First American Bank (FAB) Credit Derivatives Business Unit

Submitted By ShardulKatoch
Words: 809
Pages: 4

Based on the business model that First American Bank’s (FAB) Credit Derivatives business unit follows, it should go ahead and take credit exposure to CapEx Unlimited (CEU). Pros of undertaking such an exposure include a periodic fee payment from Charles Bank International (CBI) to FBI in exchange for credit protection. The amount of periodic fee charged to CEU should reflect adequately reflect the inherent credit risk that FAB is exposed to. Additionally, FBI will be able to strengthen its customer relationship with CBI for future business activities. Downside includes exposure FAB to high counterparty and credit risk. The CDS that FBI is entering into with CBS is unsecured without any underlying collateral increasing counterparty risk for FBI. Also CEU’s publically traded debt was already below investment grade (B2 rating from Moody’s) with average recovery rate of 40% of loan if CEU were to enter default. This leaves FBI exposed to high credit risk on their balance sheet that they need to hedge to prevent any losses in event of default. In case the $ 50 million loan to CEU is syndicated to reduce the inherent risk FAB will still be the primary syndicator and will take on the maximum exposure of risk. The low credit quality of CEU with a total debt market value of $4.1 billion, representing an average yield of 9.6% with a credit spread of 5.1% means there is high probability that CEU might default during the life of contract which increases credit risk exposure. There are two ways in which FAB can manage credit risk on its balance sheet. First, if it decides to keep the credit risk it might have to set aside some capital as collateral to hedge the inherent risk involved. The amount of capital set aside depends on the risk adjusted return that it can earn by keeping the credit risk and credit risk tolerance (risk averse or risk taker) of FAB. If the return from capital set aside as collateral is greater than the return FAB would generate if it passes on the risk than it should keep the credit risk in house. Second, if FAB decides not to keep the credit risk on its balance sheet it can transfer the risk to two low rated banks and hedge funds mentioned in the case. One of the ways it can do that is entering into a CDS transaction with low rated bank and hedge fund. The issue with this CDS transaction is that it involves high counterparty risk. It FAB were to purchase credit protection from low rated bank and hedge fund it will be exposed to high default risk that credit protection sellers have because of their low credit ratings. They might enter into default before the CDS the end of life of the CDS contract and will not be able to fulfill their obligation if CEU faces any financial distress. Also important is the fact that this CDS will be unfunded by any capital. Thus in order to minimize its counterparty risk FAB would want protection sellers to set aside significant amount of capital as collateral so that they can meet their obligation…