of Credit Derivatives
Derivatives: Market Info and awareness
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The Financial Services Authority (FSA) UK has once again highlighted credit derivatives risks. FSA has earlier brouht a discussion paper on the cross-sector risk transfer inherent in credit derivatives. Eariler, David Rules articles in Bank of England publications have also credit derivatives risks.
The instant reiterations comes as a part of the FSA publication called Financial Risk Outlook 2004 published recently.
The report says that credit derivatives are essentially instruments for transfer of credit risk, but the ease with which risks may be transferred gives rise to possibilities of concentration of such risk. The write up once again highlights the net risk transfer to the insurance sector, which was supported by the Fitch publication of Sept 2003 Global Credit Derivatives.
The report also laments that though credit derivative positions being held as trading assets are required to be marked to market on daily basis, there are no reliable methods for marking to market especially in case of portfolio derivatives and complex structured finance deals. The report says that the FSA is reviewing the valuation practices.
Speculative trades on forthcoming bond issues can also influence the price of bonds, says the report.
Bank of America, KBC Financial Products and Bank One are the latest to join 11 global dealers in iBoxx credit default swap index, thereby making it one of the popular platforms for trading in default swaps. iBox runs along with the Dow Jones TRAC-X. These two indices have quickly become benchmarks for how overall credit markets perform, and traders feel that with the entry of 3 new entrants, iBoxx has scored a point over TRAC-X.
TRAC-X was originally promoted by JPMC and Morga Stanley. The iBoxx consortium, which includes Citigroup, Deutsche Bank and Goldman Sachs, was launched last October after dealers were unhappy over the way JP Morgan Chase and Morgan Stanley selected the 100 investment-grade companies to be included in its main index.
The iBoxx consortium collectively chooses the 125 companies included
each time the main CDX.NA.IG is reset. In addition, the iBoxx group also
quickly launched an array of new alternatives, including indexes of various
Alan Greenspan, the Chairman of the Federal Reserve System in the USA, has once again applauded credit derivatives. On Jan 13, Greenspan was answering questions after his lecture in Berlin.
The greatly extended use of credit derivatives doesn't threaten the stability of the global financial system, Greenspan said, in reply to a question. "On the contrary, credit derivatives have helped to defuse financial crises," he said.
For example, he noted that the global telecommunications industry previously incurred more than $1 trillion worth of debt and much of that debt went into default. However, since much of the risk had been transferred to holders of financial derivatives, the use of those instruments "prevented a collapse in the banking industry."
Derivatives transferred the risk to insurers, reinsurers, pension funds, and others more willing to hold it. "Not one bank got one into trouble," Greenspan said.
Greenspan has applauded credit derivatives in the past, which Warren Buffet has attacked as "weapons of mass destruction". See our index page for some of these quotes.
The International Accounting standard on accounting for derivatives and financial instruments, IAS 39, that was recently revised and replaced by a new version requires embedded credit derivatives to be separated and accounted for separately from host debt instruments. Essentially, this is continuity for credit linked notes and synthetic CDO investments, but this clarification is now a part of the standard itself.
IAS 39 deals with accounting for derivatives as also other financial instruments. If there is a derivative embedded into any other non-derivative contract or instrument, it is called an embedded derivative, and requires splitting and separate accounting if certain conditions are satisfied. In context of credit derivatives, investment in a credit linked note or any other interest-bearing fully funded credit derivative will fall under the definition of embedded derivatives requiring splitting.
There was a similar guidance earlier too from the derivatives implementation group. However, now this is a part of the standard itself.
There is also a continuity as far as the difference between credit default swaps and guarantees is concerned. A financial guarantee contract is exempt from the scope of the standard if it is a contract to reimburse the creditor for the latter's losses. This is not true for a credit default swap.
Links For more on accounting for credit derivatives, see our page here.
Vinod Kothari comments: Logically, there is no basis for distinguishing between credit linked notes, asset backed securities and traditional debt instruments. A credit linked note bears the risk of a reference portfolio, which is true for an asset backed security as well - the only difference being that in case of the fomer, the reference portfolio is merely a reference, and not a part of the asset pool of the issuer. However, from viewpoint of risk - there is no basic difference between asset backed securities and CLNs - both will default if the assets or reference assets defaults. That is also the case for traditional debt instruments.
Splitting of a credit derivative from a CLN would require identification of the premium for the embedded swap - which is never easy to decipher. There are increasing number of hybrid CDOs where the cash assets of the CDO also carry risk - therefore, segregation of the premium relating to risk of the cash and synthetic asset pool is never easy.
The Singapore Exchange Ltd., Southeast Asia's biggest bourse, has recently concluded an agreement with Dow Jones Indexes to list credit derivatives. The memorandum of understanding with the index provider covers the listing of futures based on its TRAC-X indexes of credit derivatives.
TRAC- X is a credit derivatives index managed by Dow Jones. Dow Jones is known all over the world for its U.S. Dow Jones industrial average and European STOXX indexes. TRAC-X was initiated by JP Morgan Chase and Morgan Stanley to allow broad-based trades in credit default swaps.
Singapore is one of the most active credit derivatives centres in Asia and the Pacific and closely mirrors activity and interest in London market.
Some USD 150 billion worth trades linked to TRAC-X have been reported.
The burgeoning demand for synthetic CDOs has created a new scope for arbitrage in the credit default swaps market - extension trades.
Most of the synthetic CDOs sell protection for 5 years or less. Result: there is a general tighening of spreads for the short-term horizon. On the other hand, the spreads for 10 years are fairly high, leading to a very steep spread curve. This is what creates the extension trade market where you might make a profit by buying protection for a short term and selling protection for a longer term. There is obviously a risk that this trade implies as the default probabilities are substantially higher, but the spread pick-up is understandably higher than the risk inherent, primarily due to mispricing of the spreads for the shorter terms.
A news report on Reuters quoting a Citibanks source says that market practitioners still see scope for further tightening of short term spreads, as CDO managers on default-adjusted basis still find the spreads attractive enough to build CDO portfolios.
The credit derivatives market today has a substantial participation from
hedge funds. The report wonders about the potential fallout in the broader
credit market if many of them stampede in the opposite direction at the
same time as hedge funds are prone to do. Last year, many hedge funds
started the year short-selling credit, only to have a change of heart
and help propel the broader credit market rally.
The burst in synthetic collateralized debt obligation (CDO) and credit derivatives activity in Asia's structured finance market in the past year is a clear indication that Asian banks and investors are becoming increasingly aware of the untapped potential for such transactions, says Standard and Poor's. The market is clearly realising numerous benefits of the synthetics technology such as credit hedging, balance sheet management, and the ability to exploit credit arbitrage opportunities.
Among the transactions recently completed in Asia is Merlion CDO from DBS Bank/ JP Morgan. This is a repackaging deal where protection sold with reference to 100 reference entities is repackaged and transferred to capital market investors. The equity investors in the deal gain by way of arbitrage profits.
A remarkable feature of Asian synthetic CDO activity is that the banks are not essentially looking for capital relief but for arbitrage profits. Asian banks are investors, or are looking to reap additional group synergies and arbitrage profits by sponsoring and managing synthetic CDOs. Synthetic CDOs offer Asian investors diversification and fit well with the investment needs of very liquid banks, insurance companies, and fund management companies, which may not be heavily invested in U.S.-dollar assets. CDOs offer a means to further diversify from asset-backed investments.
The global market for credit derivatives will continue to grow at its recent stunning pace, as the exotic hedging instrument gains more popularity in young and underdeveloped markets such as Asia, says Robert Pickel, executive director and chief officer of International Swaps and Derivatives Association. Pickel draws his optimism from the history of interest rate swaps and currency options, the dominant and more mature components of the entire derivatives market, as well as rising investor awareness of the product. Picket said this in an interview to Dow Jones Newswire.
According to Pickel, the experience with interest rate swaps and exchange rate based OTC products should be repeated in case of credit derivatives as well. The period of initial hesitation is over; most infirmities have been resolved. The market is now slated for growth at annual rates of 40% to 50%.
In case of markets like Asia, credit derivatives have still not made much of a headway but recent deals in Singapore and Hong Kong exhibit increasing acceptability of credit derivatives deals by investment banks.
The BIS annual report dated June 30, 2003 had, perhaps for the first time, a comprehensive discussion on credit derivatives.
While talking of the developments in the credit markets, Chapter 6 of the report ascribes to credit derivatives the role of causing some structural changes in the credit markets. The use of credit default models has brought about greater synthesis among the equity markets and credit markets, says the report. "Just as financial institutions use quantitative models to manage their interest rate risk, models are now being developed to do the same for credit risk....Market participants typically use equity volatility as the key variable for estimating asset volatility, thereby introducing another channel for feedback from equity to credit markets." This development, according to the report, also brings significant vulnerabilities in the market.
Chapter 7 on the financial markets talks of an inherent vulnerability of the credit derivatives markets where the protection buyers, mostly originators of credit, have insider information about the risk they transfer, and therefore, a possible unfair advantage.
Talking of the participation of insurance companies as net protection sellers, the report says that entry of players from outside the banking world into banking risks poses unique problems for the regulators since regulatory systems were devised from the viewpoint of specialised institutions. "The involvement of the insurance sector in the provision of credit risk protection through credit derivatives is a case in point. These instruments straddle the investment and underwriting activities of the firms, which are conventionally managed separately."
An article by Bill Shepherd in Investment Dealers Digest 9th June 2003 goes into the oft-repeated theme that credit derivatives are not so much of a risk-protector as is being trumpeted; instead, they might be masking a risk. Criticising credit derivatives is currently in fashion, and the authors joins the club.
Citing practitioners, the article says that banks have not saved anything more than USD 1 billion by using credit derivatives, while the total volume of credit derivatives is running close to USD 2 trillion now. Common sense numbers suggest that much more than USD 1 billion might have been paid by way of premia on these derivatives contracts.
The author says that "enthusiasm for credit derivatives may ease this year, as credit conditions improve and fears of default subside. Bids for derivatives to hedge the latest convertible bond underwritings, for instance, have declined sharply. If growth slows, forecasts by the British Bankers Association, which expects the global market for credit derivatives to hit $4.8 trillion by 2004, may prove too rosy".
A working group of the Bank for International Settlement that recently put together a report on credit risk transfer devices has expressed dissatisfaction about the disclosures made by risk takers. While changes in the risk profile of the protection sellers are extremely significant, proper and adequate disclosures are not being made. These comments are based on studies of financial statements of 30 major credit derivatives players.
Although most banks disclosed at least some quantitative data, only nine provided some information about the amount of credit risk shed by CRT, and even fewer (six) gave information on risk taken on by CRT. Three banks disclosed their total amount of CRT activity. Some information about the types of credit exposures for which CRT is employed were provided by 12 banks, but few institutions disclosed breakdowns of CRT activity by type of credit exposure.
The report also says that the quality of disclosure on securitisation was better than that in case of credit derivatives.
A number of banks surveyed were involved in CRT as intermediaries. While two banks disclosed some information about their intermediation activity, only one provided comprehensive data about it.
The disclosures are even worse in case of insurance companies. The Working Group reviewed the annual reports of nine insurance firms from three countries. Of these, five were multiline insurance firms, three were monoline insurers, and one was a reinsurance firm. Most of the institutions disclosed some information about CRT activity, but none provided information about how CRT affected their overall credit risk profiles.
Stressing on the need for disclosure, the working group recommends: "Since CRT can have a material impact on institutions’ risk profiles, it seems important that the effect should be properly captured by disclosure. Adequate disclosure is all the more important because unfunded instruments such as CDSs, like other derivatives, can be used to build up leverage."
Links For our page on accounting for credit derivatives, see here.
The Office of Controller of Currency has published the Q1, 2003 data about OTC derivatives. The scenario of concentration in the credit derivatives market still remains largely the same as it was 2 years ago, though, in the meantime, the volume has more than doubled.
Several players with insignificant holdings have now become notable players in the credit derivatives market, yet, the larger ones such as JPM and Citibank still retain a very significant share of the total market.
For the latest market data, see our page here.
J.P. Morgan Securities, the investment banking arm of J.P. Morgan Chase haslaunched an index tracking the performance of emerging market credit in the booming credit derivatives market. The index, called the EMDI (Emerging Market Derivative Index), follows the credit default swap spreads on 19 of the 31 countries in J.P. Morgan's widely followed index of emerging market sovereign bond spreads over benchmark U.S. Treasuries.
The countries in the EMDI include most of the biggest emerging market bond issuers, with the biggest index weighting going to Mexico, Russia, Brazil, Malaysia and South Korea respectively.
If one were to compare the EMDI with the EMBI - the cash equivalent of the emerging market index, the EMDI stood at 435 basis points on the first day of trade on 43 bps higher than the EMBI.
Iindex-based credit derivatives trades are likely to become more common in time.
He is prepared to ignore or counter Warren Buffet, and is a strong believer in the virtue of credit derivatives. Federal Reserve Chairman Alan Greenspan's views on credit derivatives are not unknown - he has backed them several times. On 9th May, Greenspan satellite-delivered a prepared key note address hosted by the Chicago Fed and praised credit derivatives again, but adding a note of caution as to the over-concentration of the market with just a few dealers.
He said he did "see the benefits of derivatives exceeding the costs, do not deny that their use poses significant risk-management challenges. But we see ample evidence that the risks are manageable in principle and generally have been managed quite effectively in practice, at least to date. Indeed, credit losses on derivatives have occurred at a rate that is a small fraction, for example, of the loss rate on commercial and industrial loans. Market discipline in the largely unregulated derivatives markets has provided strong incentives for effective risk management and has the potential to be even more effective in the future."
Striking the caution-note, he said: "I do not wish to suggest, however, that I am entirely sanguine with respect to the risks associated with derivatives. One development that gives me and others some pause is the decline in the number of major derivatives dealers and its potential implications for market liquidity and for concentration of counterparty credit risks. I also fear that the potential contribution of market discipline to stability in the derivatives markets is not being fully realized because, in our laudable efforts to improve public disclosure, we too often appear to be mistaking more extensive disclosure for greater transparency." It is a well known fact that about 65% of the credit derivatives market is controlled by a single player, and that the top 20 US banks would control something like 98% of the market. To Greenspan, "When concentration reaches these kinds of levels, market participants need to consider the implications of exit by one or more leading dealers. Such an event could adversely affect the liquidity of types of derivatives that market participants rely upon for managing the risks of their core business functions. Exit could be voluntary. In particular, losses incurred in making markets could lead a dealer to conclude that the returns from market-making are not commensurate with the risks. Alternatively, downgrades of a dealer's credit rating could force the dealer to exit. Counterparties in the OTC derivatives market are quite concerned about the potential credit risks inherent in such contracts and generally are unwilling to transact with dealers unless their credit rating is A or higher."
Links For comments of Warren Buffet, and others, browse the news items on this site or use search.
The BIS has come out with a 3rd, and likely, the last of the consultative papers on Basle II. This was issued on 29th April and has a 90 days comment period. It is expected to be finalised by the end of 2003, and slated for implementation by end 2006.
In relation to credit derivatives, the CP3 makes several significant changes. For one, restructuring has been dropped as a credit event requiring coverage, but only in certain circumstances: that is, where the protection buyer has a contractual power to block the restructuring. The list of protection sellers has been largely expanded. The w factor which caused a stir under the initial draft has been dropped.
For a detailed coverage on the latest BIS draft, see our page here.
A traditional banker in India would be least aware of derivatives, let alone credit derivatives, but the Reserve Bank of India (RBI) is keen to introduce credit derivatives in Indian banking. While capital guidelines on securitisation could still wait, the RBI has already come out with draft guidelines on credit derivatives. Looking at the non-controversial nature of these guidelines, and the fact that they do not clash with any other law, one would not be surprised if these guidelines are okayed soon.
On 26th March, the RBI released the draft guidelines, explained as a credit risk management device. While Indian regulations do not allow a bank to guarantee the exposure of other banks (except in case of infrastructure projects), they would achieve the same effect by credit default swaps. Banks are proposed to be allowed to both buy and sell protection.Banks would be allowed to hold credit derivatives positions as a part of their banking book, which means not with a trading intent.
Portfolio credit default swaps will not be allowed to start with - which means the market will be limited to single reference entity. This obviously puts off synthetic CDOs as well. It is notable that the only attempted cash CDO in India had failed - see reports on our securitisation page.
Anyone could be a protection buyer or protection seller, subject to condition of arms length relationships; however, non-residents will not be allowed to either buy or sell protection with a domestic counterparty.
The other legal and operational requirements are similar to those of FSA, UK.
Link Full text of the guidelines is on RBI website.
Global financial regulators, currently meeting in Berlin, want to study the growth and impact of credit derivatives by September this year to decide if it concerns them. The regulators are meeting under the aegis of Financial Stability Forum.
Alarmed by the fact that global credit derivatives business has reached volumes of something of USD 2 trillion, and is forecast to reach USD 4 trillion, these regulators are worried as to who is really bearing the baby. "What we don't know with enough clarity is who is bearing the ultimate risk. Some of it clearly goes into the insurance sector and within the insurance sector it may be traded between institutions but we don't know enough about who has got the risk and if there are hidden concentrations of risk," said Andrew Crockett, head of of the Forum.
The Forum clarified that there is nothing negative in these comments, but they certainly underscored the need for better disclosure, which will be discussed in their next meeting in Paris in September this year.
Vinod Kothari comments: The fast growing credit derivatives market, particularly against the backdrop of a precarious corporate credit scenario, is obviously to come on the regulatory radar. Greenspan credits credit derivatives with creating the framework of stability in global derivatives, and Warren Buffet steams out to hold them as weapons of mass destruction. There is obviously no need, in this case, to launch any "shock and awe" strike, but of course, it is important for macro-economists to study whether the economics of accumulation and diffusion of risk are not getting over-powered by a possible abdication of lending discipline by those who originate credits.
Financial Insights, an independent research agency, opines that the current growth rate in credit derivatives at about 45% per annum is driven by the strong urge among banks to buy protection against single name defaults, which in turn is due to the current credit scenario.
The authors of the report contend that "uses of these instruments and their accompanying data will continue to expand. As this occurs, it is highly likely that they will get applied inappropriately. It is our opinion that in the next two years one or more regulatory agencies will draft rules intended to head off the most likely negative scenarios."
The authors have gone into the reasons for possible regulatory backlash - such as misuse of private information by banks.
The authors also contend that such feared slowdown will also have deleterious impact on the technolgy currently support credit derivatives trades.
For full copy of the report ( a priced publication), go here.
While the corporate default scenario is extremely horrifying, how is it that banks are not defaulting? Banks derive their health from that of their borrowers. In 2002, more companies defaulted on more debt in 2002 than at any time previously. According to Standard & Poor's, 234 companies defaulted on a combined $178bn of obligations. That is more than four times the default rate of 2000. And yet, there are no major bank failures.
An article in Financial Times 17th Feb says that banks have learnt lessons from the Latin America debt crisis and the collapse of the savings and loan industry, and, among others, identified credit risk as the banking sector's Achilles' heel. So it is hardly surprising that from the late 1980s banks on both sides of the Atlantic put some of their best brains to work on ways to better manage credit risk. The result was the rapid growth of the credit derivatives market, where risk is spread more widely through the banking and financial sectors, and often outside them, to hedge funds and fund managers.
These devices have helped. The collapse of Enron in a world without credit derivatives would have had a far more severe impact on JP Morgan, and the failure of Swissair on the Swiss banks. By diffusion of risks, banks today are far more resilient that yesteryears.
Legal certainty is unarguably the most important attribute of the credit derivatives market and a recent London court ruling would help the default swap market to proceed towards the same. In a recent ruling, the Queen's Bench Division at London held that Railtrack convertibles indeed were deliverable securities in a credit default swap between Nomura and CSFB, and the refusal of the latter to accept delivery of the convertibles on Railtrack going into administration was a breach of contract, for which Nomura was eligible to claim damages and costs.
Nomura was the protection buyer and CFSB the protection seller related to Railtrack. When Railtrack went into administrative receivership, Nomura sought to deliver convertibles (which are obviously cheap - the price of equity being close to zero). CSFB refused to accept the same, holding convertibles not to be deliverable securities. Nomura was forced to sell convertibles in the market at a loss, and hence the suit.
Vinod Kothari comments: the key issue here is the optionality attached to conversion, and the fact that the option lay with the trustees for the debentureholders. Until the exercise of such option, the debentures remained a redeemable debt for the issuer: hence, the ruling clarifies an issue which should be otherwise obvious.
There are reports that CSFB might go in for further appeal.
More on convertibles The convertibles controversy, and ISDA convertibles supplement are discussed in Vinod Kothari's Credit Derivatives and Synthetic Securitisation. For details, see here.
ISDA has finally come out with Credit Derivatives 2003. The revised Definitions, which replaced the 1999 Definitions, incorporate experience of dealing with credit default swaps over several years, more particularly problems associated with increasing sovereign and corporate defaults.
The significant changes in the new Definitions are:
Links For more on ISDA Definitions, see our page here.
An article in in Wall Street Journal recently focussed on the risks of firewalls between the banking and derivatives desks of banks, and said quite often, there were cracks in these walls. In fact, it might even be contended that the firewalls between banks’ lending operations and their trading desks may have broken down as well.
At centre-stage in this firewall controversy is the credit derivatives business of the banks. WSJ reports that fund managers have often complained of the fact that the bankers are sharing confidential information about credit woes of clients, prompting the traders to place bets in the unregulated derivatives market. Bankers make maximum use of this private information in the CDS deals in which banks, hedge funds and other market participants buy protection against corporate defaults from sellers, mainly insurers and fund-management companies, the article said.
The complaints come the week after top financial firms paid a total of $1.4 billion for misleading small investors through overly optimistic research on companies that also were investment-banking clients, the newspaper said.
According to Japan Today of Saturday, 11th Jan 2003, The Financial Services Agency (FSA), Japan on Friday penalized two brokerages for engaging in such illegal activities as brokering derivatives transactions without permission and inviting a client to buy bonds to defer booking losses on other bonds. The two brokerages are the Tokyo offices of Credit Lyonnais Securities Europe-Switzerland AG and ING Securities (Japan) Ltd, the FSA said.
Credit Lyonnais broke the Securities and Exchange Law when it acted as an intermediary for credit derivatives transactions between its customers although it did not have a license to do so, the agency said. ING's offence relates to inviting clients to buy bonds (apparently not related to credit derivatives).
The ISDA master agreement, used all over the World for OTC derivatives across board, has been replaced by its 2002 avtar.
The key changes introduced by the 2002 ISDA Master Agreement are as under:
The ISDA press release also says the new Credit Derivatives definitions, 2002 are expected in next several weeks.
Links For more on ISDA definitions, see our page here.
J P Morgan has reached an out-of-Court settlement of its dispute with insurance companies regarding the legal validity of surety bonds issued by the latter, according to a report in Washington Post. The settlment of the $1 billion dispute was done on 2nd Jan 2003. According to terms, the 11 insurance companies, which promised to cover the bank against loss if Enron failed to make good on the deals, agreed to pay 60 percent of the $965 million guarantee. The amount will be reduced by an $85 million payment from the bank to the insurance companies, giving J.P. Morgan about half of its original guarantee, the insurance companies said. The settlement, signed just before a federal court jury in New York was to begin deliberations in the case, removed the risk of a verdict against the bank
The dispute related to certain energy deals with Enron which were guaranteed by the insurers. The insureres alleged that the so-called energy deals were really not commodity deals but financial transactions, and JPM was well aware of the substantive nature. The surety bonds were designed to cover a commodity trade and not financial deals.
Links We have covered the JPM-insurers dispute earlier on this site - see this link and further links on this site.
German developmental body KfW has for the first time towards end-Dec 2002 extended the reach of its Promise template to cover transactions outside of Europe. This deal covered an Austrian origination. Looking forward, KfW wants to make more aggressive use of the Promise and Provide templates to cover multiple originators, and transactions all over Europe. For details of this news item, see our site http://vinodkothari.com
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