Sunday, March 16, 2008

Credit Default Swaps

Last week, Indian economy has seen many banks creating provisions for CDS and CLNs as an after-effect of sub-prime crisis...let's get a detailed view of what Credit Default Swaps are and how does it affect the parties associated.....

CDS are an unfunded credit derivative instrument in which credit protection is bought and sold between the parties directly. When the credit derivative is entered through a financial institution and payment under it is funded through a structured financial process, it is called funded credit derivative. An example of funded credit derivative is Credit Linked Notes (CLNs).
A Credit Default Swap is a contract between two parties in which one party gets the credit protection for a fixed income product by buying the CDS and the other party guarantees for the product by selling the CDS. In this way, the risk of the default or failure to pay (called credit event) is diverted from the buying (or holding) party to the selling party. It is similar to an insurance policy in which the seller insures the credit risk in exchange for regular periodic payments (premium). In case of credit event, the protection seller purchases the product to compensate the protection buyer for the remaining interest and principal (Physical settlement) or pays the protection buyer the difference between the par and the market value of the product as a compensation (cash settlement).
Some of the questions that can arise while talking about CDS are:

1. How to define the Product? Is it a pool of assets - is the pool static or dynamic, meaning can assets be removed or substituted?

2.Does the swap allow for cash settlement so that in case of a credit event, the protection seller provides cash payments? Or does the cash payment be made at the maturity of the deal?

3.What could be the procedure and timing for determining the severity of loss on a defaulted product?

4.How is the "credit event" defined?

The explanations of the above issues can be illustrated as under:

1. In the first situation described above if the reference credit is an open ended pool, the underlying asset quality of that pool will fluctuate as credits are removed or substituted in the pool. For the Seller to avoid any unpleasant situation, there should be careful investment guidelines which cover when, how and what credits are allowed into the pool. If the terms of swap introduce elements other than that of default, the Seller is potentially exposed to risk which is not reflected in reference credit's rating.

2. In the second issue mentioned above, if the swap requires cash settlements as credit event occurs, this will present a different liquidity issue than normal for a financial guarantor. If a bond mantled by a financial guarantor defaults, the guarantor is required to make payment only in accordance with the regularly scheduled debt service payment schedule. This feature allows the guarantor to have sufficient cash reserves and liquid investments available to cover any potential payments required by a defaulted bond. But in case of credit swap, there is less predictability for the protection seller. Not all swaps require a cash payment. A physical settlement would require the financial guarantor as the Seller to pay par to the Purchaser for the credit. The credit then becomes the property of the financial guarantor as Seller. This asset can be held if the Seller anticipates that it may increase in value over time. The Seller will also be able to pursue traditional creditor remedies against the issuer which may increase the asset's value to the Seller. However, the Seller now owns an asset with limited liquidity and must continue to own is until it either increases in value or becomes liquid, thus losing the opportunity to invest in other more attractive assets.

3. The amount, the protection seller has to pay depends on how and when the loss is valued. Since the value of the credit fluctuates over time, especially after default, the timing of the determination of loss is important. There may be instances when it is in the Seller's best interest to have the value established at the time of default, if the Seller anticipates that the credit will decrease in value over time. However often the credit will increase in value over time. Then an immediate valuation at the time of the default will not be in the Seller's best interests. The market value 30 days after default is considered to be the best standard. This allows for the market to abide the available information about the credit which would be reflected in the price and that the price will be relatively stable. Any swap which calls for valuations earlier than 30 days after default will expose the swap provider to higher pricing volatility and potentially greater losses. Additionally the quantification of how much loss has occurred is a crucial point for the protection seller. The amount of loss should be calculated using objective methods. The preferred methods are either by obtaining bids from independent third parties or going through a formal workout process to arrive at a workout value. A swap provider is thus subject to the market risk of the particular reference credit as well as the default risk.

4. The last common credit default swap term is the definition of "credit event". It is the credit event which will trigger the financial obligor as Seller's obligation under the swap and is, therefore, a crucial component in determining the risk to the financial guarantor in any swap transaction. The definition of credit event in most credit default swaps will incorporate one or more of the following events as defined by the 1999 International Swaps and Derivatives Association ("ISDA") Credit Derivatives Definitions:
• Bankruptcy
• Failure to pay
• Restructuring
• Repudiation/moratorium
• Obligation default; and
• Obligation acceleration.

How is it different with normal Financial Guarantor:

The first difference lies in the high predictability and certainty for the financial guarantor for the amount to be paid in case of default, whereas in case of credit swap, the amount to be paid as default happens depends on the time and way of valuing the loss.
The uncertainty over timing of the loss and the quantification of the amount of loss are issues which a financial guarantor does not face in the operation of its business as a financial guarantor. A financial guarantor which has mantled a bond has a very definite time when payment is due. It is when the issuer has missed a debt service payment, or there has been a payment after a bankruptcy of the issuer. Both of these events are definite and can be predicted by the issuer's credit rating. Likewise the amount of loss is definite. It is the amount of the missed or disgorged payment. There is no market risk, interpretation or valuation necessary to establish how much the financial guarantor is obligated to pay.

Additional Risks Present in Credit Default Swaps

• An additional risk to the financial guarantor is introduced if the Purchaser of the protection can determine whether a credit event has occurred. Thus an aggressive Purchaser could determine that a credit event has triggered the terms of the swap, forcing the Seller to perform under the swap. Since the actions of the Purchaser will be hard to predict, the financial guarantor as Seller should make sure that the swap is structured so that the occurrence and severity of losses on the reference credit can be objectively and independently identified, calculated and verified. For example the credit event should be published in a well known news source, corporate filing or court document to prevent the staging of credit events solely to trigger the swap. The amount of loss should be calculated using bids from third parties or a formal workout process. Again these risks are not present in a financial guaranty. There either a payment has been missed by the issuer or a payment previously made by an issuer who has subsequently filed for bankruptcy has been disgorged by the bankruptcy trustee. Thus the instances in which a financial guarantor must make a payment are clearly defined and the amount of the payment required is also not subject to interpretation.

• A correct documentation is an important factor in the protection bought by the Purchaser and the final loss attributable to the Seller. A mistake in even a simplest term can have important consequences. For example, the reference credit must be referred to in the documents using the correct legal name of the entity (product) for which the Purchaser is seeking default protection. A default by an improperly identified reference credit from the Seller's perspective may not legally trigger its obligation to pay under the swap. However, lack of proper documentation is the same risk factor for a financial guarantor either in its financial guaranty business or in the credit default swap business line.

No comments: