CLN & Risk Transfer

[reiss1]

Hi all,

1. Do Asset-Backed CLN transfer interest rate risk (market risk) as well as credit risk since investors are exposed to capital gain/loss on the credit portfolio?

2. Also would it be fair to say that the investor (credit risk buyer) is exposed to the capital gain/loss on the underlying asset (bought by the bank), while the bank (credit risk seller), in addition, is exposed to the capital gain/loss on the collateral asset (e.g. treasuries) since a fall in price of the collateral would raise their down-side risk in situations of severe deterioration of the underlying portfolio.

Thanks in advance!

 

[Lu Shu Kai FRM]

Hi @reiss1 ,

Thank you for your questions.

1. My understanding is yes. As asset-backed CLNs have a certain yield based on the underlying loans issued to borrowers, this results in the AB-CLNs being worth less or more depending on the market interest rate relative to that of the AB-CLNs.

2. Here you are taking on the perspective of the credit risk seller (the bank) and are worried about two things - the value of the collateral and that of the credit portfolio (AB-CLNs). From my understanding, the bank itself isn't really exposed to much risk (market or credit) in the transaction as it serves as an intermediary, along with the SPV, - structuring the AB-CLNs to sell to the credit investors. The fall in value of the collateral is more closely linked to margin calls in exchange-traded scenarios, this looks more OTC to me (please correct me if the AB-CLN transaction is exchange-traded). The fall in value of the credit portfolio does not really affect the bank, as the collateralization of AAA-rated securities to the SPVs (that serve to reimburse the investor in terms of default) only pay out as much as the stated recovery rate and the value of the face value/principal.

Hope this is helpful!

 

[reiss1]

Thanks for the response!