Does your CVA hedge generate CVA? April 26, 2012 at 9:10 am
Yes, it (often) does. Credit Suisse offers us an example. First, what we know, from CS themselves.
In 1Q12, we entered into the 2011 Partner Asset Facility transaction to hedge the counterparty credit risk of a referenced portfolio of derivatives and their credit spread volatility. The hedge covers approximately USD 12 billion notional amount of expected positive exposure from our counterparties, and is addressed in three layers:
- first loss (USD 0.5 billion),
- mezzanine (USD 0.8 billion) and
- senior (USD 11 billion).
The first loss element is retained by us and actively managed through normal credit procedures. The mezzanine layer was hedged by transferring the risk of default and counterparty credit spread movements to eligible employees in the form of PAF2 awards, as part of their deferred compensation granted in the annual compensation process.
We have purchased protection on the senior layer to hedge against the potential for future counterparty credit spread volatility. This was executed through a CDS, accounted for at fair value, with a third-party entity. We also have a credit support facility with this entity that requires us to provide funding to it in certain circumstances. Under the facility, we may be required to fund payments or costs related to amounts due by the entity under the CDS, and any funded amount may be settled by the assignment of the rights and obligations of the CDS to us. The credit support facility is accounted for on an accrual basis.
Basically, then, three parties own the credit exposure on CS’s OTC derivatives portfolio: the bank themselves, their employees, and a senior hedge provider. Selling the mezz to the employees (in lieu of bonus) is really smart as it gets around all sorts of disclosure and alignment of incentives issues associated with a third party hedge.
What’s left is presumably AAA risk or pretty close. But – and here’s the rub – the hedge provider has written a CDS on it. That’s an OTC derivative. So that generates CVA. Moreover like any senior tranche, while losses on it might be unlikely, there can be serious MTM volatility. So I bet, to keep the CVA down, CS has got its counterparty to agree to daily cash collateral but the counterparty, worried about the liquidity implications of this, has got CS to agree to lend it the money. It’s just a round trip. CS’s loan book lends money to the counterparty, who post it straight back as collateral under the CDS. Look, no CVA on the hedge, and all of our capital requirements on the CVA are gone. Magic, isn’t it?