Diluting risk

As the credit derivatives market has mushroomed, the need for dedicated management of credit risk within a bank’s portfolio of loans has grown. Alan McNee reports on the increasingly specialized role of credit portfolio manager

The idea of credit portfolio management has taken root in many banks in recent years, and is starting to flourish. Most sizeable institutions in North America and Europe – and many smaller ones too – have moved from a position of buying and holding credit to a buy-and-trade approach.

Until relatively recently this was done by a combination of trade in the secondary loans market and securitization, but the explosive growth of credit derivatives in recent years has added another dimension to credit portfolio management. As a result, bank loan portfolio managers have become increasingly significant participants in the credit markets. They can now buy and sell credit risk and generally behave much more like asset managers than traditional loan managers. There is little doubt that this has had an impact on the bottom line of the banks themselves.

Jack Malvey, chief global fixed-income strategist at Lehman Brothers in New York, says: “On the heels of the 2001 global recession, it’s arguable that the great precision afforded by using credit derivatives has allowed the classic commercial banks to weather the recession and come out in far better shape than they did from the previous downturn in the late 1980s and early 1990s.”

Credit portfolio management is, in essence, a way of reducing the concentration of credit risk in a particular institution. As Blythe Masters, head of credit portfolio, policy and strategy at JPMorgan, puts it: “The purpose of portfolio management is to attack concentrations of risk. It is concentration, whether on a single obligor or a whole industry, that has been the source of many of the sector’s problems with debt, for example in the telecoms sector.”

This approach may have been beneficial to the individual banks, but how has it affected the credit markets? For one thing, it has helped inject a great deal of liquidity. According to the latest figures from the International Swaps and Derivatives Association (Isda), the total notional outstanding for credit derivatives grew by 25% in the first six months of this year, reaching $2.69 trillion. A good deal of that volume growth can be attributed to banks transferring credit risk off their books as a result of more dynamic portfolio management.

“This is now one of the major flows in the credit markets,” says Chris Francis, head of credit derivatives research at Merrill Lynch. “It used to get captured in securitization and in asset swaps, but now a lot of the flow is through the credit default swaps market. Even if people are doing synthetic single-tranche collateralized debt obligations, they tend to be hedging the transactions with credit default swaps.”

Allan Yarish, head of global credit portfolio management at SG Corporate and Investment Banking in Paris, agrees that credit has definitely become more liquid, at least for major names. “Fluctuations that wouldn’t have been noticed before have now become more visible,” he says. “It’s rather like the stock markets: if equities only traded once a week, you wouldn’t see the day-to-day and intra-day variations on price that are obvious on stock markets.” Credit markets are increasingly showing the same degree of price transparency, says Yarish.

Trade-off

But has this greater liquidity come at the price of greater volatility in the credit markets, as banks increasingly ‘churn’ their credit risk? Lehman’s Malvey believes that credit portfolio management has contributed to making the credit environment a more complex one – though perhaps a less risky one for those institutions that use it wisely. “Overall, the institutions have weathered the recession well, but intra-day volatility has been higher. Both of these facts are partly the result of the development of credit portfolio management,” says Malvey. “For the credit markets, the fact that there is so much more product and the products are so much more complex has made markets more volatile than was the case before. It’s hard to decouple that volatility from the effects of Enron, WorldCom and other corporate governance crises, but the emergence of derivative and synthetic credit markets has also had a contribution.”

For the most part, risk managers and credit portfolio managers are sanguine about the level of volatility in the credit market. “Volatility is not by definition a good or bad thing – it depends on your perspective,” says Dik Blewitt, a member of Banc of America Securities’ global synthetic products team. “It simply reflects the fact that people have more information on an intra-day basis and choose to act upon that information. Certainly, volatility is now appearing on people’s books, and not everyone wants it. But for others it represents an opportunity to trade.”

Masters at JPMorgan does not believe that more active portfolio management has necessarily led to greater market volatility. “It partly depends on how you define volatility,” she says. “It can be defined as movements in market prices, but you could also say that volatility means big losses by individual firms which have the effect of destabilizing the financial system. That sort of volatility has in the past been rendered much more likely by a combination of accrual accounting and lending concentration.”

The development of an observable market price for credit risk does mean that prices for individual credits are liable to move sharply as the borrower’s credit status changes. But that volatility reflects genuine fluctuations in the creditworthiness of borrowers. “Ultimately,” says Masters, “having a visible, accurate price for credit is good for the borrowers as well. Their problem until recently has been that consolidation and a resulting decline in the number of banks has coincided with a greater demand for borrowing. With fewer banks around to lend, each one is being asked to take on more credit exposure.

“This leaves banks with very little dry powder to deal with new requests from borrowers, unless they can do something to reduce their concentrations of credit risk,” she adds. “So the corporate CFOs and treasurers now recognize that they have a shared problem with the banks, and that portfolio management is in their interests as well.”

The role of portfolio manager Credit portfolio management units have gained prestige and power within banks in recent years. These units look at credit on a macro level and work on how best to optimize the bank’s credit assets, making use of recent advances in portfolio modeling theory. As Blythe Masters, head of credit portfolio, policy and strategy at JPMorgan, says: “Banks are moving away from being originators of credit risk to structurers and distributors of credit risk. This move has been forced on them by the poor returns on equity from credit risk in the form of bank loans. That stems from a lack of diversification in those loans.” Rapid improvements in the sophistication of analyzing credit risk in portfolios and a marriage of asset-backed securities, derivatives and structured credit have allowed banks to take a much more active approach to their credit risk. Ten years ago loans would typically have been shared between a group of syndicate banks when they were first extended and less often securitized into collateralized loan obligations. Now collateralized loan obligations and synthetic collateralized debt obligations are common and credit default swaps allow a bank to reduce its exposure to an individual name. At the same time stricter rules on the level of risk that loan portfolios can contain and greater focus by bank shareholders on the return on equity have increased the importance of loan portfolio managers within banks. Alongside the development of credit derivatives, this has made it easier for loan portfolio managers to justify their role internally. In the past there were doubts over whether the investment value of credit was more important than its ‘relationship value’ – in other words, did the role of portfolio management conflict with the need for banks to retain or even extend particular loans because of the importance of maintaining a relationship with a particular client. Before default swaps were widely used, in-house bankers would frequently end up in conflict with credit portfolio managers over the issue of sustaining important client relationships. “The development of the credit default swap market means that the clients need never know,” one credit specialist puts it bluntly. “In the old days, a banker might think, ‘if IBM sees me selling their debt, that’s a negative signal to the market and they will respond by yanking their business from me’. But these days, IBM simply wouldn’t know whether or not a bank was buying credit protection against them.” All the bank is doing is buying credit protection; in the same way it might legitimately hedge its interest rate or currency exposure to the same client. Clients have also gradually come round to the new reality that banks cannot simply afford to maintain unprofitable loans for the sake of retaining their business.