Credit Defaults Swaps and the Big Bang Effect

At the same time Volcker stated that both Credit Default Swaps and Collateralized Debt Obligations – better known as CDO’s - led the economy “to the brink of disaster”. Thanks to the media, terms like the CDS, CDO, and CMO have entered the language of most citizens who have almost immediately associated them with a negative connotation. Very few people really understand the workings of these products, and far be it from Congress to be exempt from this group.

However, as the main focus both on Wall Street and Main Street continues to be the CDS, so ours will be too. The contract serves in its most basic sense to transfer the default/credit risk on debt to a third party. Institutions have a need to transfer risk off their balance sheets and can do so through off sheet transactions in CDS, i.e. by buying protection. For example, Bank A owns a bond from Caterpillar and wants to insure a return of its principal until maturity; well, they can buy protection via a CDS on that asset. In exchange they pay a premium, usually quarterly, to in this case Hedge Fund A, who sought to enhance yield through an unfunded and possibly leveraged position.  In the event of a credit event, though dependent on the event and terms of the contract; Hedge Fund A will return the full principal to the bank at par and receive either an auction-determined cash settlement amount or existing collateral: more on this later.

If this sounds just like an insurance policy, well essentially that is all it is. Media venues continuously talks about massive notional values but fails to state that actually after netting all these contracts across counterparties is much less. Surprisingly, the credit industry has already moved substantially towards these goals and has regulated itself from within. Steps include exchange (CME and ICE) clearing of contracts, and the main focus of this article CDS contract standardization.

Recently in 2009, the ISDA (International Swaps and Derivatives Association) – considered the primary ”legislative” body of derivatives, developed and submitted their Big Bang Protocol to its international parties seeking their adherence. After a large majority - 1400 signatures, the protocol went into effect as of July 27, 2009. It brought out several structural changes and implementations that have already brought down notional values.

First of the changes is the reorganization of the committee that rules on the legitimacy of a credit event claim. Previously it was composed of only 10 dealers, yet now it has been expanded to hold 10 dealers along with 5 buy side institutions. From this committee comes the decision on whether a credit event trigger and settlement payments are valid.

Currently, though susceptible to immediate change is that CDS contracts have no legal clause that entitles buyers of protection to own the reference entity. As a result, in the instance of a credit event where physical settlement is the only option, these buyers would have to step in and purchase cash market positions for future deliveries. Such instantaneous and often panic buying creates the bond market equivalent of a short squeeze where demand exceeds supply and prices rise instead of fall. As a result, the Big Bang attempts to emphasize cash settlement with counterparties by “hardwiring the auction results” into the contract. Following a credit event, an auction takes place and participants submit bids on the value of reference entity. Once established that value is what is returned to the seller of protection, or in the case of physical settlement what the actual entity is worth. This is another critical component and helps avoids legal disputes over settlement with once again, contract standardization.

Credit market participants currently deal in a variety of contract types when dealing with the restructuring clause (restructuring is considered a credit event). They are labeled as No Restructuring, Modified Restructuring, Old Restructuring, and Modified-Modified Restructuring. There is a good deal of specifics for each type of contract, but now dealers will start to quote contracts under the No-R type. This often trades at a discount to other types of contracts because it does not give buyer of protection more freedom in delivering entities during credit events.

Another and what is probably the most dynamic change is the flat 100 and 500 basis point coupons that are now standardized. Previously, parties would pay custom amounts quarterly; which often led to more extensive documentation and likewise possible legal liability further on. Now with normal contracts buyers pay 100 bps and for high yield 500 bps. Individual spreads are still available but compensate for the difference over/under 100 with a custom upfront payment to the seller. A key aspect of the CDS is that when spreads widen, mark to market values of the swap increase; likewise when they tighten mark to market values decline. Large institutions should therefore be long protection in a widening spread environment, and usually do so, also reaping the effects of funding cost arbitrage at reduced risk.

Last of the changes, it has been noted that the convention for rolling the effective date for protection will include for events within the last 60 days. This ensures no instances where a credit event could be declared in a period where there was a gap between when an institution first opened a credit position and subsequently offset it.

The Big Bang protocol has made substantial changes to the CDS market and though still in its infancy has started to perform well. Portfolio compression and reduction of gross notional values has been in the Trillions of dollars. Ahead of the Protocol Bank of America/Merrill Lynch advised it’s through its Credit Derivatives Strategist newsletter to sign it. Also, I had the opportunity to speak with a vice president at information services firm specializing in credit and they said the impact has been noticeable. Dealers specifically have been able to reduce notional values greatly via compressions while still maintaining the same exposure. Portfolio compression is still continuing and though the effects are currently mitigated by volatile market conditions, growth in notional CDS value is expected to decline.

CDS and the Big Bang Protocol will be at the front of market attention in the weeks ahead, considering the deteriorating economic conditions in Greece. Spreads on Greek debt widened to an all time this week under fears the nation will not be able to secure funding. In the case of default, protocol changes will be tested and garner international attention. More people across the world will call for more financial regulation, but it is interesting to note that if a government cannot even manage its own budget, why should it be seeking to retro-actively regulate a product? Politicians have horrible track records and hopefully they can leave Credit Default Swaps to be influenced by further adherence to the Big Bang and not impose hasty regulation.