Diversification as a tool for credit risk management

Diversification benefits are well-known for equity portfolios, where a well-diversified portfolio exhibits the minimum total portfolio risk by' diversifying away its idiosyncratic component. This can be achieved by including in the portfolio assets with low correlation coefficients. Apart from equity portfolios, the same diversification benefits can be achieved in credit portfolios. Specifically, a well-diversified credit portfolio can diversify away' the idiosyncratic component of credit risk and in this way minimise its total credit risk. This is achieved by adding different types of loans in a credit portfolio, that is, by including loans of obligors operating in different industries and/or different segments of the same industry'. The non-correlated default probabilities of these credit facilities diversify away the part of their credit risk which is due to idiosyncratic characteristics. In order to illustrate the benefits of credit portfolio diversification through an example, consider a ship-lending bank which currently' holds a credit portfolio with obligors operating exclusively in one segment of the shipping market, say the tanker segment. Naturally, this financial institution is heavily exposed to freight rate and ship-price fluctuations of the tanker market, as the repayment of its entire shipping credit portfolio depends on the cash-flow generating ability of obligors operating in tanker markets.15 Therefore, large fluctuations in tanker market freight rate and ship prices would result in several defaults of the loans in the portfolio, given the higher correlation in their default probabilities.

The ship-lending bank of this example can diversify away the idiosyncratic component of the credit risk of its portfolio by including credit facilities to obligors operating in different segments of the shipping industry, such as dry-bulk, wet-bulk, containerships, ferries, coastal shipping, offshore and cruise shipping. This would lead to lower correlations between the default probabilities of the loans granted and, in this way, decrease the overall credit risk exposure of the bank.

Downgrade triggers and credit risk management

Downgrade triggers are investment clauses which are included in a contract and give the option/obligation to a market participant to cancel, liquidate or change the terms of the contract if the credit rating of the other party downgrades below a pre-specified rating threshold. A typical downgrade trigger could be for a company to lose two credit rating notches within a year, or for a bond issue to be downgraded from the investment grade class to the non-investment grade class. In fact, this downgrading from investment to non-investment classes of a financial instrument is a frequently used downgrade trigger applied by institutional investors, such as pension funds.

To take an example from the shipping industry, a ship-lending bank may impose a downgrade trigger on a shipping company financed that if the shipping company is downgraded from a BBB+ rating to one equal or below BB during the repayment of the loan, then the bank has the option to cancel or amend the agreement by: requiring additional collateral in the form of cash; charging a higher margin for the remaining part of the debt due; and/or imposing additional terms to the original agreement, such as the renegotiation of the repayment schedule of the loan. In this way, the bank can mitigate its credit risk exposure to the specific company in case its creditworthiness decreases considerably during the repayment period of the loan, thereby casting doubt over the remaining payments of the loan due.

Netting of contracts

Another method to mitigate counterparty credit risk is through “netting of contracts”. This is usually applied when two parties are involved in several OTC bilateral derivative transactions between them. Consider the case where two parties include a netting of contracts clause for the agreed bilateral contracts between them and one party defaults on one of the contracts. In this case, all contracts outstanding will be immediately considered in default and can be closed at their current market values. Thus, the netting of contracts clause prohibits one of the two parties in a deal to apply the so-called “selective default”, i.e. to default only on specific - non-favorable for them — contracts. In this way, the netting of contracts clause protects the party of the deal that has not defaulted but is involved in several contracts with the defaulting party by limiting its losses and closing all the contracts outstanding at their current market values. The netting of contracts clause is usually applied in OTC derivative contracts as it helps the parties involved avoid excess losses due to cross-defaults.

The following example illustrates how the netting of contracts clause works in practice. Consider a shipping company involved in four OTC FFA contracts with a specific charterer. The current values of these contracts for the shipping company are: +S4 million, +$5 million, —$4 million and —$3 million, and these are due in one, six, 12 and 24 months, respectively. The other party of the deal (e.g. a charterer) faces financial distress due to its deteriorating profitability, as freight rates have risen rapidly, and fails to pay the first contract of +$4 million to the shipping company In this scenario, the shipping company has the right to use the netting of contracts clause and require the closing of all four outstanding contracts at their current market values. This would result in a loss of $2 million (= $4 million + $5 million — $4 million — $3 million) instead of S4 million for the shipping company. In contrast, if the netting of contracts clause was not included in the OTC derivative agreements between the two parties, the shipping company would incur a loss of $16 million as the counterparty would default on the first two contracts ($4 million and $5 million) and claim the last two contracts (—$4 million and —S3 million).

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