When Delphi filed for bankruptcy October 8, investors had to start assessing their losses on more than $2 billion in the auto parts maker’s bonds, which have recently traded at around 60% of their face value. As bad as that is, there is more. Looming over the market like an invisible and unpredictable giant is an estimated $25 billion in credit derivatives, a form of insurance whose value is directly linked to the ups and downs of Delphi debt.
What happens to these complex contracts as the underlying bonds plunge in value? Will ripple effects amplify the Delphi damage, spreading harm to institutional and individual investors who otherwise have no stake in Delphi?
The Delphi situation points to a broader question: Is the credit derivative market, which grew from next to nothing in the mid-1990s to an estimated $5 trillion at the end of 2004 — and is perhaps more than twice that size today — pumping new, poorly-understood risk into the financial markets? Or are these exotic products helping to mitigate the shock from corporate crises, as their proponents claim?
“They’re huge, and they have grown very rapidly,” said Wharton finance professor Richard J. Herring, describing credit-derivatives products. “In principle, they are redistributing risk,” he noted, adding that in the past few years, credit derivatives have helped the financial markets weather storms like the bankruptcies of Enron, WorldCom and Parmalat as well as Argentina’s debt default.
“Those events would have been sufficient in an earlier era to cause major problems to major banks, and even to precipitate a banking crisis,” he said. “But the banks have been fairly robust, and the reason is that someone else is holding the credit risk.” However, he added, “What we don’t know with any new market is whether something that somebody hasn’t quite thought through is going to cause a meltdown.”
In September, the Federal Reserve summoned 14 major banks to a meeting to discuss troubles with the credit-derivatives market. The concern was not that these instruments are intrinsically hazardous. Rather, the Fed worried that the market has grown so quickly that participants cannot keep up with the paperwork. If trades were not processed fast enough, investors could lose confidence in the market and a normal crisis could snowball.
The alarm had been raised earlier in the summer by E. Gerald Corrigan, managing director at The Goldman Sachs Group. As president of the New York Federal Reserve Bank in 1999, he managed the Fed’s response to an earlier credit crisis, the collapse of hedge fund Long-Term Capital Management.
Eric. S. Rosen, managing director and head of North American credit trading at JP Morgan, one of the biggest players in this market, addressed this topic during a panel discussion on sales and trading at the October 14 Wharton Finance Conference. “The Fed is getting worried about the infrastructure,” he said. Regulators made it clear at the meeting that “they don’t care what your [credit derivative trading] volumes are; you’ve got to get the system in order.” His company is spending $100 million on systems to handle the soaring volume. “I think the Fed has got it right,” he noted.
The credit-derivatives market barely existed before the mid-1990s. It developed when new mathematical insights made it possible to set prices for more complex instruments. Market participants were also gaining experience with other forms of derivatives tied to stocks, commodities and currencies. Banks and other lenders and investors were looking for new ways to hedge against risks. And investors such as hedge funds, insurance companies and pension funds were looking for ways to take on risk in hopes of earning higher investment yields.
The driving force in creating the credit-derivatives market, said Herring, was big banks looking for ways to make assets, such as loan portfolios, more liquid.
Credit Default Swaps
Credit derivatives are contracts that go up or down to track the fortunes of underlying corporate debt, such as bonds the company has issued or loans it has taken out. Typically, the company is not involved in the credit derivatives contract, which usually involves the bond holder or lender paying a fee to shift risk to a third party.
“The market for credit derivatives is mostly dominated by credit default swaps (CDS),” said Wharton finance professor Krishna Ramaswamy. He described them as “an ‘insurance’ contract in which the buyer of protection pays a periodic and ongoing premium in exchange for a payment from the protection seller when a well-defined event is triggered….”
A typical buyer is a bond owner or lender who is expecting to receive payments from the corporate borrower. The CDS can protect that income stream or offset any decline in the value of the bond or loan the buyer owns. Like an insurance claim, the payment is triggered if, for example, the bond issuer goes bankrupt, fails to make its debt payments, restructures its debt or suffers a rating downgrade. In the U.S., these contracts typically run for five- or 10-year periods, and they provide protection in blocks of $10 million to $20 million.
Once a CDS is created, it can be traded in the secondary market, much the way bundles of mortgages are traded as collateralized mortgage obligations. Its price will rise or fall as the market assesses the health of the underlying corporate debt. Thus, the risk of a company defaulting on its debt obligations can easily be passed to investors willing to shoulder it. “The system is actually more stable because of these mechanisms,” Ramaswamy said. “The losses…are best borne by a wider pool of investors, each holding a diversified basket of these obligations.”
In recent years, many credit default swaps have been assembled into baskets and traded as indexes, much the way stocks can be traded through S&P 500 index funds. This allows investors to use credit default swaps to bet on broad changes in credit markets — betting that default rates will rise or fall, for example.
With a CDS, an investor can focus a bet on credit risk, while an investment in a bond or loan entails a much broader assortment of risks — credit risk, interest-rate risk and currency risk, for example. Credit derivatives also can be used for shorting and hedging strategies. All of that is much more difficult for investors trading in actual bonds and loans.
Banks are both the biggest buyers of CDS protection and the biggest sellers, using them to reduce their risk exposure to companies to whom they have lent money, thus reducing the capital needed to satisfy regulatory requirements. Other big buyers are securities firms and hedge funds, while re-insurers, insurers and securities firms are the other large sellers.
In recent years credit default swaps have been bundled together to create collateralized debt obligations (CDOs). Typically, a CDO contains swaps from more than 100 companies. Once put together, the CDO is sliced into a several tranches, which are then sold separately. At one extreme is the high-risk, high-yield slice. Owners of these get a disproportionately large share of the income flowing into the CDO. But they also are first to suffer the losses from any companies that default. At the other extreme is a safe, low-yield tranche, with one or two other tranches occupying the middle.
The CDO market has mushroomed in the past few years as investors hunted for higher yields than they could get with more traditional interest-paying investments. Last year, an estimated $1.2 trillion in risk was transferred to investors through CDOs.
Another key feature of credit derivatives: leverage. The value of credit derivatives can greatly exceed the value of the debt they are based on. That is because the entity that buys credit insurance does not actually have to own the bonds or loans it is insuring.
Rosen estimated there are $25 billion in credit derivatives riding on $2 billion in Delphi bonds. Just as any catastrophe triggers insurance claims, Delphi’s problems mean credit default swap sellers owe payments to the buyers who took out the insurance. Many contracts require the insured party to turn the underlying bonds over to the insurer when the payment is received, much as an insurance company may take possession of a wrecked car upon paying a claim.
Insured parties that don’t have the bonds in their portfolios can buy them through the market to satisfy this obligation. But because of leveraging, there may not be enough bonds to go around. The escalating demand can cause a short squeeze, Rosen said, that would drive up the bonds’ price and cause spiraling expenses for those desperate to get the bonds, possibly forcing them to sell other assets to come up with more cash.
The solution, according to Rosen, is likely to be a push by regulators to allow the obligations to be settled with cash payments instead of physical bond transfers. The topic has been the subject of frequent meetings between participants and regulators since the Delphi bankruptcy filing. The talks are aimed at how the payments should be figured, Rosen adds. Some participants, such as hedge funds, oppose cash settlement because they got into this market for the very purpose of obtaining bonds at fire sale prices, hoping to profit when a squeeze or recovery drove the bond prices back up. Asked if the issue can be resolved before a short squeeze begins, Rosen answered, “I think that’s a great question, and I don’t know the answer.”
Although the Delphi situation is testing the resiliency of the credit-derivatives market, Rosen argues that the system actually has grown stronger in the past few years. Leverage is not as excessive as it was at the time of the Enron collapse, and dealers have better systems for tracking the value of collateral on which credit derivatives prices are based.
Herring, however, points out that this is a very opaque market, since credit derivatives are not traded in a centralized marketplace like stocks. It is therefore not clear where all the risks lie.
In some respects, these derivatives amount to a zero-sum game: risk is neither created nor destroyed; it is simply shifted from one player to another. But although the overall level of risk stays the same, credit derivatives allow it to be concentrated in the hands of participants willing to shoulder lots of it in hopes of attaining outsized gains. This is why credit derivatives have become so popular with hedge funds.
Hedge-fund investors take their chances with their eyes open, and nobody else cares much if some of them get burned. But ripple effects do sometimes swamp the innocent, too. That was the big worry when Long-Term Capital Management’s bets went sour.
According to Ramaswamy, it is unlikely that trouble related to a single company like Delphi will spill over to the broad markets, but he said it would be worrisome if a large number of companies ran into serious difficulties. And Rosen noted there is a lot of dry tinder on the forest floor — a mushrooming issuance of low-rated, high-risk debt. “I will be shocked if we don’t see a significant rise in default rates over the next 18 months,” he said.
If that happens, it will be easier to determine whether credit derivatives are making the world a safer place — or a more dangerous one.