows of HKD 10,000 principal of
BYD bonds
Sells the notes to many individual investors and
charges commissions
Individual investors subject to credit risk of both
BYD and HSBC

17. 17
Special purpose entity
A shell company
Established by a financial institution, usually
incorporated in tax heaven, e.g. Cayman
Island
Bankruptcy remote
Financially independent, not to be affected by
the credit quality of the parent institution
Primary function
To issue single name CLN

18. 18
Single name CLN
issued under SPE
An investment bank, e.g. HSBC
Establishes a SPE independent of HSBC
Grants a short term loan to the SPE
The SPE
Purchases HKD 100 mn principal of BYD bonds
Issues 1,000 notes, each with cash flows 100% matching those
of BYD bonds
Uses the proceeds from selling the notes to settle the short term
loan
HSBC, as an agent, charges commission on selling the
notes to many individual investors
SPE, a liabilities free shell company, has no credit risk
Individual investors subject to credit risk of BYD only

19. 19
Synthetic CLN
Existing BYD bonds may not match the LGD,
maturity, interest rate and interest payment dates
of the requirements from investors
Reference debt + Single name CDS Risk-free security
Single name CLN - Single name CDS + Risk-free security
≈
≈

20. 20
Synthetic CLN
SPE Investors
Top quality
assets
Premiums
Single name
CDS
Steady cash flows
Bank
Single name
CLN

21. 21
Synthetic CLN
An investment bank, e.g. HSBC
Establishes a SPE independent of HSBC
Grants a short term loan to the SPE
The SPE
Issues to HSBC single name CDSs with HKD 100 mn principal of
hypothetical BYD bonds with LGD, maturity, interest rate and interest
payment dates matching the requirements of investors
Invests in HKD 100 mn principal top quality assets (AAA)
Issues 1,000 notes, each with cash flows 100% matching those of HKD
10,000 principal of the hypothetical BYD bonds
Uses the proceeds from selling the notes to settle the short term loan
HSBC, as an agent, charges commission on selling the notes many
individual investors
SPE, a liabilities free shell company, has no credit risk
Individual investors subject to credit risk of BYD only

22. 22
Cash flows
Cash outflow
An initial amount to acquire a single name
CLN
Cash inflows
Reference debt survives
Scheduled interests and principal
Reference debt defaults
Recovered amount of the reference debt

23. 23
Yield enhancement
One shared principal
Reference to a basket of identical debts
from different issuers
Track the cash flows of the 1TD reference
debt
Higher credit risk => higher return

24. 24
Basket CLN
A basket of identical reference debts seldom
exists physically
To synthesize with 1TD CDS
Basket CLN + 1TD CDS Risk-free security
Basket CLN - Basket CDS + Risk-free security
≈
≈

25. 25
Basket CLN
SPE Investors
Top quality
assets
Premiums
Basket CDS
Steady cash flows
Bank
Basket CLN

26. 26
Basket CLN
An investment bank, e.g. HSBC
Establishes a SPE independent of HSBC
Grants a short term loan to the SPE
The SPE
Issue a 1TD CDS of HKD 100 mn principal on three identical
hypothetical bonds issued by BYD, Tencent and Tsing Tao Beer
Invests in HKD 100 mn principal top quality assets (AAA)
Issues 1,000 notes, each with cash flows 100% matching those of the
1TD reference bonds
Uses the proceeds from selling the notes to settle the short term loan
HSBC, as an agent, charges commission on selling the notes to
many individual investors
SPE has no credit risk
Individual investors subject to credit risk of the 1TD reference bond
only

27. 27
Cash flows
Cash outflow
An initial amount to acquire a basket CLN
Cash inflows
All reference debt survives
Scheduled interests and principal
Either one reference debt defaults
Recovered amount of the debt defaulted

28. 28
Market value CLN
SPE Investors
Top quality
assets
Premiums
Basket CDS
Steady cash flows
Bank
Basket CLN
Active trading portfolio

29. 29
Market value CLN
Top quality assets
Sell high
Buy low
Trading profit to offset part of default loss
Risk
Credit risk of reference debts
Trading risk of top quality assets

30. 30
Credit default swaps
Credit linked notes
Collateralized debt obligations
Sales and marketing
Regulatory requirements
Credit structuring in mainland China
Outline

31. 31
Illiquid secondary market
of credit risky debts
Mis-match of demand and supply
High demand of high quality debts
Limited supply of high quality debts
Information asymmetry
Owner with more understanding demands a
higher ask price
Investor with less understanding offers a lower
bid price

32. 32
Traditional CDOs
Debt 1
Debt 2
Debt 3
Debt N
Principal =
HKD100 mn
SPE
Ultra senior tranche
Principal = HKD 40 mn
Senior tranche
Principal = HKD 40 mn
Mezzanine tranche
Principal = HKD 10 mn
Equity tranche
Principal = HKD 10 mn

33. 33
Cash waterfall
Cash inflows (interests and principal) are collected from a
debt portfolio
Cash is first paid to the ultra senior tranche as much as
possible according to the specifications of the ultra senior
tranche
If residual cash is available, then paid to the senior
tranche as much as possible according to the
specifications of the senor tranche
If residual cash is available, then paid to the mezzanine
tranche as much as possible according to the
specifications of the subordinated tranche
If residual cash is available, then paid to the equity
tranche according to the specifications of the equity
tranche

34. 34
Cash waterfall
Equity tranche
Ultra senior tranche
Mezzanine tranche
Cash inflows from
debt portfolio
Senior tranche

35. 35
Tranching
Attachment point
The percentage of defaulted portfolio principal from which the
CDO tranche starts to suffer from loss
Detachment point
The percentage of defaulted portfolio principal starting from which
the CDO tranche will suffer from total loss
Thickness = Detachment point - Attachment point
Ultra senior tranche
100% attachment point and no detachment point
Equity tranche
0% attachment point

36. 36
Tranching
Ultra senior tranche
Senior tranche
Mezzanine tranche
Equity tranche
Senior tranche
Mezzanine tranche 3
Mezzanine tranche 2
Mezzanine tranche 1
Equity tranche

37. 37
Synthetic CDO
Similar to synthetic basket CLN
Using portfolio CDS and top quality assets to
replicate the cash flows of a CDO tranche
CDO Tranche + Portfolio CDS Risk-free security
CDO Tranche - Portfolio CDS + Risk-free security
≈
≈

38. 38
Synthetic CDO
SPE Investors
Top quality
assets
Premiums
Portfolio CDS
Steady cash flows
Bank
CDO tranche

39. 39
Market value CDO
Collaterals
Traditional CDO – debt portfolio
Synthetic CDO – top quality assets
To push up the value
Sell high
Buy low
Trading profit to offset default loss

40. 40
Market value CDOs
Debt 1
Debt 2
Debt 3
Debt N
Principal =
HKD100 mn
SPE
Ultra senior tranche
Principal = HKD 40 mn
Senior tranche
Principal = HKD 36 mn
Mezzanine tranche
Principal = HKD 12 mn
Equity tranche
Principal = HKD 12 mn
Active
trading
portfolio

41. 41
Market value CDO
SPE Investors
Top quality
assets
Premiums
Portfolio CDS
Steady cash flows
Bank
CDO tranche
Active trading portfolio

42. 42
Cash flows
Cash outflow
An initial amount to acquire a CDO tranche
Cash inflows
Tranche principal survives
Scheduled interests and principal
Tranche principal defaults partially
Interests and principal in proportion
Tranche principal defaults completely
No interests and principal

43. 43
Functional purpose
Broadening of credit market
Producing higher quality debts from lower quality raw
material
Default dependency as a new investment class
Credit risk mitigation
Selling debt portfolio to other investors
Cash flow CDO

44. 44
Agency rating (1)
A CDO tranche rated A is somewhat more susceptible to the adverse
effects of changes in circumstances and economic conditions than the
CDO tranches in higher rated categories. However, the capacity of the
debt portfolio and tranche structure to meet the interests and principal to
the CDO tranche is still strong.
A
A CDO tranche rated AA differs from the highest rated CDO tranches
only to a small degree. The capacity of the debt portfolio and tranche
structure to meet the interests and principal to the CDO tranche is very
strong.
AA
A CDO tranche rated AAA has the highest quality. The capacity of the
debt portfolio and tranche structure to meet the interests and principal to
the CDO tranche is extremely strong.
AAA
DescriptionRating

45. 45
Agency rating (2)
A CDO tranche rated B is more vulnerable to violation of payment
schedule than the CDO tranches rated BB, but the debt portfolio and
tranche structure currently has the capacity to meet the interests and
principal to the CDO tranche. Adverse business, financial, or
economic conditions will likely impair the capacity of the debt portfolio
to meet the interests and principal to the CDO tranche.
B
A CDO tranche rated BB is less vulnerable to violation of payment
schedule than other speculative issues. However, it faces major
ongoing uncertainties or exposure to adverse business, financial, or
economic conditions which could lead to inadequate capacity of the
debt portfolio and tranche structure to meet the interests and principal
to the CDO tranche.
BB
A CDO tranche rated BBB is subject to adequate protection from the
debt portfolio. However, adverse economic conditions or changing
circumstances are more likely to lead to a weakened capacity of the
debt portfolio and tranche structure to meet the interests and principal
to the CDO tranche.
BBB
DescriptionRating

46. 46
Agency rating (3)
A C rating is assigned to a CDO tranche that is currently highly
vulnerable to violation of payment schedule or has payment arrearages
allowed by the terms of the documents. Among others, the C rating may
be assigned to an equity tranche on which cash payments have been
suspended in accordance with the terms of the CDO contract.
C
A CDO tranche rated CC is currently highly vulnerable to violation of
payment schedule.
CC
A CDO tranche rated CCC is currently vulnerable to violation of payment
schedule, and is dependent upon favorable business, financial, and
economic conditions for the debt portfolio and tranche structure to meet
the interests and principal to the CDO tranche. In the event of adverse
business, financial, or economic conditions, the debt portfolio is not likely
to have the capacity to meet the interests and principal to the CDO
tranche.
CCC
DescriptionRating

47. 47
Credit default swaps
Credit linked notes
Collateralized debt obligations
Sales and marketing
Regulatory requirements
Credit structuring in mainland China
Outline

48. 48
From media
Lehman Brothers minibonds
Very complex structured products
Prospectus difficult to understand
No risk disclosure
Small print in contract
High expected return at high risk
Customers
Retail customers
Old aged, less educated, mis-sold by banks
http://www.sfc.hk/sfc/html/EN/general/general/lehman/lehma
n_structure_products.html

49. 49
Lehman Brothers
minibonds

50. 50
Lehman Brothers
minibonds
Market value CLN
Linked to a few high credit quality
companies when the CLNs were first
issued
Operating under a SPE
Low risk investments before 2006
Moderate nominal yield 3% to 7%
No secondary market

51. 51
Prospectus
Well written documents
A few pages of upfront summary
Very clear disclosure
50 to 100 pages
May reference to other program
prospectuses

52. 52
Sales and marketing
Marketing
Nice features of a structured product
Strong sales channels – the dominating
factor
Sales channels
Professional investors
Financial institutions
Private banking customers
Corporations for “hedging” purpose

53. 53
Why minibonds?
Low interest income on regular fixed
deposits
Higher yield on minibonds
Operating like deposits
Confidence in commercial banks
Attractive gifts on purchase of
minibonds

54. 54
Why credit linked
structured products?
Bank’s own investments
Earning interest income
Higher yield at the same credit rating
Products sold to corporate and private
banking customers
Operating like deposits and bonds
Customized in accordance with the preference
of customers in terms of return, risk and
horizon

55. 55
Credit risk re-distribution
through CDO

56. 56
Credit default swaps
Credit linked notes
Collateralized debt obligations
Sales and marketing
Regulatory requirements
Credit structuring in mainland China
Outline

57. 57
Structured products
under the SFO
A financial instrument with its payoff determined
by reference to one or more of
the value, rate, level (or a range of value, rate, level)
of any type or combination of types of currency,
interest, equity, commodity, credit event or index
the value, rate, level (or a range of value, rate, level)
of any basket of more than one type or combination of
types of currency, interest, equity, commodity, credit
event or index
Excluding bonds, mutual funds and exchanged traded
products

58. 58
Regulatory requirements
After financial tsunami 2008
Credit linked structured products can only be
sold to professional investors
Professional investors are not covered by the
SFO’s investor protection regime
Professional investors
With sufficient knowledge and experience
With at least USD 1 mn free cash

59. 59
Investor protection
Standardized legal documents
Lawyers
Civil litigation
Experience with bankers

60. 60
Credit default swaps
Credit linked notes
Collateralized debt obligations
Sales and marketing
Regulatory requirements
Credit structuring in mainland China
Outline

61. 61
China market
The largest debt markets
Loans to government departments
Loans to government owned corporations
Municipal debts
Wealth management
Commercial bank
Shadow banking
Alibaba

62. 62

63. 63
Credit securitization
Credit risk transfer
Bank transfers lower quality debts to asset
management company
Asset management company forms many
SPEs
SPEs to issue single name CLNs and/or
CDOs
Circulation of funding supply
Funds from selling CLNs/CDOs return to the
bank and facilitates further lending

64. 64
An emerging subprime
crisis in China
Chinese investors has little understanding
on credit securitization, in particular the risk
Cash flows similar to deposits and bonds
hide credit structuring behind the scene
Banks position themselves as a
commission earning intermediary only
Credit rating agencies in China are solely
profit driven
Political risk dominates

65. 65
Reference
https://sites.google.com/site/crmbasel

66. 66
Q & A

67. 67
Thank You

68. 68
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