Counterparty Risk

What is “Counterparty Risk”?

Counterparty risk refers to the likelihood that a party to or signatory of a financial contract may fail to meet their contractual obligations. Counterparty risk can exist in almost any type of financial activity, including trading, investing, or credit transactions.

Understanding Counterparty Risk

In financial transactions, lenders and investors are exposed to default risk. Also known as counterparty risk, this is the likelihood that a party to a financial contract will fail to meet obligations or make timely payments.  Each party to a transaction must evaluate the counterparty risk before signing a contract.

Until the 2008 global financial crisis, financial institutions tended to overlook counterparty risk. However, the severe blow to the global financial system and resulting fallout saw market participants significantly increase their focus on counterparty risk. The financial services industry undertook stringent measures to more accurately assess and manage this risk.

High-risk transactions involving one party carrying a higher risk of default often include a premium to the contract value to compensate the other party for the risk. This premium is called the risk premium. There are a number of factors that contribute to determining the risk profile of a party to a transaction. These may include credit score, existing debt capacity, existing credit facilities, and the availability and type of collateral.

Credit reports can be used in business, commercial, and retail financial transactions to determine the risk of default. Borrowers’ credit scores are often analyzed to assess the level of risk to the creditor. Finance companies, credit card companies, and banks typically use credit scores to inform their lending decisions, as they offer insight into the level of counterparty risk involved in a transaction.

A credit score assigns a numerical value to an individual’s or company’s creditworthiness based on a number of variables. A personal credit score can range from 300 to 850, with a higher score indicating a lower likelihood of default. Credit scores are categorized as follows:

• Excellent: 750 and above
• Good: 700 to 749
• Fair: 650 to 699
• Poor: 550 to 649
• Bad: 550 and below

There are numerous factors that can affect an individual’s credit score. Payment history, total debt outstanding, age of accounts, and credit utilization, or the percentage of total available credit in use, all contribute to the credit score.  Lenders use credit scores to assess the counterparty risk attached to a potential borrower. Borrowers with excellent credit scores are considered to carry little counterparty risk, while borrowers with scores of 550 and below are considered high risk.

Creditors charge higher interest rates, or risk premiums, to borrowers with low credit scores to compensate for the risk of default. For instance, credit card companies can charge borrowers with low credit scores rates of 20% annually or more.  Borrowers with high credit scores receive preferential interest rates. Credit card companies impose a “penalty rate” when a cardholder exceeds their credit limit or fails to make timely payments. Delinquencies of  60 days or more can push the annual rate to more than 29%.

Securities transactions also carry counterparty risk. Credit rating agencies such as Moody’s, Standard & Poor’s, and Fitch apply credit ratings to bonds ranging from AAA to junk bond status, and these ratings convey the level of counterparty risk to lenders. Bonds with lower ratings pay higher yields. Investment-grade bonds with very low counterparty risk carry lower coupon rates.

High yield bonds, also known as junk bonds, pay high coupon rates to compensate investors for the higher level of default risk. However, investment-grade bonds with low counterparty risk have lower coupon rates given the likelihood that the issuer will meet its financial obligations. Government bonds are offered at lower rates than corporate bonds because governments have a significantly lower risk of default. Government bond rates represent the risk-free rate in many financial calculations.

Example of Counterparty Risk

When counterparty risk is not properly assessed and one party defaults, the resulting effects can have far-reaching consequences. The 2008 global financial crisis was largely due to widespread defaults on subprime mortgages.

Mortgages were securitized into collateralized debt obligations (CDO) and these instruments, backed by the underlying assets, were sold to investors. Many of these CDOs included subprime and low-quality mortgages but received the same high ratings as corporate debt. These deceptively high ratings attracted institutional investments. Many borrowers were offered “NINJA” loans, or “no income, no job, and no assets.” Such borrowers presented significant counterparty risk and eventually defaulted when house prices dropped. This led to massive losses for investors, banks, and reinsurers. Credit rating agencies were heavily criticized for the collapse because they failed to properly identify and assign accurate credit ratings to CDOs that incorporated low-quality mortgages.

Conclusion

Counterparty risk is widely present in financial markets and is experienced by every investor, both large and small. Investors in bonds take on counterparty risk, especially when investing in corporate bonds. Credit card companies bear counterparty risk when offering credit cards to individual borrowers. Any lender or any party to a financial contract must ensure that they accurately assess counterparty risk before entering into a transaction.

Below is a multiple-choice question to test your knowledge. Please download the Excel spreadsheet attached for a complete explanation of the answer.