Рост и падение кредитных дефолтных свопов

Introduction

Credit Default Swaps (CDSs) rank to important financial instruments in the world capital markets despite its declining volumes in recent years (gross notional amounts outstanding of CDS contracts fell down from USD 58.2 trillion as of the end of 2007 to 28.6 trillion as of the end of 2011). CDSs played an important role during the 2007-2009 global financial crisis caused by financial tsunami that visited the Wall Street, became the front page news around the Word. The fall of some of the biggest Wall Street firms like Lehman Brothers, Merrill Lynch and American Insurance Group (AIG) which was unbelievable compelled the people to wonder if financial institutions across the globe are safe due to financial and economic integration.

Teplý (2010) point out that most of the banks across different countries started suffering liquidity crunch and central banks were forced to inject the liquidity into their financial system. Stock markets in almost all countries fell sharply. The ability and expertise of investment banks to create new products and structures resulted in increased willingness to lend those including banks. These borrowed funds were invested to buy assets, where returns from trading these assets were higher than funding costs. This was possible due to low FED rates. Investment banks bought mostly liquid assets, and for illiquid assets they managed to create liquidity through “Financial engineering” and various securitization techniques.

One group of the illiquid assets were housing loans. Retail banks started lending enormous housing loans to borrowers with poor credit history and inadequate security. These loans were repackaged as tradable securities and sold to investment banks such as Merrill Lynch and Lehman Brothers. When these borrowers defaulted the market for these securities crashed and value eroded. Investment banks had considerable amount of exposure in the booming real estate market. Housing boom led to crash in housing prices added the pain in the neck of investment bankers adding to the losses of these investment bankers. Credit markets went down forcing investors to transfer their money to safer investments like Treasury bills. The exotic financial instruments like CDSs also have partly contributed to the crisis although their primary motive is hedging/credit risk management (Figure 1).

Figure 1. Motives for using CDSs (percentage share of global banks), survey data

Source: DB Research (2009)

Credit derivatives basics

Credit derivatives

Mejstřík et al. (2008) explain that credit derivatives are an off-balance sheet instrument to hedge credit risk and are based upon the credit performance of some credit-sensitive assets or group of assets such as loan, bond etc. Put differently, credit derivatives are the financial instruments to assume or lay off credit risk. It allows management and trading of risk in isolation from other types of risks. Apart from this it enables banks to decouple the credit risk of an exposure from the credit relationship. There are variety types of credit derivatives and one of them is CDS (see Figure 2).

Fabozzi and Kothari (2008) define CDS as an option to swap a credit asset for cash should the credit asset trigger a credit event (the protection buyer is in a similar position as going short on a bond (pays a fixed payment, a premium), and the protection seller is in a similar position as going long on a bond). When entering a CDS one party (the protection seller) pays only if a credit event (such as a default, downgrade, or restructuring of the reference entity, repudiation etc.) occurs. CDS covers the losses from the underlying asset and hence is similar to bank guarantees or insurance (Mejstřík et al., 2008).

At a first glance CDS does not at all look scary. It is just a contract like any other contract. It is used soberly, it offers concrete benefits. CDS serves a very useful function of allowing financial markets to efficiently transfer credit risk, because they are contracts rather than securities or insurance and easy to create. On the other hand, credit derivatives are usually traded on over-the-counter (OTC) markets meaning that are not standardized instruments but based upon an agreement between counterparties. This fact might cause problems

Figure 2. Credit derivatives hierarchy

Source: Mejstrik et al. (2008)

when calculating a total CDS exposure on reference assets of a reference entity. For instance, when Lehman Brothers went bankrupt in September 2008, nobody did know how big Lehman’s real exposure was and what credit risk was in stake. Lehman was engaged in two levels on the CDS market – it issued its own debt and simultaneously was a dealer with approx. 10% share on the market. Despite initial expectations of hundreds of billions in stake, only USD 6 billion were settled in the Lehman organized by the International Swaps and Dealers Association (ISDA), because most payments had already been made as swap-sellers revaluated their exposures mark-to-market. It implies that expected Lehman’s credit risk had been highly overshooted causing panic on the market and followed by world financial markets contagion.

There are several measures to market size of the CDS market. First, gross notional value is the sum of CDS contracts bought (or equivalently sold) across all counterparties, where each trade is counted once. Gross notional amounts outstanding of CDS contracts fell down from USD 58.2 trillion as of the end of 2007 to 28.6 trillion as of the end of 2011 (see Figure 3), what seems relatively high. However, this is a suitable measure as gross market value of derivatives does not reflect true market risk. Second, gross market value is a better measure since it shows, at a given point in time, the amount of risk that is transferred using derivatives contracts. Despite the fact that this measure requires summing the gross positive market values of all market participants (not just of reporters), the gross positive market value of nonreporting firms can be approximated by measuring the negative market value of reporting firms’ contracts with non-reporting firms. Figure 3 displays that as of 31 December 2011 gross market value of CDS contracts amounted to USD 1.6 trillion or only 5.5% of gross notional amount as of the same date.

Figure 3. CDS gross vs. net values gross and net notional amounts (USB billions) in 2004-2011

Source: BIS (2012)

The structure of a credit default swap

It is a hedging instrument like any other credit derivative instrument with at least three parties involved. It is used to eliminate or minimize credit risk. To understand the structure of a standard credit default swaps (CDS) instrument lets take an example (Figure 3).

Figure 3. The structure of a credit default swap

Source: Mejstrik et al. (2008)

Here “Reference Asset” can be a bond issued by, for instance, a corporate house (namely reference entity) and the entity “Bank” or protection buyer is purchasing that. Now, the Bank can hedge itself from the risk of default by the reference entity which in finance parlance known as credit event by purchasing „insurance“ from an issuing agent “Investor”. The agent “Investor” charges a premium depending upon the agreed contract. In case of default of the reference entity, the Investor pays the agreed amount to the Bank.

Credit default swap settlement

There are basically three types of settlement in an event of a credit default. The first can be called physical settlement. In this type the protection buyer, after credit event hands over the defaulted bonds or loans to the protection seller in return for the face value of the defaulted loan or bond.

The second type is called cash settlement. In this type of settlement there is mutual consent and understanding between the parties. There is no handing over of the actual bonds or loans. Cash settlement is done by the assessment of the present recoverable value of the bond or loan and the payment is done by the amount that is the difference between the actual value of the bond or loan and the recoverable value. This calculation is done by calculation agents in business parlance.

The last and third type is the most interesting one on the fact that it has got no name for it but its existence is defined. It is that there is no settlement. It’s just that a protection buyer after a credit event does not find its protection seller to make its claim and lands up nowhere (for more details see Fabozzi (2008)).

ISDA documentation lists different credit events for different types of credit derivatives (such as bankruptcy, failure to pay, obligation default, obligation acceleration, repudiation or moratorium, and restructuring). In September 2008 one of the largest defaults in the history of the credit derivatives market happened, when the US government took over Fannie Mae and Freddie Mac, US government sponsored enterprises (GSEs). As mentioned above, there are no exact numbers on particular CDS exposures, neither it was for Fannie Mae and Freddie Mac (it was estimated that CDS has been written on the agencies’ $1.5 trillion of bonds). To avoid panic on the market, the ISDA enabled settlement of these CDS through a special protocol.

What fuelled CDS growth?

The CDS market has seen fast development in past years and their notional value peaked at USD 58.2 trillion as of the end of 2007 and decreased to USD 28.6 trillion as of December 2011, what was a small fraction of gross notional value of all derivatives amounting USD 647.8 trillion as of the same date (Figure 6). However, this amount is indicating only and does not represent the real risk of the CDS market, what was approx. USD 1.5 trillion or less than 3% of the CDS notional value in early 2008, as Segoviano et al. (2008) explain. There is no end to the determining factors behind the success of CDS in financial capitalism. During the early 2001-2003, market participants started becoming more sensitive to credit risk subsequent to delinquency and insolvency of companies so market forces created a vacuum for products that can mitigate the credit risk.

Figure 6. World derivatives´ market development in 2004-2011 (notional amounts)

Source: BIS (2012)

This requirement was aided by the ISDA which introduced a standardized contract in the year 1998 which aided in transferring credit risk by keeping the underlying relationship between the borrower and the lender intact. Further it has been started to be used in the design of structured financial products like Hybrid Collateralized Debt Obligation. Using such structured products, credit risk can also be reduced by credit enhancements, which, for example, cover any non-covered residual risk that a risk taker may have.

Changes to credit risk management in the banking sector are an additional factor contributing to greater use of CDS. As part of their credit risk management, banks are viewing CDS more and more often as tradable products, which can be transferred to third parties before the maturity date. In this respect, the new supervisory rules provided for by Basel II are also increasing the incentives for banks to use CDS in the long term. For example, Basel II raises the incentive to transfer credit risks to unregulated non-banks with a good credit rating as the core capital backing of the counterparty risk focuses only on default risk in general and does not differentiate between banks and non-banks.

The regulatory capital freed up through the transfer of to be undervalued can purchase protection by paying a premium. Owing to the limited possibilities for short sales in the bond market, hedge funds are increasingly entering into positions in the CDS market to implement their investment strategie. CDS allow participants to take advantage of arbitrage opportunities vis-a-vis the bond market since, in principle, a risky bond can be replicated through a risk-free investment or a CDS contract taken out on a suitable reference debtor. As a rule, however, CDS trade is limited to liquid credit positions, which means that any operations in the CDS market are possible for only a limited number of debt securities.

Dark side of credit default swaps

Undoubtedly CDS is a proof of brilliance of the bankers who devised them but unfortunately these instruments succumbed to rampant speculation as investors tried to exploit them, what led to revulsion as crisis caused widespread losses. Mejstřík et al. (2008) point out that there are several advantages of CDS, such as a transfer of an illiquid position, better credit risk management, possible participation in credit risk arbitrage etc. On the other hand, several disadvantages exist, what has become clear during the current crisis.

Firstly, CDS can contribute to instability in the financial system. Owing to competitive pressure, for example, banks might use their newly gained leeway to enter into new risks. The transfer of risks to market players outside of the banking system which do not have a suitable risk management system in place and are subject to less supervision would lead to an increase in the accumulated risks in the financial system as a whole.

Secondly, further risks arise from the trade of CDS which, in the event of major shocks, could possibly exacerbate the risk of systemic crises (see the Lehman’s case above).

Thirdly, the CDS market remains characterized by a large concentration of trading at a few large banks. Apart from their own direct operations as risk shedder or risk taker, banks are also active in the CDS markets as intermediaries. Hence, the withdrawal of one large intermediary from the market could impair the smooth functioning of trading in CDS.

Fourthly, given asymmetric information, an opportunistic streak (moral hazard) could stand in the way of efficient CDS trading. It is therefore conceivable that banks, in their capacity as lenders, could use their information advantage regarding individual loans to pass on mainly bad risks. Furthermore, for the protection buyer, there might be less incentive to continue monitoring the creditworthiness of the reference entity with the same intensity. This would result in market participants being less willing to assume credit risks and in the market charging an additional risk premium for this structural risk. Any such additional risk premium would then also distort the information content of the CDS spreads as a measure of credit risk. The threat of a tarnished reputation to the risk shedder could, however, mitigate the moral hazard problem. This problem should not have any impact on highly liquid bonds in particular.

The above-mentioned pitfalls of CDS have launched discussions over regulation of OTC markets, specifically about reducing counterparty risk in the CDS markets, and the establishment of a central counterparty (CCP) for CDSs. For example, the foundation of the CCP was initiated by both Eurex and Liffe in Europe in July2008. Inthe US market, The President's Working Group on Financial Markets (“PWG”) announced a series of initiatives to strengthen oversight and the infrastructure of the OTC derivatives market in November 2008. The PWG also issued a Memorandum of Understanding regarding CDS central counterparties among the Federal Reserve Board of Governors, the Securities and Exchange Commission and the Commodity Futures Trading Commission. The Memorandum mentioned four main policy objectives:

i) improve the transparency and integrity of the credit default swaps market;

ii) enhance risk management of OTC derivatives;

iii) further strengthen the OTC derivatives market infrastructure;

iv) strengthen cooperation among regulatory authorities.

When talking about a CCP, two main players have been mentioned recently: the Intercontinental Exchange and a joint venture of CME Group and Citadel. However, discussions over a CCP has not finished yet and long debates over this issue are expected.

The future of CDS market

In just last decade privately traded derivative contracts rose to size of USD 58.2 trillion market. CDS were the fastest growing financial derivatives which trade in a vast unregulated market that most people neither have heard of and fewer not understood even and almost nothing is disclosed publicly. They have played a pivotal role in unfolding the financial crisis by providing “insurance” on risky mortgage bonds.

The major reason that regulators stepped in to bail out Bear Stearns and buy out AIG probably was a fear of spreading the virus out from the failing institutions and infecting hundreds of other companies which were linked to one another by CDS and other instruments. All these infected companies are public companies (Banks and corporations) and they are not aware of what exposure they have got from the CDS contracts. Chris Wolf, a co-manager of Cogo Wolf, a hedge fund of funds compares them to one of the great mysteries of astrophysics: say that “this has become essentially the dark matter of the Financial Universe”.

There is an ongoing debate concerning the possibility of limiting so called “naked” CDS (where the buyer has no risk exposure to the underlying entity, hence naked CDS do not hedge risk per se but are more speculative bets that actually create risk). There are certain suggestions that buyers are required to have “skin in the game” or element of risk exposure in the underlying entity. In short the CDS player would have to own the bond or loan that leads to payout on default. The opponents to this suggestion thinks that outright ban on naked CDS would not work because speculation is the key to the efficient pricing of risk in the same way that most players in the stock market.

CDS exposure of a bank is not public knowledge; the fear that one could face large losses or possibly even default themselves was a contributing factor to the massive decrease in lending liquidity during September/October 2008. The amount at stake in the credit default swap market is greater than the world’s annual economic output. Warren Buffett famously called derivatives as “Financial weapons of mass destruction”.

The Financial Accounting Standard Board is implementing a new role that will require sellers of CDS and other credit derivatives to report the detailed information stating the reasons for entering into the contracts, their maximum payouts and assets to offsets these payouts. More discloser practices do not guarantee any clarity or governance but reporting will lead to increase in information and will be of a benefit. This might limit the effect of CDS on the next disaster.

Conclusion

A meltdown in the CDS market has wider and deeper impact than the sub-prime mortgage crisis on financial markets. Bond insurance would either disappear or become costly and lenders will become more cautious about making loans which could impact amount and cost of liquidity in the market adding fuel to the liquidity crunch. The CDS contracts are non-standard contracts; there is no standard capital requirement and non-standard way of valuing them. When a default occurs, insured party or hedged party does not know who's responsible for making up the default and whether that end party has the enough resources to pay.

There are several advantages of CDS, such as a transfer of an illiquid position, better credit risk management and possible participation in credit risk arbitrage etc. On the other hand, several disadvantages exist such as contribution to moral hazard and instability in the financial system and to higher systemic risk, a large concentration of CDS trading at a few market players. The above-mentioned pitfalls of CDS have launched discussions over regulation and transparency of OTC markets, specifically about reducing counterparty risk in the CDS markets, and the establishment of a central counterparty. CDSs mean important financial instrument in the world capital markets. However, they should become more standardized and transparent, what will require higher regulation and cooperation of the CDS market. Although the discussions will take some time, it will be a good step for restoring confidence of the CDS market.