Credit Default Swaps I: Fixing CDS

Includes: BX, HOV
by: Kurt Dew

Observers have blamed several recent untoward developments in corporate debt markets on the ill effects of credit default swaps (CDS).

Perhaps responding to criticism from Commodity Futures Trading Commission (CFTC) chairperson J. Christopher Giancarlo, the industry has reacted.

The International Swaps Dealers Association (ISDA) has proposed revisions to the CDS master agreement.

This ISDA measure addresses one of the symptoms of the underlying problem – collusion between CDS traders and corporate borrowers.

However, bondholders must address the broader problems with the debt market that CDS blowouts reveal. Buyside risk managers cannot depend on others to solve their problems. Not even CDS problems.

This article is the first of a multi-part series discussing the failing credit default swaps (CDS) market in the broader context of the overall failings of the debt market. The article seeks a way to save the CDS market from its imminent demise while demonstrating that simply changing the terms of CDS contracts will not solve either the problems of CDS or the problems in the debt market that CDS reveal. These articles show that CDS problems are only a symptom of the failings of the broader debt market. The first article provides recent examples of CDS market failures, characterizing the failures’ properties to identify the broader debt market issues that CDS’ were designed to protect against.

The article proposes an alternative to the recent proposal by the International Swap Dealers Association (ISDA), described here, which proposes to “clean up” the CDS market by changing the language of the master agreement used by writers of CDS. The ISDA proposal is fine, as far as it goes. However, a change in the CDS master agreement addresses only one source of the problems created by the coexistence of debt options like CDS and debt unduly dependent on the foibles of individual issuers.

One example identifies a bankruptcy brought on by CDS without any of the interaction between borrowers and CDS traders that the ISDA initiative addresses. A resolution of the broader problem requires that debtholders address the shortcomings of the market for debt.

A CDS is a financial instrument, a form of over-the-counter (OTC) option – I buy a CDS to make a focused bet against the performance of some debt instrument or class of debt instruments. The CDS provides the writer (seller) regular payments (the premium) in return for the writer’s commitment to pay the buyer an agreed amount in the event of a pre-specified “event of default.”

The purpose of a CDS, from a price discovery perspective, is to shed light on the market’s impression of the likelihood and cost of default of a given debt issue. This information also is partially embedded in other market prices, such as the risk premium on the debt itself, but a CDS returns this information more specific than the debt risk premium and permits traders to trade that risk without much regard for other issues that affect the price of a given debt security – at least in principle.

Why do CDS matter?

CDS fill a fundamental need identified by financial economists long ago. One of the basic tenants of financial economics is that financial markets are the least expensive way to provide consensus valuation information to market participants, assisting an economy’s production of a collection of goods and services with maximum economic value at minimum cost. Specifically, financial markets are, in principle, an inexpensive way to describe the consensus values of future courses of action.

A corollary of the need for financial markets is that financial market information ought to be complete. That is, the market ought to provide consensus views of the value of every important decision and the ability to benefit from important personal price evaluations through the purchase or sale of a financial instrument.

Credit risk is, along with price risk, a central issue in financial decision making. A “working” CDS market would thus provide a sorely needed piece of information to investors and a way to elect whether to take each important credit risk. What's a working CDS market? CDS markets are functioning well when prices are readily available to the public, along with the assurance that this price information faithfully reflects the risk the CDS is pricing.

The creators of CDS intended this result. Like most market innovations, the CDS was created to increase the ease with which market participants manage risk - credit risk in this case. CDS creators expected an active CDS market to reduce the cost and increase the simplicity of choosing credit risk.

However, CDS are derivative instruments. As an asset class, derivatives generally have done more damage than might have been hoped, giving rise to a belief that derivatives generally, and CDS specifically, might be improved in a way that might reduce the degree to which the CDS produces undesirable side effects. How can the CDS market be rescued?

CDS or Three-Card Monte?

The reason for CDS’ fall from grace is that market participants have found CDS sometimes add to total risk instead of simply pricing and transferring existing risk. Transferring existing risks is, of course, the primary purpose of financial markets. Creating a new risk is an unfortunate occasional side effect.

The problems created by CDS are an effect of the ease with which debt market participants can, and often do, collude with debt issuers to change the risks and prices of CDS to their mutual advantage. Thus, the problems facing the CDS market are a symptom of the poor overall governance of the market for corporate debt. Below I will provide three recent examples considered from a market efficiency point of view. The solution to CDS market problems is a new kind of debt with a new kind of issuer, traded in a new venue that lists CDS as well. Following articles recommend this course of action.

A stumbling market

The CDS market has fallen upon hard times. CDS trading volume has declined substantially – unique among major financial derivatives. Here are three prominent recent market failures, dissected.

An important aspect of this discussion is that none of the market abuses described here are, as far as I know (and I hasten to add that I'm no expert in the legal issues raised here), illegal. Nor are they, in my opinion, violations of market regulations. Nonetheless, the CFTC has recently complained to the International Swap Dealers Association (ISDA) about the need to “clean up” the CDS market. However, the ISDA represents dealers and is not a likely source of solutions to problems of the buyside or of solutions for the market as a whole.

CDS, in today’s market, exploit debt market vulnerability to hidden schemes that sometimes work against CDS buyers on one hand, and at others, CDS sellers. The most obvious way to corrupt the CDS market is to collude with the issuer of the debt upon which the CDS was written. This collusion can work in favor of either CDS buyers or CDS sellers. Examples follow.

Debtor and CDS writer save an otherwise defaulting debt, at the expense of CDS buyers.

Writers of CDS have influenced debt issuers by putting an otherwise defaulting debt on life support to the benefit of both the issuer and the CDS writer at a cost to buyers of CDS who correctly forecast that the bonds would indeed default absent outside tampering.

Examples of this phenomenon include the case of Matalan. As Robert Smith of the Financial Times described it, “A group of hedge funds that sold CDS on UK retailer Matalan recently offered to fully support a new bond issue from the company, so long as the company issues the debt out of a new entity. This process would “orphan” existing CDS contracts written against the old entity, making them essentially worthless, as they no longer reference the repaid debt, and hand the funds a profit. Sources with knowledge of the matter said that Matalan was unlikely to accept the deal, but noted that concerns around orphaning had still contributed to a collapse in the value of CDS contracts linked to its (Matalan’s) debt.”

Debtor and CDS buyer “manufacture” a default of an otherwise performing debt, at the expense of CDS writers.

Examples include borrowers that have benefited from their own defaults because those defaults have triggered CDS-related payments to them from third parties. These third parties have compensated the borrowers for their costs of default at a profit, leaving the writers of CDS to lick their wounds.

The example of a bond default that would generate payments to buyers of CDS is the celebrated scheme Hovnanian (HOV) and Blackstone (BX) concocted, where Hovnanian would intentionally default. Hovnanian’s incentive was Blackstone’s commitment to replace the defaulted debt issue with another more attractive debt issue. Blackstone would have profited from the lucrative effects of the default on Blackstone’s substantial portfolio of CDS written in Blackstone’s favor that would have paid off more than enough to support the cost of Blackstone’s extension of new credit to Hovnanian. In the actual event, Hovnanian and Blackstone unwound their deal under threat of a lawsuit from one of the CDS holders.

Why CDS fail.

The ability to coopt the decision-making process of a debt issuer is the primary underlying market problem. Opening a market for trading the credit risk of an issue creates a way of profiting by influencing the debt issuer’s decision to default. However, do not blame the CDS market. There's a successful market for stock options that create similar incentives for stock price manipulation. Why no similar problem with stock options?

The difference is that debt has a different standing within the corporate decision-making process than common stock. The law requires corporations to maximize the value of their corporate shares by all legal means. However, if stockholders would benefit from a corporate decision that legally destroys the value of a debt issue, a corporation is bound to do so. Thus, corporations are not immune from external means of compensating a firm to default on an otherwise viable debt.

When CDS can bankrupt an otherwise viable firm.

There's a third, more interesting, sort of CDS-generated market donnybrook. In this case, the corporation issuing the debt did not collude with the CDS trader that profited from a defaulted debt issue.

Consider the lawsuit, Windstream Holdings Inc. (WIN) vs. Aurelius Capital Management. Windstream had defaulted on one of the terms of its agreement with its debtholders. These debtholders thus had the right to sue in bankruptcy court, but (as is the case with some regularity in the debt market) decided that their interest was best served with the continued unimpeded operation of Windstream rather than seeking a less certain partial recovery in a bankruptcy proceeding.

However, in an aggressive act following the event of default, the hedge fund Aurelius bought some of the defaulted debt and then demanded full payment of about $310 million for the defaulted bonds. There's little doubt that Aurelius did not expect to receive the $310 million. Instead, Aurelius most likely expected the case would precipitate Windstream’s bankruptcy. Thus to force Windstream’s bankruptcy, Aurelius took both a debt position and a larger CDS position betting against the debt, and then sued for bankruptcy.

What makes this an interesting development is that nobody did anything illegal or unethical. However, the event leads to the conclusion that CDS alter the incentives of the issuers of other financial instruments. One must weigh the loss of the contribution to the economy of viable defaulting firms such as Windstream against the effects of CDS-induced lawsuits. Weigh the survival of issuers of debt with poorly conceived contract terms, on one hand.

Compare that to the value of troops of lawyers, searching through the small print on thousands of debt contracts, looking for an opportunity to surprise the CDS market by filing against otherwise profitable companies with checkered pasts after taking CDS positions on the down low, on the other.

Why save CDS?

CDS make financial markets more complete. The only reason for this market to fail is if there's no way to prevent manipulation of the value of debt in the presence of CDS. Is the problem CDS or the failures of the market for debt itself? I contend the market for debt fails, not CDS.

Today debt issuers dominate the debt markets. Why? Because debtholders damaged by the shortcomings of debt as a risk management vehicle are not effective advocates of risk managing debtholders’ important contribution to the market. If debtholders sought to protect their interests as a group, debtholders would boost more than their own self interest. They would promote the success of the market for debt as a whole – and as a result, their efforts would lead to both lower interest rates and larger quantities of debt sold as the market for debt becomes more liquid.

To balance the weight of issuer self-interest in determining market performance, a forum that represents the interests of both parties, on an even playing field, along with the concerns of the broker/dealers and traders who provide liquidity to the market, would go far toward remedying the problems of CDS described above.

Following articles show how a new exchange, a self-regulatory organization representing the broader interests of the risk management professionals in the financial markets might improve the liquidity of the debt market and return the CDS market to viability.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.