Tuesday, January 13, 2009

Important changes afoot in the CDS market

Continuing my recent credit default swap theme, I'm going to discuss a couple of important changes in the CDS market that are now imminent. First, after talking about it for years, market participants in the US have agreed to drop the "restructuring" credit event — which is actually called "modified restructuring," and is commonly known as Mod-R — for standard US single name CDS. From Reuters:

A protection buyer can be paid out the insurance when a borrower files for bankruptcy, fails to make an interest or principal payment on their debt or, in some cases, when a company restructures its debt. Changes expected to roll out as early as next month, however, will remove the restructuring trigger for standard contracts in North America. Buyers of protection may still request restructuring triggers in tailored trades, although it would cost more. The changes will standardize contracts on single company debt with those on indexes, which do not include restructuring.
Removing Mod-R from standard investment grade corporate CDS is an important step on the path to a central clearinghouse, for one thing because it allows the clearinghouse to net an index CDS and its single-name components. The restructuring credit event has always been a source of problems, and Mod-R has been a fiasco. Mod-R puts different limitations on the maturity of deliverable obligations depending on whether the buyer or seller triggers the termination, which was a stupid idea to begin with. It would also make it very difficult for a clearinghouse to conduct a cash settlement, because what maturity should the bonds in the auction be? The solution to the cash settlement problem that has gained the most traction so far—bucketing maturities together and holding separate auctions for each bucket—seems unworkable to me, so I'm glad they decided to just scrap Mod-R entirely from standard CDS contracts. Neither the US high yield index (CDX.NA.HY) nor high yield single-name CDS include a restructuring credit event, so the era of Mod-R should thankfully come to an end soon. However, it looks like no such change will occur for European CDS, which will continue to use "modified modified restructuring" (known as Mod-Mod-R) in both single-name and index CDS. The maturity limitations on deliverable obligations under Mod-Mod-R aren't nearly as retarded restrictive as the limitations under Mod-R. Still, with a record number of restructurings expected this year, I have to believe the European market will end up regretting the decision to keep Mod-Mod-R. The second important change in the CDS market will be a direct result of the elimination of Mod-R. As it currently stands, eliminating Mod-R from standard US contracts will force banks to take a hefty capital charge, which would lead to another round of forced liquidations as banks raise cash to meet capital ratios. As the Reuters article notes:
For banks, however, the move may prove expensive. It will reduce by 40 percent the capital relief awarded by using use CDS to hedge bond and loan holdings, said Bank of America analyst Glen Taksler. "The downside to removing restructuring is that banks get full capital relief from buying CDS with restructuring, but only 60 percent capital relief without restructuring," Taksler said. Banks may react to the change by selling bonds and loans, which could pressure their valuations. ... Market participants are in discussions with regulators with the hope of removing or reducing the penalty for excluding restructuring as a trigger in contracts, said a person familiar with the discussions who declined to be identified.
Given current market conditions, it makes sense for the BIS to reduce the penalty for removing Mod-R as a trigger in CDS contracts, and I think that's ultimately what they'll do. Remember, only investment grade corporate CDS trade with a Mod-R provision. With all the emergency government programs supporting commercial financing, such as the Commercial Paper Funding Facility (CPFF), a restructuring of investment grade debt will likely be much less costly to bondholders than it would be in a normal market. Moreover, with DIP financing hard to come by, and a much higher chance that Chapter 11 bankruptcy will turn into Chapter 7 liquidation, banks will be able to extract much more stringent restructuring terms. If restructurings will be less costly to banks, then it makes sense to reduce the capital charge for failing to have CDS protection for restructuring.


Anonymous said...

Using homeowner's insurance as an analogy to credit default swaps- I can understand why a homeowner would purchase protection for his home, but why would someone half way around the world purchase insurance on that same home? and wouldn't that second guy have an incentive to set it on fire? Thanks.

Economics of Contempt said...

Well, I don't think it's always proper to use insurance as an analogy to CDS, because there are key differences -- namely, there's dynamic collateral posting in CDS, whereas the insurance company doesn't pay you money as the chances of your house catching fire rise.

But even when the insurance analogy is entirely appropriate, I still think there are plenty of situations where it's reasonable to buy CDS on a bond you don't own. You don't have to own a company's bonds to have exposure to it. Lehman was a perfect example. Everyone had some level of exposure to Lehman, whether they owned Lehman's debt or not. In that case, I think it's appropriate for firms to buy CDS on Lehman even though they don't technically own Lehman's debt. Modern financial markets are so interconnected and complex that credit risk isn't confined creditors anymore. So I don't mind allowing non-debtholders to buy CDS.

You're right that so-called "naked CDS" gives protection buyers an incentive to attack the reference entity's creditworthiness, and there's some debate over whether speculators have been spreading rumors to drive up CDS spreads. The Wall Street rumor mill being what it is, it's hard to know how much truth there is the claims of conspiracy and manipulation. Short-sellers have the same incentives, though, and we've managed to make our peace with their existence (though not so much recently!). So I don't think that particular alignment of incentives should rule out naked CDS as useful financial instruments.

jklondon said...

"European market will end up regretting the decision to keep Mod-Mod-R." - did Europe make a decision to keep this or really have they just not made any decision yet and will follow the US ...eventually.

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