A V Rajwade: The real picture on credit derivatives

While outstanding investment grade bonds total $2 trillion, the notional principal is as high as $17 trillion!

In the last three articles, I have been discussing some of the complexities modern finance has introduced in the interest, currency derivatives, and credit markets. Credit derivatives, as a combination of credit and derivatives, are hardly immune to complexity. But to start with basics, a Credit Default Swap (CDS) insures credit risk on a bond. The buyer of the protection pays to the seller a fixed fee, and the seller contracts to pay the buyer a certain sum of money in the event there is a default on the insured bond. In the early years of the CDS market, the contracts usually called for the actual defaulted bonds being delivered to the seller of the protection, in return for the payment. Lately, however, in many cases, while the theoretical underlying remains a bond, the actual delivery of the bond is not insisted upon "" only money changes hands. The reason for this amended practice is very simple: outstanding investment grade bonds total $2 trillion, while the notional principal of outstanding CDS was as high as $17 trillion at the end of last year, thanks to explosive growth in CDS volumes and secondary market trading. One of the worrying facts for the buyer of the protection has been that, in a recent court case in New York, a judge ruled that the seller need not pay money to the buyer of protection, because the latter has failed to meet the contracted deadline for delivery of the underlying bond "" the judge was obviously not impressed with the plea that, because of the explosive growth, such large arrears have developed in back office work (confirmations, settlements, and so on) that failure to meet deadlines had become an accepted industry practice! Indeed, the backlogs have led to serious regulatory concerns in both New York and London, where much of the trading takes place. Both the Federal Reserve in New York and the Financial Supervisory Authority in London have exhorted participants to clear up the arrears, and considerable progress seems to have been made. One way of avoiding such back office problems is the move to electronic trading platforms.

Of course, there are other issues as well. For one, there are question marks about the degree with which counterparty risk on the seller of the CDS is being measured and monitored. There are also worries about proper assessment of recoveries under a defaulted bond. While the pricing of CDS is based on the probability of default, recovery rates are assumed to be 40 cents on the dollar. While this may be reasonable for the entire population, it ignores corporate-specific variations. Despite many such weaknesses, regulators in general, are happy about the growth in credit derivatives as it helps spread credit risks across the financial system.

With the basic credit default swap now an established product in the financial market, several variations are being innovated and traded:

Loan Credit Default Swaps "" in this case, the underlying risk is default on a loan and not on a bond. Also, most of the insured loans are of the so-called "leveraged" variety, that is, to below-investment-grade borrowers.

CDS on Asset Backed Securities (ABS), on Colleralised Debt Obligations (CDOs), on Asset Backed Corporate Debts (ABCDs) and Constant Proportion Portfolio Insurance (CPPIs), the same alphabet soup I wrote of last Monday.

Participants have recently constructed an index of CDS prices. Over the last several months, the index has dropped sharply suggesting that credit conditions are benign and default risks have come down. Futures on CDS prices are also expected to start trading on a European exchange shortly. Of all the new products, LCDS are expected to grow the fastest, based on leveraged loans outstanding an estimated $300 bn.

The credit derivatives tail has also started wagging the dog "" namely the terms of the debt market. In at least two recent cases of corporate restructuring, the proposal had to be modified to consider the default definitions of the insured bonds, in outstanding credit default swaps. Conservative analysts are also worried about the implication of the explosive growth in the CDS market, for the underlying credit quality. Would not the lenders, who have already bought protection, be less concerned about supervising and monitoring the credit exposure? Speaking personally, I also am not sure about the wisdom of moving credit decisions from analysts in the loan department, to derivatives traders in the dealing room who, too often, base their decisions on the "greater fool theory" (see World Money, May 29).

Tailpiece: The government has decided to constitute a committee for undertaking "a comprehensive and objective assessment of the Indian financial sector". Care has been taken to ensure that no member of the committee has a direct exposure to, or participated in, the financial market!

Email: avrco@vsnl.com