Credit and Counterparty Risk - Malz

[Roshan Ramdas]

Hi David,

Need your help please in understanding a section at the start of "Credit and Counterparty Risk" by Malz,....that very briefly speaks about credit risky securities.

Not able to understand the sections (in bold) in the below passage. To me, an issuer filing for bankruptcy is a logical ending to default. I thereby cannot understand what the sentence means by structured credit products not defaulting in the "narrow sense" ?

Also, could you explain the last line please,.....cannot understand the meaning of "liabilities issued against the collateral" ?

"Structured credit products are bonds backed by pools of mortgage, student, and credit card loans to individuals, by commercial mortgages and other business loans, and by other types of collateral. They often cannot default, in the narrow sense, because the issuer can file for bankruptcy.
They are, however credit risky in the sense that, when enough loans in the collateral pool default, at least some of the liabilities issued against the collateral must be written down, that is, the creditor takes a loss."

Thank you,
Roshan

 

[Alex_1]

Hi Roshan,

regarding the second point, it means (imo) that if loans offered as collateral for the structured products lose their value in case of a default, they pose a credit risk as at least a part of the liability position built due to the investment in the structured credit products has to be written down in the balance sheet and therefore the creditor loses at least a part of her investment.

Regarding the bankruptcy - I am not 100% sure but I thought that filing for bankruptcy does not always lead to a default. In some bankruptcy cases (Chapter 7 or 11, not sure right now) a third party takes control of the bankrupted assets and in some cases a default can be avoided. But let's wait for David's feedback on this.

BR
Alex

 

[Roshan Ramdas]

Hi Roshan,

regarding the second point, it means (imo) that if loans offered as collateral for the structured products lose their value in case of a default, they pose a credit risk as at least a part of the liability position built due to the investment in the structured credit products has to be written down in the balance sheet and therefore the creditor loses at least a part of her investment.

Regarding the bankruptcy - I am not 100% sure but I thought that filing for bankruptcy does not always lead to a default. In some bankruptcy cases (Chapter 7 or 11, not sure right now) a third party takes control of the bankrupted assets and in some cases a default can be avoided. But let's wait for David's feedback on this.

BR
Alex

Hi Alex,

Understood the first part around liability position - thanks.

On the bankruptcy point, there is a small note in the very same passage that describes Corporate debt securities as below.

Corporate debt securities “are the only type that can default in the narrowest sense” and include fixed and floating rate bonds, and bank loans.

Your reasoning of default being avoided in some cases should apply for Corporate debt securities as well.
So still not able to understand why the structured credit products was described as "cannot default in the narrowest sense because the issuer can file for bankruptcy".

Thank you,
Roshan