There are some other aspects of derivative credit provision that deserve some scrutiny.
First, there are other elements which a bank's credit department will look at to take an overall view of the amount of credit which it is appropriate to extend. These include:
- Size of the total pension fund (rather than just the assets controlled by this particular client)
- Extent to which a legal charge could easily be ascertained over the assets of the scheme in question
- Whether any leverage is present in the scheme.
The existence, or lack, of a strong and committed pension fund sponsor is likely to be extremely relevant (although sometimes completely irrelevant, like in the case of a bank that was unwilling to extend credit to its own pension fund!!). I have certainly heard of banks trying to slip in 'Alternative Termination Events' (ATEs) regarding on-going contributions into a certain pension fund.
One significant mitigant which has not been discussed until now is the imposition of 'Early Termination Agreements' (ETAs, not to be confused with ATEs!). These are often known as "break clauses". These are peculiar agreements which often appear to the untrained eye to be a derivative within a derivative, as they give each counterpart the option to exit their derivative obligations at various points in the future. The agreements, however, require that the exiting counterpart pay or receive the current mark-to-market of the portfolio when closing out. Most interbank counterparties will now utilise a standard of incorporating ETAs into every new derivative traded, with a first exercise date 5 years from the trade date, and every year thereafter.
Another aspect which requires some small scrutiny is the means by which banks manage future cash flows which they are owed. In the event of a large and extended shift in interest rate expectations (as we have seen over the past couple of years), it is likely that banks and clients find themselves on either side of a large mark-to-market on derivative portfolios – as clients who received fixed at higher interest rates are owed large sums of money over the coming years. Rather than receive collateral every day to insure against the possibility of not receiving this money, many clients prefer to re-strike the portfolio – moving the interest rates of the swaps closer to current interest rates, and receiving an upfront payment in exchange for accepting less down the line.
Most pension funds and insurance companies, however, have made it clear that they are not prepared to include these terms of business, which has at various times presented challenges to their banking counterparties. Likewise, more "valuistic" judgements will also be made, such as the frequency with which a counterpart trades certain derivatives and the bank's perception of their operational capabilities. A bank will clearly be more comfortable entering into larger transactions with a counterpart that demonstrates an ability to correctly and rapidly value their derivative portfolio.
In the case of uncollateralised exposure this can be particularly attractive – and banks have been keen to purchase Credit Default Swap protection on clients from whom they are owed large sums of money on an uncollateralised basis to insure them against the possibility of not being paid. All these possibilities, however, open up another can of worms, as it turns out that there is no hard-and-fast standard when it comes to the valuation of OTC derivatives.
[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer]