VIEWPOINT – Credit Default Swaps: Let The Games Begin
Dow Jones Daily Bankruptcy Review January 31, 2007
The enormous growth of the credit default swap (“CDS”) market has been well documented. From notional principal outstanding of a little over $2 trillion in 2002 to $26 trillion by midyear ’06 (a more than 50% increase from year-end 2005 alone), the explosion of CDS activity is unlikely to halt soon. The obvious benefits to lenders and investors who want to precisely (they hope) tune their credit exposures and the just-too-good-to-be true fee opportunity jumped on by many protection-sellers is sure to keep this market humming. Interestingly, while credit default swaps are purported to reduce the risk of the economy – by diversifying risk among many players – the untrammeled expansion of CDS products may have actually injected risk and instability into the system while adding new uncertainties to the restructuring process of CDS credits when they become distressed.
By way of background, a credit default swap is all about protection. Often, the protection buyer is a bank, which enters into a CDS to transfer the credit risk of a loan to a 3rd party who essentially insures the bank against the occurrence of a defined credit event – which might be a payment default, a bankruptcy or some form of a restructuring. For that protection, the bank pays a “premium” until the CDS expires; if a credit event occurs in the interim, the protection seller delivers compensation for the face value of the obligation to the buyer. In the case of physical settlement, the protection buyer delivers the defaulted (or comparable) paper to the seller in return for a par payment. If the CDS terminates through a cash settlement, the seller simply makes a net payment to the buyer.
The current CDS market has expanded well beyond that simple use, however. Today, many counterparties enter into a CDS simply to take a view on a credit – going long or short via their position in a CDS with no actual involvement with the underlying security. And there are many, many ways to play the credit game as the CDS has developed well beyond a simple two-party contract to include such popular variants as synthetic CDOs, which pool swaps on numerous bonds, and CDS indices. So popular are CDS instruments these days that, when Delphi defaulted, it emerged that there was as much as $28 billion of credit derivative exposure against only $5 billion of bonds and loans. Delphi bond prices went haywire as investors scurried around for paper to deliver as required under their swap obligations. Ultimately, ISDA, the industry trade group, stepped in to manage a conversion of certain CDS transactions from physical to cash settlement and reduce the demand for Delphi paper – crisis averted.
Perhaps the Delphi situation was nothing more than a growing pain, but one cannot say the same about the potentially more systemic impact that CDSs have on credit extension. Look at banking for example. Thanks to credit default swaps, bankers can originate loans with abandon. They reap all the fees from origination and then, by selling off their credit exposure, they can free up regulatory capital to do the same thing again and again. Bond issuances are fueled by the same sorts of considerations.
Is it any wonder, then, that we’ve seen such remarkable increases in leverage ratios and decline in debt issuance credit quality over the past couple of years? Tellingly, according to Fitch, sub-investment grade CDS activity was nearly 1/3 of the business in 2005 vs. less than 10% in 2002.
Of similar concern to market observers is the potentially negative effect CDS activity has had on credit monitoring. It is hard to believe that banks are really investing the same effort to keep tabs on a company’s performance when they’re not at risk for it anymore. And it is equally unlikely that those who are long the credit risk -- insurance companies, pension funds, hedge funds -- are stepping into the breach. Not only do they generally not have the expertise or manpower to perform bank-like credit monitoring functions, even if they did, it is improbable that they have the information or standing with the borrower (with whom they have no relationship) to do so. More leverage and less monitoring is sure to result in heightened default activity down the road.
While that last sentence may bring smiles to the faces of those in the restructuring business, professionals may soon find out that the CDS overlay will add more than a few complications to workout situations. In the good old days, creditors were often willing to accept a somewhat painful debt renegotiation rather than face a protracted workout or bankruptcy which might be less advantageous to their ultimate recovery. But a creditor who’s hived off his credit risk has little incentive to participate in a restructuring, particularly one which might vitiate his credit protection. In the CDS world, lenders and bondholders might even be happy to force a credit event rather than work with the borrower to avoid one. Poor Tower Automotive saw itself pushed into bankruptcy by bond-owning hedge funds which refused to grant it concessions needed to bring in new money.
Why? Because, it was rumored, the hedgies were seeking to make their real money from short positions in Tower stock. Such a strategy would be extremely easy to emulate using the CDS market. With creditor intentions murkier and more dubious than in the past, future pre-bankruptcy workout discussions will often prove futile.
Of course, life won’t get any easier after a credit event either. Thanks to the shuffling generated by CDS settlements, figuring out who’s a creditor and who’s not could well become a nightmare. Protection buyers who are party to physical settlement swaps will need to find paper to deliver to their counterparties which, as was seen in Delphi, could get a little tricky. Many CDS participants may even be running around trying to figure out exactly who their counterparty is since, pre-2006, it was fairly common practice to sell a CDS position without notifying the other side. And then there’s the hedge fund factor. CDS contracts are unfunded instruments – a cheap source of premium profits which can be entered into virtually without constraint, that is, until the party ends – and there may be any number of hedge fund counterparties who won’t be able to make good on their promises – sticking the protection buyers on the other side with the paper and credit they thought they’d be rid of.
Ah yes, thanks to the CDS market, restructuring is going to get a whole lot more interesting.