Tying Interest Rates to CDS Is a Recipe for Main Street Disaster

Warren Buffett called credit default swaps “weapons of financial mass destruction” and they are about to annihilate Main Street. In a disturbing new trend, money center banks are “weaponizing” credit default swaps (CDS) by using the trading price of a borrower’s CDS to adjust the borrower’s interest rate. Unfortunately, banks don’t understand that they are arming speculators with the power to ambush and kill unsuspecting and otherwise healthy companies. Regulators appear oblivious to the market realities and dangers of CDS, and the banks are unwittingly putting their own portfolios at risk by potentially damaging their borrowers.

CDS are unregulated derivative instruments that are essentially a bet on the creditworthiness of a company. Unfortunately, the market for CDS is an over the counter opaque market with no regulation and prices with questionable value. Recently, Bloomberg reported that several money center banks are inserting terms into loan documents that automatically adjust a borrower’s interest rates based upon the trading price of a borrower’s CDS. This seemingly innocuous loan provision allows speculators to bet that a borrower’s stock price will go down and ensure that the bet pays off when speculators manipulate the borrower’s CDS prices upward. Higher prices on CDS increase the borrower’s interest expense and destroy its earnings per share. Dropping earnings per share cause the borrower’s stock price to fall, which means that the speculator makes money on their bet that the borrower’s stock price will decline. Banks don’t realize that they are creating an unfair investment game that is the dream of every rotten short seller and speculator. Today the Wall Street Journal reported how similar trading schemes have virtually destroyed brokers and banks.

A hypothetical example can illustrate how speculators can use this loan provision to kill an otherwise healthy and unsuspecting borrower. Sunshine Widgets is an imaginary and otherwise healthy company that is actively traded on the NYSE. Sunshine Widgets has a new credit facility that includes an interest rate that is tied to the trading price of its CDS.

Three speculators read Sunshine Widgets' SEC filings and decide that it will be their victim. They bet on a decline in Sunshine Widgets’ stock by shorting the stock and buying puts in a careful series of trades that don’t attract market attention. Then the speculators start daisy chain trading in Sunshine Widgets’ CDS. Speculator #1 sells CDS to Speculator #2 at an artificially inflated price. Speculator #2 hedges its position by selling CDS to Speculator #3 at the same inflated price. And, Speculator #3 hedges its position by selling CDS to Speculator #1 at the same inflated price (which also acts as a hedge to Speculator #1’s original trade). The next day, the three speculators enter into the same daisy chain scheme at a higher price and the next day they do the same at an even higher price.

The high CDS price causes an increase in Sunshine Widgets’ interest expense, which reduces Sunshine Widgets’ earnings per share (EPS). Because of falling earnings, equity investors punish Sunshine Widgets' stock price in a broad selloff. As Sunshine Widgets’ stock goes down, the speculators make money on their short stock position, but the worst is yet to come. Sunshine Widgets’ interest cost rises with the increase in its CDS prices. As a result, its ratio of cash flow to debt service declines. This means that the underlying creditworthiness of Sunshine Widgets deteriorates. As a result, legitimate investors start to trade the CDS at higher levels. Equity investors continue to sell the stock. Speculators started a negative feedback loop where higher CDS prices cause deterioration in the creditworthiness of Sunshine Widgets which in turn cause higher CDS prices. The way to stop this negative feedback loop is for Sunshine Widgets to raise equity and deleverage. But Sunshine Widgets’ lower earnings has destroyed its stock price and made issuing new stock very dilutive and potentially impossible.

On Friday the Fed, the SEC and the CFTC announced that they are cooperating to bring transparency to the CDS market by working to create a central CDS clearinghouse. Unfortunately, Friday’s news doesn’t reflect today’s realities and illustrates how regulators continue to fall behind dynamic and changing problems. Without substantive regulation, CDS clearinghouses will provide false transparency and legitimize abusive and manipulative behavior. For CDS clearinghouses to add value, all trades need to go through the clearinghouse, substantive regulations need to be enacted that make market manipulation a crime, and the reach of regulators needs to be global. What regulators are doing is analogous to arms inspectors declaring that nuclear proliferation is under control because the International Atomic Energy Agency counted the number of centrifuges being used by rogue nations to produce nuclear weapons for terrorists.

The unintended consequences of using CDS for dynamic credit pricing are predictable, unnecessary and dangerous. Regulators shouldn’t be wasting their time working on systems to keep track of trades that put financial nukes in the hands of economic terrorists. Instead, they need to immediately and unconditionally ban the tying of loan interest rates to CDS prices. They need to think clearly about why it is “good” to allow speculators to make naked bear bets on companies and then “shave the dice” by playing in the unregulated CDS market. Substantive regulation of CDS is needed immediately before a few good companies are sacrificed on the altar of “free markets”.

Comments

[Tom Armistead:]

Rating agencies don't admit it, but they check the CDS spreads and if the spreads go up they find an excuse to lower the ratings.

2008 Nov 24 09:00 PM

[dlaw:]

This is an important article.

Thank you.

2008 Nov 24 09:40 PM

[Tony Petroski:]

I get to buy an insurance policy on the house across town and then attempt to burn it down. What a country!

2008 Nov 24 10:29 PM

[jcrash:]

Good article.

2008 Nov 24 11:31 PM

[headlocal:]

so, let's get the recipe right -
a) find firms getting loans from Citi or Credit Suisse, per Bloomberg cite, or
b) scan "candidate" firms' SEC filings for CDS references

c) determine how fast they roll their financing, and how much
d) project news events likely to lower estimates of revenues, etc
e) buy deep-out-of-money PUT LEAPS, say 2010 or 2011 series, strike maybe 20% below current price
f) sit back and let the speculators work their magic, or just wait for the recession to erode the firm's financials anyway
...
is there any way such borrower firms DON'T get hosed, sinking the above strategy??

2008 Nov 25 05:01 AM

[morph366:]

Careful you're giving the game away.
Very good read but letting too many people in on these tactics will only increase the peculiar feature about this crisis which is that the predators are starting to feed on their own
This could collapse the whole food chain!

2008 Nov 25 07:34 AM

[the_Bird:]

Nailed it. People are finally starting to recognize how some of these frauds have been perputated. Put on some seemingly legitimate short positions in the regulated market, collude in the unregulated CDS market and cause a panic in the common shares (and bonds). Having the debt's interest rates linked to CDS rates makes this worse, but since so many investors today are looking at the CDS markets for clues about who is next to collapse, even companies without that direct exposure to the CDS market are at risk. A clearinghouse is absolutely needed.

2008 Nov 25 07:44 AM

[xmplary:]

Great article. Thanks for writing about this. I've got to add this to my list xmplary.blogspot.com/2...

2008 Nov 25 11:02 AM

[Here's a th...:]

I believe CDS to be a overall a good idea. It allows lenders to diversify risk which in turn provides funding for less qualified buyers. The lending of money is essential to create wealth. CDS open new markets but obviously regulation is needed.

2008 Nov 25 11:22 AM

[Jason Rines...:]

Good article. I am thankful there are still what we call 'gentlemen' in America. I hope you consider running for office someday Mr. Sunshine.

2008 Nov 25 04:28 PM

[Ransome:]

The CDS as a business credit score and every loan an ARL. Perfect. Rust never sleeps.

2008 Nov 25 06:39 PM

[happysoul77777:]

A very good article!

I also have long suspected that the CDS market can be manipulated. Your hypothetical scenario may have already happened when a few speculators colluded and widened the CDS spread of some financial companies and then killed them.

Your article implicitly brought out an indictment against Fair Market Value accounting. This accounting rule is based on the premise that the market value of a security (either stock, bond, or derivative) is always accurate and free from manipulation.

The reality points to the contrary. Market value is inherently volatile and can be manipulated. Reliance on an accounting rule which depends on the fairness of market place, and the ability of regulators to prevent manipulation, is ill-advised.

No wonder that we are witnessing an implosion of capital and wealth around the world! The bean counters need to have more common sense!

2008 Nov 25 08:41 PM

[jtr:]

I agree that the feedback loop caused by transferring market and issuer credit risk from the lender to the borrower, as produced by an interest grid based on market spreads, is preposterous. However, this article overshoots this point in an attempt to capitalize on the en vogue trend of scapegoating misunderstood CDS markets (and the role of shorts in general). The issue here is not that "banks don’t understand that they are arming speculators with the power to ambush and kill unsuspecting and otherwise healthy companies" but rather bank balance sheets are strained and undrawn lines of credit are a horrible use of capital.

To take your Sunshine Widgets example, let's suppose Sunshine Widgets actually operates in the real world and is looking to extend an existing or enter into a new credit line. The bank doesn’t want to tie up capital in an undrawn facility and risk lending out at rates below its own cost of capital or have to risk taking a write down on a contingent liability should Sunshine Widgets’ credit worthiness deteriorate. Thus, the bank proposes a deal: it will provide a line of credit with rates indexed to its own existing cost of capital as well as the Sunshine's credit risk. The bank debt market used to be a par market, and it appears that this mechanism was structured to provide for a piece of paper that would retain a par mark to market value. It's a free, competitive market, so if Sunshine Widgets can find better terms, it will borrow from another bank. And if (when) the credit markets stabilize, Sunshine Widgets can always look to refinance this line or enter into new ones. Perhaps this exposes the Company to manipulation, but the alternative would be to lock in borrowing costs at a much higher rate. Further, as difficult as it is to believe these days, credit spreads actually can go tighter. Given that spreads are at historical wides, such an arrangement could actually be beneficial to the borrower. In fact, your example can just as easily be reversed (eg sellers of CDS force spreads tighter, pushing the interest rate tighter, interest expense down and share price up). In the FirstEnergy Credit Agreement, the Company’s one year credit default swap is used as the reference spread. Should this blow out to a level that misprices the Company’s true credit risk, people will line up to take the other side of the trade and sell CDS until it tightens back in.

As easy as it is to blame the CDS for the imperilment of financial institution balance sheets, the reality is that the balance sheets were overleveraged and stuffed with troubled assets. To disprove the conspiracy theories, one need only look to the recent events at Citigroup, where the Company’s CDS only widened to the ~400 bps context even in the throws of the equity decline which prompted an emergency bail-out. Or take Lehman, if the CDS market is really to blame and the company’s unsecured credit really did have a higher recovery value than the CDS market implied then why is it that the bonds are still only trading in the low-teens?

Also notable is that despite all the flack the CDS market is getting in the press, CDS spreads for most issuers actually trade significantly tighter than the spreads of the underlying cash instruments.

2008 Nov 26 01:52 AM

[Kinabalu:]

"Recently, Bloomberg reported that several money center banks are inserting terms into loan documents that automatically adjust a borrower’s interest rates based upon the trading price of a borrower’s CDS"

It astounds me that a CFO for significant company would even consider a financing with such a provision. As a financial executive for a capital intensive Fortune 500 company I learned early that sometimes you just have to say NO to the lender. Every time I did that we completed the financing within 3 months without the onerous provision.

2008 Nov 26 03:53 PM