Testing times

IFR Derivatives 2008
10 min read

The credit derivatives market is experiencing the gravest test of its short existence after years of exponential growth. Concerns over the continuing stability and the default of many financial institutions, calls for greater regulation and oversight, rising risk aversion and the deterioration across capital markets are all testing the market’s resolve. Hardeep Dhillon reports.

The volume of outstanding credit derivatives contracts declined for the first time in the market’s history over the first half of this year. It fell to US$54.6trn at the end of June, down 12% from US$62.3bn at the end of 2007, and a 20% annual drop, according to International Swaps and Derivatives Association (Isda).

This decrease primarily reflects the industry's efforts to reduce risk by tearing up economically offsetting transactions, and demonstrates the industry’s ongoing commitment to reduce risk and enhance operational efficiency, said Robert Pickel, Isda executive director and chief executive officer. “We expect to see more effects of this over time,” he added.

“There has been a lot of pressure, from regulators and an operational point of view, to reduce the notional volume within banks, resulting in a big focus on compressing trades. Volumes will further reduce if many of the contracts move to a central clearing facility, which could clear many index trades that account for around one-third of the credit derivatives market,” said Michael Hampden-Turner, structured credit strategist at Citi.

Volatility has ravaged both single-name and index spreads, pushing them to record levels. The iTraxx Crossover reached a record of 750bp while the iTraxx Main was trading in the 140bp area, below its peak levels in March, on October 10. Sovereign CDS also came under intense pressure due to wholesale government bailouts across Europe, aimed at stabilising the fragile financial sector. One quantitative credit strategist said that though government actions did not provide relief to financial stocks, synthetic credit spreads of the financial sector outperformed the market, evidenced in the spread between the iTraxx Main and Financials Senior indices reaching over 20bp by October 10. Government bailouts were well received by the derivatives markets as the iTraxx main closed at 128/129bp, the Crossover at 686/689bp and the financial indices moved to 93/96bp by October 13.

Despite the market’s immense size, analysts estimate that roughly US$15trn of credit default swaps (CDS) are concentrated among the top 20 to 25 banks. This has highlighted counterparty risk concerns among investors, who now have to analyse and understand concentration risk issues. The solvency of institutional counterparties has become a major concern, said Domenico Picone, head of structured credit research at Dresdner Kleinwort.

“The concentration of the market among very few players means counterparty risk is huge. There is little information shared with other players, on CDS volumes and counterparties each banks has. The market is very opaque and as a result no player has a clear knowledge of the ramification of a "senior" name defaulting on the credit market overall,” he said.

It is not only banks that are being affected. Insurance companies and investors, such as sovereign wealth funds and hedge funds, have written credit protection via CDS, and these institutions could be faced with huge payout amounts or liquidating assets to raise money for the final settlement. Credit derivative product companies have also suffered from recent CDS default events, resulting in Primus Guaranty and Theta Corporation losing their Triple A counterparty rating.

Auctions under way

The auction season for settling contracts began with Canadian forest products company Tembec on October 2, followed by Fannie Mae and Freddie Mac on October 6 and Lehman on October 10. Washington Mutual is scheduled for October 23 and the auctions for Iceland banks, Landsbanki Islands, Glitnir and Kaupthing Bank for early November. In these settlement auctions, the reference price for the underlying bonds will be set, thus determining the payout levels for cash settled CDS, CDX and iTraxx indices, index tranches and synthetic CDOs.

How these auctions fare, and the reaction from regulators, is an important test for the credit derivatives market, said Hampden-Turner. “It will be important how efficiently auctions are carried out and how close the final recovery rate is relative to where bonds are trading. The gross volumes will be in the hundreds of billions, although net volume will be smaller because of the big build up of contracts,” he said.

Fannie and Freddie senior debt settled at 91.5 and 94 cents on the dollar respectively, while Lehman produced one of the lowest recoveries on record at 8.625 cents on the dollar. Some predict the Lehman settlement on October 23 could trigger a record payout of up to US$400bn, and that the Icelandic banks payout could reach US$200bn, though net payouts would be much lower.

“In general, we think much of the concern about gross CDS outstanding prior to the Lehman auction is very overdone; net settlement volumes will be far, far smaller,” said Hampden-Turner. Some expect the net payout on Lehman CDS to be well below reported headline numbers and only around $10bn. The Depository Trust & Clearing Corporation has calculated that payments relating to Lehman’s bankruptcy indicate that the net funds transfers from net sellers of protection to net buyers of protection are expected to be in the US$6bn range.

Significant CDS payouts could put tremendous strains on financial counterparties that had written contracts. Concerns abound that many counterparties, such as hedge funds, will be unable to raise cash to meet payout demands following the recent large-scale defaults. This in turn may force write-downs for those failing to receive the payouts, many of them major banks.

Nonetheless, a substantial portion of CDS contracts is cash-settled on a daily basis. And many firms have taken steps to soften the blow and prevent further contagion by offsetting their obligations, netting of positions, collateralisation, hedging of the hedges and reducing hedge fund leverage.

Credit Derivatives Research suggests there could be some downward pressure on physical bonds and potentially lower recovery rates as more protection sellers will opt for cash settlement and more protection buyers will opt for physical settlement. “The lower than expected recovery rate on credit derivatives is likely to further fuel market concerns about the impact of future defaults,” added Hampden-Turner. “Going forward, we expect corporate and financial downgrades to continue, and credit events to be an increasingly common feature of the credit environment.”

The knock-on effects of Lehman’s default will take time to filter through the financial system. It will be easier to gauge the extent of loss and how to replace the most visible derivatives contracts but the hidden factor is the impact on the structured credit market, said Philip Gisdakis, head of credit strategy at UniCredit Markets & Investment Banking. “We are only starting to see the implications from the default and the fact that Lehman bonds are in so many structured credit transactions will keep markets busy for a long time,” he said.

DK’s Picone expects large liquidations of rated collateralised debt obligations (CDOs) where Lehman acted as protection buyer with the SPV and some impact on the prices of the mezzanine tranches of the iTraxx and CDX as a result of rising defaults.

More oversight

The New York Insurance Department, the Securities and Exchange Commission and the Commodity Futures Trading Commission have all called for greater supervisory oversight of the market. The Federal Reserve Bank of New York met with CDS dealers and exchanges on October 10 to accelerate market adoption of a central counterparty that would reduce risks and absorb counterparty losses.

A number of initiatives to resolve the problem are already underway. The Clearing Corporation, backed by a group of banks, inter-dealer brokers and data providers, is joining forces with IntercontinentalExchange, Markit and RiskMetrics to provide a central counterparty clearing facility for credit default swaps, while the CME Group is teaming up with hedge fund Citadel for a similar proposal.

Picone believes that the move by regulators to impose changes on how the market operates, an example is through an exchange, could drastically change the industry. “For example, an exchange would make it easier to monitor concentration risk in the system, calculate the net exposure to the exchange as opposed to other counterparties, but reducing the bid/offer spread in the long run,” he said.

Gisdakis believes that minimising counterparty risk by putting derivatives market onto cleared exchanges is an important point. If the market had been able to trade CDS on a stock exchange the Lehman default would have been a different issue, he added. “If a specific derivatives class is essential for the functioning of the whole market we have to make sure that this market is up and running under all circumstances. The derivatives market is not completely bullet proof, that is clear, but they are more stable against bank runs and crisis of confidence than an unregulated base of broker dealers,” he said.

He is sanguine about the market’s prospects, stating that the sheer ability to trade credit derivative instruments is more important than the fact that only investment banks can trade them. “It is not the instrument, the CDS itself, that went sour; it was the underlying credit that ran into trouble. It is a completely different situation when you look at CDOs or securitisation where you can blame the instrument or the structure itself. Credit derivatives are still a valid instrument for hedging and managing credit risk,” he said.