A V Rajwade: The real picture on credit

derivatives

WORLD MONEY
A V Rajwade / New Delhi September 25, 2006

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 corporatespecific 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