Public CompanyA V Rajwade: Credit default swaps
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Another move by the Reserve Bank of India (RBI), which has surprised me (I commented on purchase of gold a couple of weeks back), is the announcement in the October monetary policy statement about the introduction of credit default swaps (CDSs). To quote the RBI Governor, the central bank proposes “to introduce plain vanilla over-the-counter (OTC) single-name CDS for corporate bonds for resident entities subject to appropriate safeguards.”
The surprise comes from two different sources:
*Only a few months ago, the central bank had banned banks from guaranteeing corporate bonds (Off-balance sheet exposures, June 8). CDSs, in their basic format, are, in effect, guarantees against losses arising from bond defaults.
*In the recent banking crisis in the US, the largest capital infusion was in AIG, a giant insurance company, to rescue it from liabilities arising from the CDS contracts it had written. Even otherwise, authorities in the West are getting increasingly worried about the impact of CDSs on corporate and bank restructuring.
In its most basic form, the asset exchange under a credit default swap is as follows:
*Default protection buyer pays CDSs spread periodically, until an event of default occurs.
*Default protection seller
1. receives CDS spread;
2. buys bond at face value if credit event occurs, against delivery of bond; or
3. pays difference between face and residual value.
*Residual value is bond’s market value immediately after a default — actual or, often, polled.
*In effect, protection seller is writing a put option on bond with CDSs spread as price of option.
As usual, in the case of most derivatives, a hedging instrument (in this case against credit risk) has been converted into yet another speculative market. Today, in the US and Europe, the gross notional principal of outstanding CDSs is several times the aggregate corporate debt in the form of bonds and loans! Clearly, too many purchases of protection against default seem to be purely speculative — and this means that the holder/buyer of the protection has a vested interest in, and benefits from, corporate defaults. Bank guarantees for bonds, which RBI banned in May 2009, at least had the merit of there being an underlying credit exposure to a non-professional investor in the bond. (I had argued earlier that such guarantees may be needed for smoother development of a corporate bond market).
In a study published in August, the European Central Bank highlighted the dangers CDSs pose to financial stability. One of the reasons is the concentration of risk: In Europe, two-thirds of banks’ CDS exposures are concentrated in just 10 counterparties. Globally, there are just five banks account for half the CDS market.
There is another angle to credit default swaps: Those who have a net long position in the credit exposure to a particular counterparty (that is, notional of protection purchased more than the actual bonds held), have an incentive to see the reference entity fail: Genuine creditors and other stakeholders in the company could well be better off with a restructuring. Such investors “have an incentive to use their position as bondholders to force bankruptcy, triggering payments on their CDSs rather than negotiating out of court restructurings or covenant amendments with their creditors” as David Einhorn, promoter of a hedge fund, argued (Financial Times, November 7) recently, terming CDSs as anti-social. This conflict of interest between holders of CDSs and other stakeholders is coming to the fore in several actual current cases: CIT, GMAC, General Growth Properties and AbitibiBowater. In fact, holders of CDSs for speculative purposes have become an increasingly important influence in bankruptcy proceedings. This is true even in cross-border transactions: Consider what is happening in Kazakhstan. It seems Morgan Stanley, the big investment bank, has bought huge CDS protection against defaults by banks in that country — it also holds some bank bonds. In the case of BTA, a financial institution, the efforts of the central bank to restructure it have been thwarted by Morgan pushing it into default. The Turner Review (March 2009) cautioned, “Existence of significant investors who have an interest in a company running into trouble, when combined with the potential for short selling, creates a heightened risk of abusive market behaviour.”
But apart from this, as the market becomes more speculative, pricing anomalies are widening. In principle, the price of buying credit protection should be equal to the credit spread in corporate bond yields over risk-free securities of the same maturity. In practice, the two are differing widely. And, there is a move to price loans as per CDS spreads, neatly reversing the causation.
The RBI Governor has stated that CDSs would be introduced “subject to appropriate safeguards”. If this means that CDSs would be allowed to be purchased only for hedging, why not just remove the ban on guaranteeing bonds? That will be far better than another still- born market in derivatives: We have the example of the interest futures contract in 2003. Even in its more recent avatar, the trading volumes have dropped, at least partly because of the unnecessarily complex structure of the contract.
avrajwade@gmail.com