Collateral, guarantees and credit risk mitigation · RiskAtoms Academy

By the end you will be able to

1Apply haircuts to collateral, including a currency mismatch, and work out the exposure and LGD that remain.
2Value a guarantee by substitution and by double default.
3Explain how a credit default swap protects a loan, and what it costs.
4Name the limits of mitigation: wrong-way risk, maturity and basis mismatches, counterparty risk and legal certainty.

Why it matters

Six of RiskAtoms Bank's twelve corporate loans are secured. Their expected loss is £677k a year; without the collateral it would be £1,424k. Credit risk mitigation halves the loss on those loans. But collateral can lose value, a guarantor can fail, and a hedge can turn out not to cover the loss. Mitigation works only if it still works on the day the borrower defaults.

Core explanation

Protection that must hold on the worst day

Illustrative dataRiskAtoms Bank plc's credit book

One made-up lending book on one made-up date (31 December, year 0), in pounds: a ten-grade master scale, a one-year rating transition matrix, twelve invented corporate borrowers (£587m of exposure, expected loss £2.81m), retail portfolios and twenty past workout cases. The firms are invented and the numbers are round illustrative values, not anyone's data. The same book runs through every lesson in Module 3.3.

The asset types behind the collateral, the guarantee on Larkhollow, the CDS on Bramwick and the currency haircut are extras for this lesson; they do not change the book's figures.

Credit risk mitigation comes in two kinds (L2.6.06: Collateral and netting). Funded protection is an asset the bank can sell: collateral. Unfunded protection is someone else's promise to pay: a guarantee or a credit derivative. Netting, which matters most for derivatives, is in M3.4: Counterparty credit risk.

Collateral and haircuts

Collateral is valued today but sold, if ever, months after a default, often in a falling market. A haircut allows for that. The bank's haircuts, and what they leave:

Illustrative data Asset types are illustrative; values and haircuts are the book's.

Borrower	Collateral	Value	Haircut	After haircut	EAD	Exposure left
Thornvale Engineering Ltd	Plant and machinery	£30m	30%	£21.0m	£52.50m	£31.50m
Pellcourt Properties Ltd	Let commercial property	£180m	35%	£117.0m	£120.00m	£3.00m
Larkhollow Freight Ltd	Lorries and trailers	£18m	40%	£10.8m	£29.00m	£18.20m
Mirefield Care Homes Ltd	Care homes	£50m	35%	£32.5m	£44.25m	£11.75m
Vellacourt Hôtels SAS	Hotels in France	£46m	40%	£27.6m	£39.00m	£11.40m
Sallowmere Logistics GmbH	Warehouses	£28m	35%	£18.2m	£45.00m	£26.80m

Haircuts are larger where prices swing more, sales take longer or the market is thin: 40% on lorries, 30% on machinery that a specialist buyer might want. A currency mismatch adds another cut. Vellacourt Hôtels SAS's hotels are valued in euros; if they secure a sterling loan, the bank deducts 8% more points, the covered amount falls from £27.6m to £23.92m, LGD rises from 21.7% to 25.5%, and expected loss from £191.2k to £224.5k. Good collateral management also means regular revaluation, loan-to-value triggers, insurance on the assets, and a registered (perfected) charge, without which other creditors may get there first.

Guarantees

A guarantee moves the risk on the guaranteed part to the guarantor. The simplest treatment is substitution: that part is treated as a loan to the guarantor. Say an insurer at grade 3 (PD 0.14%) guarantees £12m of Larkhollow Freight Ltd's loan. The expected loss on that part falls from Larkhollow's risk to the insurer's, and the loan's total EL from £230,068 to £102,028.

Substitution is cautious: in fact the bank loses on the guaranteed part only if both fail (double default). With the one-factor model of L3.3.11: Unexpected loss and default correlation and an asset correlation of 0.20 between them, the chance of both defaulting in a year is 0.0119%, against 0.14% for the insurer alone. But that rests on the two being only loosely linked. If the insurer has written a lot of cover on haulage firms (correlation 0.6), it is 0.067%. And a guarantee from Larkhollow's own parent, as weak as Larkhollow and tied to it (correlation 0.9), fails with it 59% of the times Larkhollow defaults. That is wrong-way risk.

Credit default swaps

A credit default swap is a guarantee in derivative form. The bank buys 3-year protection on Bramwick Stores plc with a notional of £30m from a dealer at grade 3, paying 120bp a year (£360k). If Bramwick has a credit event, the dealer pays the notional minus the recovery value, set in an auction run under ISDA's rules; at a 40% recovery that is £18m. By substitution, the facility's expected loss falls from £386.5k to £252.8k a year, a saving of £133.7k, less than the premium. The premium also pays the seller for bearing unexpected loss and for market risk premia, which is why spreads exceed expected loss (L3.3.16: Market-implied default risk); the bank buys it to free capital and limits, not to save expected loss.

The limits

Sort each problem by the limit of mitigation it shows:

Sort itWhich limit is it?

A loan to a property developer is secured on shares of the developer itself.
The CDS ends after three years; the loan runs for five.
The insurer that sold the bank credit protection is itself downgraded and cannot post collateral.
The charge over a borrower's lorries was never registered, and the administrator rejects it.
The CDS references the borrower's bonds, but the bank's loan is secured and recovers much more.
A domestic bank's loans are guaranteed by its own government, which is in fiscal trouble.

Legal certainty is the quietest limit and the most basic. A guarantee has to be direct, explicit, irrevocable and unconditional to count fully, and a CDS pays only on the events its contract defines. Greece in 2012 showed both sides:

TimelineGreek CDS, 2012

1 / 4

October 2011

A voluntary exchange

A euro-area deal for Greece proposed that private bondholders exchange their bonds for new ones worth much less. As first proposed, the exchange was voluntary, and ISDA said that, subject to its Determinations Committee, it did not appear likely to trigger payments under CDS contracts.

The formal version

Collateral. With exposure $E$ , collateral value $C$ , haircut $H_C$ and currency haircut $H_{FX}$ , the exposure left after collateral is

E^{*} = \max\bigl(0,\ E - C\,(1 - H_C - H_{FX})\bigr)

Guarantee. Split the EAD into the part covered by collateral $C^{*}$ , the guaranteed part $G$ and the rest $R$ . With borrower PD $p_B$ and guarantor PD $p_G$ :

\begin{aligned} \text{EL}_{\text{subst}} &= p_B\,\text{LGD}_C\,C^{*} + p_G\,\text{LGD}_G\,G + p_B\,\text{LGD}_U\,R \\ \text{EL}_{\text{DD}} &= p_B\,\text{LGD}_C\,C^{*} + \Pr(B \text{ and } G \text{ default})\,\text{LGD}_G\,G + p_B\,\text{LGD}_U\,R \\ \Pr(B \text{ and } G) &= \int p_B(z)\,p_G(z)\,\varphi(z)\,dz \qquad \text{(one-factor model, L3.3.11)} \end{aligned}

Since $\Pr(B \text{ and } G) \le \min(p_B, p_G)$ , substitution is never less cautious than double default, but the joint probability climbs towards $\min(p_B, p_G)$ as the correlation rises.

CDS. On a credit event the protection buyer receives $N\,(1 - R_{\text{auction}})$ on notional $N$ , in exchange for the premium $s N$ a year until then.

Try it

Change the haircut on Larkhollow's lorries, add a guarantee and switch between substitution and double default. Then raise the correlation: the guarantee is worth less when the guarantor shares the borrower's fate.

Try itMitigate Larkhollow Freight's exposure

Haircut on the lorries (value £18m)40%

Amount guaranteed£12m

Guarantor's grade3 (PD 0.14%)

Asset correlation, guarantor and borrower0.20

Treatment of the guaranteed part

Covered by collateral (LGD 10%)£10.80m
Guaranteed£12.00m
Unsecured, unguaranteed (LGD 50%)£6.20m
EAD£29.00m

Expected loss£102,028

Without any mitigation£327,700

From the collateralised part£24,408

From the guaranteed part£7,560

From the uncovered part£70,060

Book's figure (lorries only)£230,068

Under substitution the correlation does not matter. Under double default, push the correlation towards 0.9 and watch the guarantee lose its value: guarantor and borrower then tend to fail together.

Worked example

Larkhollow Freight Ltd: lorries and a guarantee

Layer by layer

Step 1 of 5

1
The exposure
EAD £29m (£26m drawn plus 75% of £4m undrawn), grade 7, PD 2.26%, unsecured LGD 50%. With no mitigation: EL = 2.26% × 50% × £29m = £327,700.

Regulatory lens · looking ahead

Capital rules recognise mitigation only within strict limits: eligible collateral with supervisory or own haircuts, guarantees and credit derivatives through substitution, adjustments for maturity and currency mismatches, and minimum requirements for legal certainty and risk management. The detail is in M4.2: Credit risk capital. Collateral and netting for derivatives, and wrong-way risk in counterparty exposures, are in M3.4: Counterparty credit risk; CDS pricing and its spreads are in L3.3.16: Market-implied default risk.

Spark Atoms

Spark AtomThe protection seller that needed protection

By 2008 AIG had written credit default swaps on more than $500 billion of assets. When it was downgraded in September 2008, collateral calls on those swaps jumped, and on 16 September the Federal Reserve Bank of New York lent it $85 billion to keep it from failing. Protection is only as good as its seller.

Spark AtomSmall numbers, big fears

For months in 2011 and 2012 markets worried about what a Greek default would do to CDS sellers. When the credit event came, net protection outstanding on Greece was about $3.2 billion, and ISDA reported that the auction was successfully completed.

Key takeaways

Collateral counts after a haircut: E* = max(0, E − C(1 − H_C − H_FX)).
Mitigation halves the expected loss on the bank's six secured loans: £677k against £1,424k.
Guarantees: substitution gives the guaranteed part the guarantor's PD; double default needs both to fail.
A CDS pays par minus recovery on a credit event; its premium exceeds the expected loss it removes.
Mitigation fails through wrong-way risk, maturity and basis mismatches, the protection seller's own default and weak legal documentation.

Reaction

Check what stuck

Glossary

Credit risk mitigation: Credit risk mitigation: anything that reduces the loss a lender would suffer if a borrower defaults, such as collateral, guarantees, credit derivatives and netting.
Funded and unfunded protection: Protection where the lender holds an asset it can sell (collateral). Unfunded protection is a promise to pay by someone else (a guarantee, a CDS).
Haircut: A cut to the value of collateral, so that what is counted would still be there after a fall in price, the time to sell, costs and any currency mismatch.
Substitution: Treating the guaranteed part of a loan as an exposure to the guarantor: its PD (and LGD) replace the borrower's.
Double default: The guaranteed part is lost only if both the borrower and the guarantor default.
Credit default swap (CDS): Credit default swap: the protection buyer pays a regular premium; if the reference entity has a credit event, the seller pays the loss on par (par minus the recovery value).
Credit event: An event that triggers a CDS payout, as defined in the ISDA Credit Derivatives Definitions: bankruptcy, failure to pay and, in some contracts, restructuring, among others.
Wrong-way risk: When the protection or exposure gets worse just as the borrower gets worse: the guarantor, the collateral or the CDS seller is tied to the borrower.
Legal certainty: Confidence that the mitigation will hold up in court in every relevant country: valid documents, a perfected (registered) security interest, an enforceable guarantee.
Basis risk: The gap between the risk hedged and the hedge: a different obligation, maturity, currency or definition of default.

Deep Dives & Origins

Deep Dives

J. C. Hull, Options, Futures, and Other Derivatives, 11th ed., Pearson, 2021, the chapter on credit derivatives. Intermediate.
Basel Committee on Banking Supervision, Basel Framework, the standardised approach's chapter on credit risk mitigation (CRE22) and the IRB chapter on risk components (CRE32), BIS. Advanced.

Origins

ISDA, Greek Sovereign CDS: Credit Event Frequently Asked Questions, 9 March 2012.
I. Rajaratnam, Credit Default Swaps: The Vanilla Essence, Risk Books, 2022, chapter 11 “Credit event overview” and the chapters on bankruptcy, failure to pay, repudiation/moratorium, restructuring and governmental intervention.
Kellogg Insight, “What Went Wrong at AIG?”, Kellogg School of Management, Northwestern University, 2015, on R. McDonald and A. Paulson's research.

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