XVA. Green Andrew

convention is the one often used by CVA management functions; however, note that the accounting impact of the same number is negative as in this case the credit risk reduces the value of the derivative so that

      There are a variety of different models for CVA and the market uses models in which only the credit riskiness of the counterparty is considered (unilateral), and models in which the credit worthiness of both counterparties is considered (bilateral).

      Bilateral CVA models add an additional term, Debit Valuation Adjustment or DVA that arises from the credit risk of the reporting institution. As the credit worthiness of the institution declines, usually marked through widening CDS spreads, the institution books an accounting gain on its derivative portfolio, with the gain reflecting the fact that should the reporting institution default it will not fully repay all its obligations. DVA is a very controversial topic as it acts to increase the accounting value of a portfolio of derivatives at the same time that the credit worthiness of the institution is declining. There is also considerable debate around whether DVA can be effectively hedged or monetised.

      There are in fact two types of DVA appearing in accounts, derivative DVA, as described above and debt DVA that arises when an institution opts to fair value its own issued debt. In this case the institution books an accounting gain when their debt declines in value. In theory the institution could buy back the debt thus crystallising the gain, although in practice this does not often happen. The institution is unlikely to have funds available to buy back debt in such a scenario.

      CVA was introduced as a financial reporting requirement under FAS 157 issued in September 2006 by the Financial Accounting Standards Board (FASB) and coming into force for all entities with fiscal years beginning after 15 November 2007. The requirement to consider credit risk was also introduced by the International Accounting Standards Board through IFRS 39 (IASB, 2004) that was endorsed by the European Commission in 2005. IAS 39, unlike FAS 157, did not explicitly state that own credit risk should be taken into account (McCarroll and Khatri, 2011). This was subsequently changed in IFRS 13 (IASB, 2012) and IFRS 9 (IASB, 2014).

      2.3 The Default Process

      While in simple terms default occurs when the counterparty fails to make a payment, in reality the process is a complex legal one that varies between legal jurisdictions. The case of the default of sovereigns and supranational entities is more complex still as it enters the domain of international law. The legal process can be a long one, lasting many years, particularly in the case of large multinational entities; Enron filed for bankruptcy protection on 2 December 2001 (BBC, 2002), however, the company did not emerge from bankruptcy until 14 July 2004 (Hays, 2004). This then poses two important questions; what types of default are there and when do we consider default to have occurred?

      The Credit default swaps market has defined a number of different Credit Events that trigger the payout on CDS contracts on the defaulted entity. The 2003 ISDA Credit Derivatives Definitions (ISDA, 2003; Parker and Brown, 2003) sets out six different credit events:

      • Bankruptcy

      • Failure to pay

      • Obligation acceleration

      • Obligation default

      • Repudiation/moratorium

      • Restructuring.

      The exact definitions of these conditions are not important here, it is sufficient to recognise that there are a variety of credit events that can be considered to constitute a default. However, even these definitions are specific to the CDS market and do not necessarily reflect the practicalities of the default of a derivative counterparty and hence the impact on CVA calculation and the operation of a CVA desk. For a major international corporate or financial with traded CDS contracts it is likely that the CDS contract definition and trigger event will coincide with the failure of the derivative contract and this was certainly the case with the collapse of Lehman Brothers. However, for smaller entities the default process may be less clear cut. If there are no CDS contracts the CDS definitions are irrelevant. The event of default may be due to the restructuring of a counterparty portfolio in response to difficulties faced by the counterparty. The restructuring may be enacted by a group of creditors if there is more than one or the single bank counterparty if the defaulted entity only had a single banking relationship. In such cases it is not even clear if a credit event on one part of the portfolio automatically means that a default has occurred on all of the portfolio of transactions. So for example, an impairment may be taken on a loan by the lending bank but not on derivatives with the same counterparty. The key point to take away is that what constitutes a default is not always certain and that a CVA desk faces a range of different counterparties with a range of different possible credit events.

      A second key question is when does default occur? Again this can vary, depending on the circumstances of the default. A failure to pay, for example, can be accompanied by a grace period which can vary from a few days up to a month. This is intended to ensure that issues such as IT system failure do not cause a technical default. Nevertheless, default cannot be confirmed until the grace period has passed. A counterparty could be placed in a workout process by its bank or bankers before impairments are taken. Restructuring may be inevitable but no actual credit event has occurred. From a CVA perspective the time that default is recognised depends on both external factors and internal management processes. For large counterparties with liquid CDS contracts, recognition of the default will tally closely with external market action and the close-out process for CDS contracts. For smaller illiquid counterparties the process will be governed by internal management process and will link with the internal impairment and workout process. Nevertheless, a CVA management function will typically be forced to recognise the loss and make good the derivatives trading desk long before any workout process has been concluded.

      2.3.1 Example Default: The Collapse of Lehman Brothers

      The most significant default in recent years was the collapse of the investment bank Lehman Brothers in 2008, at the height of the credit crisis. The collapse of the US subprime mortgage market led to significant losses on transactions linked to pools of mortgages, including mortgage and asset-backed securities and credit derivatives such as CDOs. This had already led to the collapse of Bear Stearns and its subsequent rescue by J.P. Morgan (Winnett and Arlidge, 2008). The problems of Lehman Brothers became visible with the publication of a second quarter loss of $2.8bn, coupled with $17bn of write downs on assets including mortgage and asset-backed securities, commercial mortgages and leveraged loans in June 2008 (Quinn, 2008d). On 9 September, negotiations around the sale of a stake in the bank to Korean Development Bank collapsed, prompting a 30 % fall in the share price on a single day (Onaran, 2008). On 11 September the Lehman share price fell as much as 46 %, while Lehman Brothers began exploring the possibility of selling itself to Bank of America (Quinn, 2008b). On 13 September Barclays Bank engaged in takeover talks, but subsequently pulled out on 14 September (Quinn, 2008c). With no rescue options left, Lehman Brothers filed for bankruptcy on the morning of 15 September 2008 (Quinn, 2008a).

      When Lehman Brothers Holding Incorporated filed for bankruptcy, the court appointed PricewaterhouseCoopers (PWC) as administrators of the four main legal entities that comprised Lehman Brothers: Lehman Brothers Limited, Lehman Brothers Holdings plc, Lehman Brothers International (Europe) and LB UK RE Holdings Ltd (PWC, 2011). Clearing houses such as LCH.Clearnet acted swiftly to close out Lehman Brothers exchange-traded instrument positions in the weeks following the default (LCH, 2012d). Significant parts of the Lehman Brothers business were sold off rapidly after the bankruptcy with Barclays purchasing the New York investment banking and capital markets business on 16 September 2008 (Teather, Clark and Treanor, 2008) and Nomura purchasing Lehman Brother’s European and Middle East businesses on 22 September 2008 (Telegraph Staff, 2008). The CDS market auction process to determine the payout on Lehman Brothers took place on 10 October 2008 and set a recovery rate of 8.625 % (Barr, 2008), a relatively low figure in historical terms. The final recovery rate is now expected to be around 18 % (Carmiel, 2012). A year after the bankruptcy, Tony Lomas of PWC suggested the administration process could take 10–20 years to complete (Ebrahimi, 2009), because of the complexity of the business. Nevertheless,