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Credit Default Swap Unraveling?

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Documentation muddles contract enforcement.

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In May 2006 Alan Greenspan, the former Chairman of the Fed, noted:

"The CDS is probably the most important instrument in finance... What CDS (credit default swaps) did is lay-off all the risk of highly leveraged institutions – and that's what banks are, highly leveraged – on stable American and international institutions."


It will be interesting to see whether reality proves to be different.

The CDS is economically similar to credit insurance. The buyer of protection (typically a bank) transfers the risk of default of a borrower (the reference entity) to a protection seller who, for a fee, indemnifies the protection buyer against credit losses. The CDS market has grown exponentially to current outstandings of around $50 trillion. Even eliminating double counting in the volumes, the figures are impressive, especially when you considered that the market was less than $1 trillion as of 2001. However, the size of the market (which has attracted much attention) is not the major issue.

Banks have used CDS contracts extensively to hedge credit risk on bonds and loans. Documentation and counterparty risk means that the market may not function as participants and regulators hope when actual defaults occur.

CDS documentation is highly standardized to facilitate trading. It generally does not exactly match the terms of the underlying risk being hedged. CDS contracts are technically complex in relation to the identity of the entity being hedged, the events that are covered and how the CDS contract is to be settled. This means that the hedge may not provide the protection sought. In fairness, all financial hedges display some degree of mismatch or "basis" risk.

The CDS contract is triggered by a "credit event", broadly default by the reference entity. The buyer of protection is not protected against "all" defaults. They are only protected against defaults on a specified set of obligations in certain currencies. It is possible that there is a loan default but technical difficulties may make it difficult to trigger the CDS hedging that loan. Some credit events like "restructuring" are complex. There are different versions – R (restructuring), NR (no restructuring), MR (modified restructuring) and MMR (modified modified restructuring). Different contracts use different versions.

"PAI" (publicly available information) must generally be used to trigger the CDS contract. Recent credit events have been straightforward Chapter 11 filings and bankruptcy. For other credit events (failure to pay or restructuring), there may be problems in establishing that the credit event took place.

This has a systemic dimension. A CDS protection buyer may have to put the reference entity into bankruptcy or Chapter 11 in order to be able to settle the contract. A study by academics Henry Hu and Bernard Black (from the University of Texas) concludes that CDS contracts may create incentives for creditors to push troubled companies into bankruptcy. This may exacerbate losses in the case of defaults.

In the case of default, the protection buyer in CDS must deliver a defaulted bond or loan – the deliverable obligation – to the protection seller in return for receiving the face value of the delivered item (known as physical settlement). When Delphi defaulted, the volume of CDS outstanding was estimated at $28 billion against $5.2 billion of bonds and loans (not all of qualified for delivery). On actively traded names CDS volumes are substantially greater than outstanding debt making it difficult to settle contracts.

Shortage of deliverable items and practical restrictions on settling CDS contracts has forced the use of "protocols" – where any two counterparties, by mutual consent, substitute cash settlement for physical delivery. In cash settlement, the seller of protection makes a payment to the buyer of protection. The payment is intended to cover the loss suffered by the protection buyer based on the market price of defaulted bonds established through a so-called "auction system". The auction is designed to be robust and free of the risk of manipulation.

In Delphi, the protocol resulted in a settlement price of 63.38% (the market estimate of recovery by the lender). The protection buyer received 36.62% (100%-63.38%) or $3.662 million per $10 million CDS contract. Fitch Ratings assigned a R6 recovery rating to Delphi's senior unsecured obligation equating to a 0-10% recovery band - far below the price established through the protocol [see James Batterman and Eric Rosenthal Special Report: Delphi, Credit Derivatives, and Bond Trading Behavior After a Bankruptcy Filing (28 November 2005); www.fitchratings.com].

The buyer of protection, depending on what was being hedged, may have potentially received a payment on its hedge well below its actual losses – effectively it would not have been fully hedged.

The settlement mechanics may cause problems even where there is no default. One company refinanced its debt using commercial mortgage backed securities ("CMBS"). The company was downgraded by rating agencies. A shortage of deliverable obligations (the company used the funds from the CMBS to repay its bond and loans) meant that the CDS fee for the company fell sharply (indicative of an improvement in credit quality). This resulted in mark-to-market losses for bemused hedgers. This is known in the trade as an "orphaned CDS".

In the case of actual defaults the CDS market may provide significant employment to a whole galaxy of lawyers trying to figure out whether and how the contract should work. There is the risk that contract may not always provide buyers of protection with the hedge against loss that they assumed they would receive.

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