The Cost of Credit Swaps When a Nation Defaults

Bonne vulgarisation des CDS

Extrait de: The Cost of Credit Swaps When a Nation Defaults, By Peter Coy, Bloomberg, July 25, 2011

Sellers of credit swaps are on the hook if a nation defaults. Regulators have reined in risk, but some steps could make things worse.

Jamie Dimon was all about reassurance on July 14 as the chief executive officer of JPMorgan Chase (JPM) announced second-quarter earnings. He said that the bank’s gross exposure to sovereign and other debt in Greece, Ireland, Italy, Portugal, and Spain was $100 billion. Its net exposure, Dimon said, was only $15 billion. The difference? Collateral posted by borrowers, which it can seize in a default, offsetting loans, and credit default swaps—insurance that pays off when a borrower defaults.

Credit default swaps are a source of pride for Dimon. His bank invented CDS in the 1990s and is the world’s largest dealer in them. Hedging with credit default swaps allows JPMorgan to keep lending in Europe, Dimon said: “We’re not going to cut and run.” Yet credit default swaps, like any insurance, are only as reliable as the company promising to pay. If the banks that sell protection to each other all start to suffer loan losses, they’re like drowning men offering to save each other. Keeping the benefits of swaps while reducing their potential for trouble is tricky business. Regulators are only partway to a solution—and some fixes could make matters worse.

Consider how a credit default swap works. You own $100 million in Italian government bonds, and you’re worried Italy might not pay. So you enter a contract with someone—typically a large bank or hedge fund—to buy what amounts to insurance. If Italy defaults in the next five years, the other party must make you whole. You get the difference between the bonds’ face value and whatever they’re trading for post-default.

You can buy this insurance even if you don’t have any exposure to Italy, in which case you’re simply speculating on default.

The beauty of the swaps is that they transfer risk from people who don’t want it to people who are happy to bear it, for a price. They’re also an early indicator of trouble. “They make a lot of things transparent that would otherwise be hidden,” says René M. Stulz, an economist at Ohio State University’s Fisher College of Business.

At the same time, CDS can distort creditors’ incentives. An investor holding a company’s bonds normally wants to see the company work its way through trouble. A bondholder who bought protection with CDS might be indifferent to the borrower’s bankruptcy. It’s what University of Texas School of Law professor Henry T. C. Hu dubs the “empty creditor” problem. In the extreme, Hu says, an empty creditor might even have an incentive to thwart a restructuring.

Regulators also worry that sellers of protection are making promises they can’t keep. Executives of American International Group&rsquo (AIG);s London-based financial products division foolishly sold loads of underpriced protection on overrated American mortgage-backed securities. The federal government—American taxpayershad to prevent a default meltdown by stepping in with that $182 billion rescue.

In truth, cascading failure from credit default swaps is unlikely. The “net notional exposure” of protection sellers to Greek sovereign default is just $4.6 billion, according to data collected by the Depository Trust & Clearing Corp., a New York-based firm that serves as the bookkeeper of finance. Decoded, that means that even if the value of Greek bonds fell to zero (which won’t happen, because the Greeks can pay at least part of their debt) and all the exposure were on the books of a single bank (which it isn’t), the most that bank would be out would be $4.6 billion. The corresponding systemwide exposure to Italy is $24 billion.

Sometimes, though, the fear of the unknown matters more than the reality. European negotiators live in fear that the Credit Derivatives Determinations Committee of the bank-controlled International Swaps and Derivatives Assn. (ISDA) will declare the next Greek restructuring a trigger event for credit default swaps.

Regulators are seeking a framework that would disclose where risks lie; expose who the “empty creditors” are; and ensure that sellers of default protection can fulfill their promises.

·         The first part is under way: Investors are reporting swap deals to special data repositories, so we now know who’s on the hook if Greece, for example, defaults. That’s already demystifying swaps, while greater awareness of empty-creditor issues is helping in restructurings, says Hu.

·         The hardest part, though, is regulating clearinghouses, mandated under the 2010 Dodd-Frank Act, that guarantee the fulfillment of swaps contracts. Last month, still uncertain what to do, the five-person U.S. Commodity Futures Trading Commission voted to miss its July 16 timetable for rules to carry out Dodd-Frank. Its new deadline is Dec. 31.

Clearinghouses predate modern regulation—before there was a Federal Reserve, the New York Clearing House was American banking’s de facto regulator and lender of last resort. Dodd-Frank and similar rules in Europe call for interposing a super-strong intermediary in every transaction. As a condition for guaranteeing trades, the clearinghouse demands that every clearing member be financially strong. It updates the collateral that must be posted on a contract as conditions change. Even before the government specifies how clearinghouses should work, big banks are using them for more than 90 percent of new, eligible credit default swap contracts (though few if any contracts on sovereign debt)

As clearinghouses become a key valve in the world’s financial plumbing, they also become a new point of failure. While Federal Reserve Chairman Ben Bernanke lauded clearinghouses in an April speech, he warned of

“the concentration of substantial financial and operational risk in a small number of organizations, a development with potentially important systemic implications.”

There’s pressure on regulators to crack open the insiders’ club of big banks that dominate derivatives trading. (The ISDA says the world’s biggest dealers held 90 percent of credit derivatives last year.) The Commodity Futures Trading Commission says clearinghouses should accept members with as little as $50 million in capital. But that’s a fraction of what private players have concluded is a safe threshold. ICE Clear Credit, which clears credit default swaps, requires members to have $5 billion in capital. Likewise, clearinghouses need to be big and broad to capture all of firms’ activities and set collateral correctly. But regulators are allowing clearinghouses to proliferate. Countries such as South Korea and India are setting up their own national clearinghouses.

In his April speech, Bernanke paraphrased Mark Twain’s character Pudd’nhead Wilson:

“If you put all your eggs in one basket, you better watch that basket.” The clearinghouse basket needs more attention.

The bottom line: Regulators are still fixing the market for credit default swaps. Weak or fragmented clearinghouses could make matters worse

Extrait de: 'Empty Creditors' and the Crisis, By HENRY T.C. HU, The WSJ, APRIL 10, 2009

How Goldman's $7 billion was 'not material.'.

The defining moments of our financial crisis are now familiar. Last September, Lehman collapsed and AIG was teetering. Because an AIG collapse was viewed as posing unacceptable systemic risks, the Federal Reserve provided the company with an emergency $85 billion loan on Sept. 16

But a curious incident that fateful day raises significant public policy issues. Goldman Sachs reported that its exposure to AIG was "not material." Yet on March 15 of this year, AIG disclosed that it paid $7 billion of its government loan last fall to satisfy obligations to Goldman. A "not material" statement and a $7 billion payout appear to be at odds.

Why didn't Goldman bark that September day? One explanation is that Goldman was, to use a term that I coined a few years ago, largely an "empty creditor" of AIG. More generally, the empty-creditor phenomenon helps explain otherwise-puzzling creditor behavior toward troubled debtors. Addressing the phenomenon can help us cope with its impact on individual debtors and the overall financial system.

What is an empty creditor? Consider that debt ownership conveys a package of economic rights (to receive principal and interest), contractual control rights (to enforce the terms of the agreement), and other legal rights (to participate in bankruptcy proceedings). Traditionally, law and business practice assume these components are bundled together. Another foundational assumption: Creditors generally want to keep solvent firms out of bankruptcy and to maximize their value.

These assumptions can no longer be relied on.

Credit default swaps and other products now permit a creditor to avoid any actual exposure to financial risk from a shaky debt -- while still maintaining his formal contractual control rights to enforce the terms of the debt agreement, and his legal rights under bankruptcy and other laws.

Thus the "empty creditor": someone (or institution) who may have the contractual control but, by simultaneously holding credit default swaps, little or no economic exposure if the debt goes bad.

Indeed, if a creditor holds enough credit default swaps, he may simultaneously have control rights and incentives to cause the debtor firm's value to fall. And if bankruptcy occurs, the empty creditor may undermine proper reorganization, especially if his interests (or non-interests) are not fully disclosed to the bankruptcy court.

Goldman Sachs was apparently an empty creditor of AIG. On March 20, David Viniar, Goldman's chief financial officer, indicated that the company had bought credit default swaps from "large financial institutions" that would pay off if AIG defaulted on its debt. A Bloomberg News story on that day quotes Mr. Viniar as saying that "[n]et-net I would think we had a gain over time" with respect to the credit default swap contracts.

Goldman asserted its contractual rights to require AIG to provide collateral on transactions between the two, notwithstanding the impact of such collateral calls on AIG. This behavior was understandable: Goldman had responsibilities to its own shareholders and, in Mr. Viniar's words, was "fully protected and didn't have to take a loss."

Nothing in the law prevents any creditor from decoupling his actual economic exposure from his debt. And I do not suggest any inappropriate behavior on the part of Goldman or any other party from such "debt decoupling." But none of the existing regulatory efforts involving credit derivatives are directed at the empty-creditor issue. Empty creditors have weaker incentives to cooperate with troubled corporations to avoid collapse and, if collapse occurs, can cause substantive and disclosure complexities in bankruptcy.

An initial, incremental, and low-cost step lies in the area of a real-time informational clearinghouse for credit default swaps and other over-the-counter (OTC) derivatives transactions and other crucial derivatives-related information. Creditors are not generally required to disclose the "emptiness" of their status, or how they achieved it. More generally, OTC derivatives contracts are individually negotiated and not required to be disclosed to any regulator, much less to the public generally. No one regulator, nor the capital markets generally, know on a real-time basis the entity-specific exposures, the ultimate resting places of the credit, market, and other risks associated with OTC derivatives.

With such a clearinghouse, the interconnectedness of market participants' exposures would have been clearer, governmental decisions about bailing out Lehman and AIG would have been better informed, and the market's disciplining forces could have played larger roles. Most important, a clearinghouse could have helped financial institutions to avoid misunderstanding their own products, and modeling and risk assessment systems -- misunderstandings that contributed to the global economic crisis.