of Credit Derivatives
Derivatives: Market Info and awareness
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Enronitis has affected markets world-over, so that everything which is complicated looks dangerous. Complicated, as we said elsewhere, is a relative term. However, the financial media has reasons to be concerned about such developments, and of late, they have been writing no holds barred.
BBC of 26th Feb comes with a piece titled A Scandal waiting to happen [see it here]. Emma Clark wrote: "The ongoing furore over Enron's "aggressive" accounting, combined with a spate of corporate bankruptcies, has heightened sensitivity about more complex derivatives, known as credit derivatives. "
The article cites recent regulatory concerns of UK's financial regulator - see below. The risks of investing in instruments like synthetic CDOs which provide risk cover, often against a blind pool of credits, are not properly analysed and insurance companies in particular may not be assessing the risks they are underwriting. See, for instance, the Economist article cited below which says the process involves transfer of risks from those who know to those who don't.
On the other hand, credit derivative professionals point out that it is only the rapid growth in the business which is worrying the observers. The market is mostly standardised and there is very little room for confusion.
However, clearly enough, there is an increasing pressure on the credit derivatives market for increased regulation and increased disclosure.
According to a press release of XL Capital Ltd, its insurance subsidiary, XL Insurance (Bermuda)'s credit-default-swap-related dispute with Swiss Re Financial Products Corp. has been settled out of the Court. There was a lawsuit filed some months ago in a London court which the parties have decided to withdraw. We had covered this dispute on this site - see report here.
The dispute related to "reference entity" in a CDS transaction referenced to Armstrong World Industries. The dispute was whether the reference entity was the holding company or the operating unit, or both.
The swap was signed in 2000 and under its terms, Swiss Re was claiming default payments. The XL press release says: "As part of the settlement agreement, SRFP and XL Insurance (Bermuda) Ltd will keep the swap in place as well as amend and restate a written confirmation that they originally executed. They agreed to keep all other details of the agreement confidential."
With the collapse of Enron and bankruptcy of Kmart, two things are decisively happening to the credit derivatives market: a, the default swap premia are increasing across board and particularly for companies whose balance sheets are bit tricky, and b, smaller and regional banks have realised the worth of credit derivatives.
The market has turned extremely volatile as far as default premia go. That is, however, natural given the present state of flux and uncertainty surrounding even the best-known financial companies and conglomerates such as GE Capital and Tyco. However, an essential outcome of the volatility is that against the typical 5 year tenure for most CDS transactions, players are now looking for 1 year quotes.
As for interest by smaller and regional banks, most of them have not got into credit derivatives trades as for now, but many of them might have burnt their own fingers in one or more of the recent fallen angels and would have come to know that a Citibank avoided losses due to credit derivatives. So, the interest level is bound to go up. An article in Bank Loan Report of Feb 25 quotes market players saying confirming that they are getting dozens of enquiries every day from smaller banks.
Next time, you need to predict the bankruptcy of a company, you do not have to run Altman's Z-score: simply look at the way the default swaps on the company's name are quoting. It is either a case of the credit derivatives market being used as a premonition for impending bankruptcies: it appears that good 2 months before the actual news of the collapse of Enron was out, the default swaps market had already begun pricing it.
An article in Forbes of 4th March says that on Aug. 15, the day after Enron's chief Jeffrey Skilling abruptly resigned, the default swap price on Enron moved up 18%, though there was no impact on the stock prices. On that day, default swaps were priced 185 basis points By Oct. 25, the default swap price had soared to 9000 bps which essentially meant the protection seller would get 90% to guarantee a 100% repayment of Enron's debt. The article says that even at that price, it was a great deal buying protection. Several banks did buy protection.
Yet another example of the credit derivatives pricing efficiency, the cost of default swap on GE Capital has soared 3 times since early February this year. GE Capital is presently quoting somewhere around 34 bps which is like a AA rating, rather than a AAA.
It is not just David Clementi, who is talking of the possible legal issues in settlements on credit derivatives. Even the Financial Services Authority Chairman, Howard Davies who recently spoke of the contentious legal issues that may arise on credit derivatives trades.
While addressing the Euromoney Bond Investors Congress on 20th Feb., Chairman Davies presented a "cautionery catalogue" to bankers, which included legal risk. "Recent default events such as Enron, Railtrack, Swissair and Argentina have provided important tests for the growing use of credit derivatives. There have been concerns that significant defaults could expose flaws in the market’s underlying legal infrastructure – with disputes about the definition of a credit event, the terms of delivery obligations etc. "
"So far, in spite of one or two well publicised cases which remain to be resolved, I would say that the documentation has proved reasonably robust and sellers of credit protection are generally meeting their obligations. But I think we are all aware that there are imaginative deals out there in the market, where the legal basis has not so far been rigorously tested. This is not an area in which we the regulator can provide absolute certainty. Only the courts can do that. But we are always concerned to encourage firms to exercise the maximum due diligence they can, and subject the documentation to the most rigorous and sceptical analysis."
Links See David Clementi's comments here.
JP Morgan (JPM), which has been in various kinds of adverse news in the market due to its exposure to Enron and Argentina, has been more than a victium of the general fear and suspicion over financial sector's balance sheets. Default swap rates referenced to JPM's debt have gone up in the market. A report recently in Investment Dealers Digest of 18th Feb says that the default swaps are currently quoting around 80/90 bps for JPM. This suggests that though JPM is a AA-, the default swaps indicate the market has already discounted a possible downgrade.
After Enron and Argentina, JPM has been on a "negative outlook" but there has been no downgrade so far. However, the default swaps market has priced in a possible downgrade: Lehman, which is rated A is quoting at 65/70 bps should be an example.
Contrasted with the fact that in December, JPM was quoting at 30/37 bps, it is a precipitous decline in market acceptance of credit risk in JPM.
JPM is the largest dealer in credit derivatives in the USA.
In the backlash of Enron collapse, derivatives business continues to get brickbats. Christopher Whalen, writer and investment banker, writng for Barron's Online laments that Wall Street has forgotten the most basic lesson it should have learnt decades ago: distinction between gambling and investing. "LTCM, Enron and Allied Irish Banks head a growing list of speculative fiascoes that suggest Washington and Wall Street have eradicated the legal distinction between investing and gambling. Wall Street's best minds were Enron's inspiration and they will cause similar disasters in the future", writes the author.
The author apprehends that a number of large US banks might be dead men walking as their financials might be disguising risks and losses on derivative contracts. Part of these losses show up due to derivatives accounting standards, but derivative values, and more so, valuation under the accounting standards, is itself an extremely subjective and volatile issue.
The ending line of Christopher's piece is clear of his strong views against derivatives: "Enron was a derivative-trading company, the latest creation of Wall Street's gaming culture, and it surely won't be the last as long as we pretend investing and gambling are the same thing. There isn't anything immoral about speculating, but such risky activities must be voluntary, with informed consent. The SEC cannot protect investors before the fact any more than state gaming commissions can protect compulsive gamblers; they just clean up the mess and punish the obvious perpetrators. The sooner investors refocus on what is and is not investing, the less pain they will suffer from future scams", says the author.
If you step on a banana skin, there is a good chance to tumble. An autonomous body based on London called Centre for Study of Financial Innovation [CFSI] comes out with periodic reports on banking banana skins: areas where bankers feel shaky and slippery. These reports are based on surveys of bankers, regulators, etc. The year 2002 banana skins report was recently published, and it lists several banana skins. The top 10 are: 1. Credit risk; 2. macro economy; 3. equity markets; 4. complex financial instruments; 5. business continuation; 6. domestic regulation; 7. insurance; 8. emerging markets; 9. Banking over-capacity; 10. international regulation.
Credit derivatives are covered in complex financial instruments, and have come up to 4th position from 10th last year.
This is what the survey had to say about credit derivatives: "Credit derivatives drew a lot of comment. A regulator wrote: “One of the big tests this time round will be the ability of the credit derivatives market to handle ‘credit events’ - including the question what constitutes a credit event.” Others worried about the ability of these derivatives to transfer credit risk to inappropriate institutions like insurance companies or unregulated non-financial companies like Enron."
Further, it went on to say: "A senior investment banker feared that credit derivatives “may bring substantial dispute or litigation initiated by counterparties of (in economic terms) writers of credit insurance whose approach is quite different from that of the banks who are laying off risk in this new fast-growing market which has not yet been tested”. Chris Sutton of Logica saw derivatives as a way of “circumventing new regulations”. Other respondents highlighted the added risks from leverage."
Thanks to Enron, the environment for complex financial instruments has suddenly become adverse with journalists, analysts and shareholder lobby hitting hard such instruments as the reason for the present malaise. On one hand, off balance sheet funding and securitization are being questioned [see our securitization site for complete story as it develops], also under attack are credit derivatives and similar instruments of risk transfer.
An article in Economist [9th Feb 2002] hard hits risk transfer devices. It compares a credit risk protection seller as "a foolish driver who launches his car into a busy road on the say-so of his passenger, without looking both right and left himself."
The article says that some insurance companies and other investors are insuring bank loans, bonds and other corporate debt by devices generically called "credit risk transfer" which includes credit derivatives. According to the author, this is a transfer of risk from the better-informed to the worse-informed. The protection providers know little about the borrowers, sometimes not even their names and go solely on the basis of the rating reports. When some or all of the loans go bad, they are surprised and disappointed but all they can do is to write a loss.
While most regulators favour this development and see it as an efficient transfer of risk from the banking sector to the capital markets, others merely see this as risk building up elsewhere, without realisation and regulation at the receiving end. The article refers to the writings of David Rule of Bank of England, whom we have cited before on this site.
As the entire system is dependant on rating agencies, the article sees a danger. "Andre Perold, a professor at Harvard Business School, refers to a form of rating-agency arbitrage, whereby the formulae used by rating agencies will tend to give a better rating to assets put in special- purpose vehicles. And there is a danger, argues David Llewellyn of Loughborough University, that banks, rating agencies, insurers and even regulators may fall victim to a collective myopia that blinds them to the true risks of what is being packaged and distributed. He points to the sovereign syndicated loans of the 1970s, or the telecoms mania of only two years ago."
Though it is widely known to have substantial exposure to Enron, JP Morgan Chase, the world's most active players in credit derivatives business, is bullish about it. Couple of days ago, JPM Chase gathered some 800 of its clients in New York to teach them about credit derivatives.
JPM's Chairman and CEO William Harrison is reported [Financial Times 17 Jan] to have said at the meeting that thanks to credit derivatives, despite losses associated with the collapse of Enron and Argentina's debt default, JPM was better equipped than ever to manage risk.
"Credit derivatives are one of the must-haves for a global full-scale investment bank," he said. Referring to Enron episode being seen by many as a jolt to the fledgling market, Harrison said that rather than being seen as a problem, Enron's involvement in the credit derivatives market should instead be considered "a bright spot" and that he was not anticipating any problems in settlement of damages.
If credit derivatives needed an ordeal to prove their mettle, here is it. In a short time span of about a month, two credit events of an enormity never seen before have hit the credit derivatives markets, triggering substantial default claims.
An article in The Economist of 12th Jan says that "in the early days, just a few years ago, the joke among traders at investment banks was that the busiest person on a credit-derivatives desk was the lawyer". Although several billions of claims are supposed to have been triggered due to Enron, the limited number of investment banks that comprise the market have not yet reported any major legal wrangles. [See the story below, talking of a surety bond, which is not exactly a credit derivative]. A number of the credit default swaps in respect of Enron are funded swaps, covered by collateral under the control of SPVs, which will be utilised paying writing off investors' principal - see our story on default in synthetic securities during 2001 on our Securitization site.
In case of Argentina, however, the story is different. While the total amount of USD 10 billion worth default protection gets triggered with the interim President's decision to suspend payments, there are likely to be issues as to deliverable securities. The best part is that most credit derivative dealers have so far indicated intent to go by market consensus.
Certainty is being claimed as the most significant feature of credit derivatives, and it is to be seen whether Enron and Argentina survive this test.
Credit derivatives, guarantees, surety bonds - are all devices to lay off risk. Everything is fine between the parties as long as the risk does not hit. Exactly when the risk event happens, the lawyers take over.
There have been several disputes involving credit derivatives, which prompted the regulators (such as the Deputy Governor of Bank of England) to comment that they are not iron-clad. The insistence of the BIS to impose a residual risk for credit derivatives was also inspired by similar reasoning.
The latest dispute between JP Morgan and insurance companies may give one more reason for the regulators to doubt the protection risk mitigation devices such as surety bonds, credit derivatives, etc provide. The dispute involves Enron, whose dealings are anyway mired in controversy.
Financial Times of 15th Jan reports that JPM had entered into certain forward contracts with Enron whereby the latter sold on forward basis crude and gas to JPM. JPM paid for the same, and in order to cover itself for the credit risk involved, bought a surety bond from certain insurance companies for USD 965 million. With the bankruptcy of Enron, JPM claimed the money from the insurers which they balked, contending that the forward deal with Enron was not truly a purchase of commodities but a loan in disguise, and the insuers had not guaranteed a loan.
So, the true character of the forward contract with Enron would be in question when the issue goes to Court. Financial Times says that the issue will go to US Court today.
There are two likely issues emerging in the legal battle: when, whether the guarantor in a surety bond could plead recharacterisation of the original contract as a defence. In the context of credit derivatives, US Courts have ruled that the validity or character of the basic contract is not an isse in a derivative transaction which is a contract independent of the original - see our legal issues page here. However, a surety bond stands surely on a different footing.
Two, the character of the forward contract as a purchase or financial deal. The essential defining line between a forward contract and a disguised loan is the question of inherent intent. If the intent can be demonstrated as one of taking delivery of the stock, it surely is a commodity contract.
On this site, we will track the progress of this legal dispute. Stay in touch.
Your comments Do you have any comments on the use of credit derivatives, surety bonds for laying off credit risk? Do write them.
While there are many markets and investors who bear the burns of Enron's collapse, credit derivatives market had an active trader, and traded, in Enron. Total exposure to Enron via the credit derivative market has been estimated at as much as Dollars 6.3bn by Standard & Poor's. Apart from its participation in the market, Enron was also running website Enroncredit.com.
Enron's failure will have lot of indirect implications for the credit derivatives market as well. For example, Wall Street Journal recently carried comments which called for more regulation of the derivatives market as the derivatives trades of Enron are believed to have been partly responsible for the debacle. This had prompted strong and abrupt reaction from ISDA which blames Enron's practices, and not its derivatives trades, as the cause.
Credit derivatives make headway in Asia
Journal The Asset published a cover story [http://theassetonline.com] on its 28th December 2001 issue saying credit derivatives are already making a headway in Asia. What was little known a few years ago is already a hot product among investment bankers, treasury managers and high-finance practitioners. The article says that a regional hub for credit derivatives is emerging in Hong Kong and Singapore which are developing as extention for London and New York. The article says that market volume for Asian credit derivatives, sans Japan, would have already crossed USD 40 billion.
The story has quoted several credit derivatives practitioners in Hong Kong, Tokyo and Singapore, who have either already done trades, or are on the look out for trades. Much of the credit derivatives business is OTC business and is therefore not in the radar, but some of the deals are well a matter of public knowledge. For example the recent DBS Bank's credit default swap pursuant to a synthetic CLO transferred credit risk in SgD 2.8 billion worth of credits mostly domiciled in Singapore. More synthetic CLOs are being discussed. Given the fact that Asian finance professionals are very comfortable with credit derivatives technology, it should be easy to develop this business. The only issue is the painful memories of the 1997 crisis: should something like that hit Asian credits, the protection sellers will have to write substantial losses.
Credit derivatives have grown more in Europe than in the USA, and one prominent reason cited for this is that well-rated corporates are no more on bankers' balance sheets in the USA, where the percentage of bank funding for corporates has steadily come down, largely due to securitization. What is true for Europe is also true for Asia: most well-rated corporates still rely on bank funding as primary source of funding, and there are difficulties in true sale required for securitisation. So, the issue is, if there is a race between securitization and credit derivatives, the latter may easily be expected to win.
Links For more on credit derivatives in Asia, see our page here.
They are rivals in the marketplace, but when it comes to giving a pricing tool to the fledgling credit derivatives market, they can even join hands. In a unique move, Deutsche Bank, Goldman Sachs, JP Morgan Chase and RiskMetrics are jointly rolling out a new tool that derives credit spreads from measures of a company’s debt and its equity’s volatility. As per reports on website risk.net , the tool is based on the Merton model, which underlies KMV’s credit risk model and is one of the factors used by Moody’s Risk Management Services’ RiskCalc product.
Rating agency Fitch recently came out with a report that notes the fast growing market for synthetic CDOs. At the back of most of these synthetic CDOs lie portfolio CDS deals. Most of these have been deals referenced to a static portfolio of investment grade credits. Going forward the rating agency also expects growing volumes of actively managed portfolio CDS.
This increasing market for portfolio CDS deals is remarkable in view of the steep growth in defaulted bonds. Particularly notable in this scenario is the share of "fallen angels", that is, companies which have suffered a sharp fall in their ratings over last one year. The list of fallen angels got the latest and the hottest addition recently - Enron, which was one of the most common names traded in the CDS market.
The report analyses several risks in portfolio CDS transactions:
Full text of the report is available at this link on http://www.fitchratings.com
Credit derivatives markets have faced the blows of the Asian crisis in 1997 and the Russian crisis in 1997-98, but have been growing singularly over the last 3 years or so. Enron's debacle may prove tough for the fledgling market in credit derivative contracts. Enron was a leading player in the credit derivatives market, both as a buyer of protection and a seller. And Enron was also one of the most frequently traded reference obligation in credit default swap transactions. Hence there were transactions with Enron, and transactions by Enron, and transactions with reference to Enron.
Enron filed for bankruptcy on 3rd December.
At the same time, Enron saga will also bring the credit derivatives market into spotlight, particularly for the European banks, some of which had sought credit protection for investments in Enron bonds.
JP Morgan,one of the leading players in the US credit derivatives market, had admitted an exposure of some USD 500 million on Enron although this is supposed to include several other unsecured commitments of Enron. Citibank is another name in the market with substantial exposure to Enron. Swaps Monitor estimated the total derivatives liabilities of Enron to be about USD 18.7 billion.
Rating agency Standard and Poor's has estimated losses of some USD 3.3 billion in credit derivatives transactions. Credit derivatives transactions apart, CDOs are are also likely to suffer substantially. Monday, S&P downgraded 5 synthetic CDOs where Enron was a reference debt. Enron itself had issued credit linked notes.
Railtrack, the UK railway utility filed for administration recently. The event caused considerable jitters among the protection sellers in the CDS market as Railtrack was one name whose credit default swap was very actively traded.
A story in Financial Times of 11th Oct. says that there are no doubts as to the fact that a credit event as per the default swap has been triggered, and the payments are therefore due to the protection buyers. Unlike some of the earlier examples of restructuring or mergers, this one is a clean case and protection sellers will be bound to pay up.
Given the fact that a number of protection sellers, particularly the insurance companies, were coming into the credit derivatives market for yield enhancement, the huge bankruptcy of Railtrack is surely not a very happy event.
Though the work on a revised capital adequacy framework is still on, a September update from the Bank for International Settlements [BIS] says that the BIS has decided to remove the residual risk factor in case of credit derivatives. This factor, called w factor, as earlier proposed meant credit derivatives could give risk protection only to the extent of 85% and the balance 15% risk depended on the risk weightage for the underlying transaction.
The w factor was based on what was referred to as "residual risk" in risk mitigation devices such as credit derivatives. The underlying philosophy was that much as an entity might try to hedge against the risk in the underlying asset, there is a possibility that the risk of the underlying asset might still hit the entity due to legal uncertainties, and such other factors.
The Sept 2001 update from the BIS says: "In order to treat such risks [residual risks], the Committee proposed in January the application in certain cases of a so-called w-factor for both collateral and guarantees/credit derivatives. The Committee has received extensive comments on how such risks could be treated within a capital adequacy framework and the Capital Group has been continuing its work on this issue. After further consideration, the Capital Group believes the most effective way forward would be to treat this residual risk under the proposed framework's second pillar, i.e. the supervisory review process, rather than using the w-factor under the first pillar, i.e. minimum capital requirements. "
The credit derivatives community, led by the ISDA, was strongly opposed to the w factor and has expressed considerable happiness at its deletion.
Links For the BIS original proposals, see our article here.
The Sept. 11 2001 events in New York, and their aftermath have shaken the equity and bond markets all over the World, but credit derivatives continues to have a strong year. Analysts expect credit derivatives volumes to soar past expectations as turmoil in equity and bond markets is exactly what leads to more risk, and therefore, more people seeking more protection. There are increased global concerns towards credit risk.
Financial Times on 27th Sept carried a survey on derivatives industry. An article by Rebecca Bream says: "In the past 12 months credit risk has moved from being a secondary consideration for most companies and fund managers to an issue at the top of their agenda."
There is yet another reason for which there might be an increased appetite from the seller of protection: the declining interest rate regime. The successive bank rate cuts by the Fed have brought them down to the least level in past 20 years; in this scenario, it is evident that portfolio managers will look to investments for yield enhancement. Synthetic securitisations with in-built credit derivative options allow yield to be leveraged several times.
So we might be heading for another record year of unstinted growth.
For the first time in last 30 years, an Indian insurer has unveiled plans to provide credit risk protection, by an insurance cover albeit. However, this surely marks a maturity that will usher in a market for credit risks, and eventually, a template for credit derivatives trade.
New India Assurance, a nationalised insurance company, has proposed a Business Credit Shield, which will be unveiled by the Finance Minister on Sept 12. This will provide insurance for a credit of Rs. 100 million or above.
The insurer is also in parleys with the German credit insurer Gerling. Gerling, it may be noted, has also developed expertise in credit risk securitization and has done at least one such deal.
Indian insurance industry was opened up to competition recently. India presently allowed not more than 25% equity by foreign partners in an Indian insurance outfit, which is subject to regulation by the Insurance Regulatory Authority.
The IT boom and the boom in credit derivatives combined to instil an unbounded enthusiasm in young professionals to put up websites that were supposed to be web-based trading platforms in credit derivatives. However, they have not been able to attract a lot of business from the physical world to the cyberspace.
A report on Reuters quotes a survey conducted by credittrade.com which says that it will take two to five years for a migration of credit derivatives trading to the Web. The survey reveals that while traders may be embracing the speed and accuracy of pricing on the Internet, the vast majority still insist on closing deals over the telephone. They have even confirmed that even where deals are struck over the Net, they are later confirmed telephonically.
One of the website owners said: "The screen-based model failed miserably -- I can't see it happening for the foreseeable future."
According to a recent amendment in Building society rules in the UK, societies have been permitted to add credit risk to the list of factors for which they can use derivative contracts. To put it simple, building socities in UK are now permitted to enter into credit derivatives. The change follows a proposal put to the Treasury by the Building Societies Commission.
Accordingly the Building Societies (Restricted Transactions) Order 2001, which comes into force on 1 July 2001, creates an additional factor to be taken into account when considering whether building societies or their subsidiaries are permitted to enter into transactions involving derivatives.
The explanatory statement to the new rule says as follows: "Section 9A(4)(b) of the Building Societies Act 1986 permits a building society or a subsidiary undertaking of a building society to enter into a transaction involving derivative investments, notwithstanding the prohibition on such transactions in section 9A(1)(c), if it is entered into for the purpose of limiting the extent to which the society, or a connected undertaking of the society, will be affected by changes in certain factors. This Order varies section 9A(4)(b) by adding as a factor the ability or willingness of one or more persons to pay or repay a sum or sums owing at law or in equity to the society or a connected undertaking of the society". Ability or willingness to pay is clearly a credit risk and building societies can now hedge against credit risk by entering into derivative transactions.
Office of the Comptroller of Currency (OCC), the US banking agency which monitors and supervises US banks, has reported a dip in credit derivatives volume in Q 1, 2001. The OCC monitors credit derivatives held by US banks. This is inspite of the fact that derivatives volume in general has increased during the quarter, inspite of FAS 133.
There was a fall of USD 74 billion in credit derivatives volume during the first quarter of 2001. The volume at the end of Q1 stood at USD 352 billion. The OCC regards this as unusual, in view of the declining global credit quality in all major regions during the first quarter, which is where the need for such derivatives is more intensely felt. This is only for the second time after 1997 that there has been a decline in credit derivatives volume.
The OCC ascribes the decline to concern about contracts used by banks to protect them against credit defaults. Institutions were apparently uncertain about whether loan restructuring constituted a default. As reported on this site before, the dispute relating to restructuring as a credit event was resolved in April this year - so it is quite likely that the volume may rise in Q2.
Link For more on the US credit derivatives market, see our page here.