Credit default swaps are over-the-counter derivatives that shift the burden of loan risk from banks to investors. But they also change the traditional lender/borrower relationship
Property price falls across the UK and Europe have created a discrepancy between asset values and loan-to-value (LTV) ratios, pushing highly geared investors close to their limits. This has complicated loan refinancing and increased the likelihood of borrower default. Credit default swap (CDS) protection offers banks insurance against credit default by selling the risks.
CDS is an over-the-counter credit derivative that can be used by banks to hedge against credit events. The buyer of a CDS contract pays a quarterly fee to the seller in return, if there is a default on the debt underlying the transaction, the seller pays out the face value of the contract and receives the defaulted debt. Contracts usually last five years typical credit events can include a material default or debt restructuring. The life of the swap ends when the agreement expires or if credit default occurs.
CDS tools are used by banks to limit their exposures and reduce regulatory capital to comply with international banking standards. The underlying loan is stripped of its credit risk but retained on the originator’s balance sheet. “CDS is a way of moving default risk from the underlying assets,” says Cameron Munro, chief executive of the Derivatives Consulting Group. “Banks are able to make loans and sell the risk without losing their relationship with the borrower.” This allows banks to pass the buck, if not shift the debt entirely, which is virtually impossible in current market conditions.
The system contrasts with the securitisation process, whereby loans are broken down into bonds and sold on through the capital markets. “Banks use CDS to mitigate exposure on their loan books,” says Ed Stacey, head of derivatives at Eurohypo. “For a primary underwriter, it is a way of distributing risk without relying on syndicating or securitising the debt.”
In a recent case, HSH Nordbank sold around €3bn worth of European real estate loans to Lehman Brothers, while CDS contracts were struck with Hypo Real Estate and BNP Paribas on underlying loans worth €4.6bn. The transactions helped to clear HSH Nordbank’s balance sheet for new business following the securitisation freeze. All parties involved refused to confirm, or discuss, the CDS deals.
The global value of outstanding credit derivatives grew by 32% to $45.46trn in the first six months of 2007, according to a survey by the International Swaps and Derivatives Association. This represented a jump of 75% on the same period in 2006, and has partly been the result of banks’ desire to remove risk from their balance sheets to meet Basel II criteria.
Introduced at the beginning of the year, the Basel II regulations are designed to establish an international banking standard by promoting a risk-sensitive approach to capital allocation. In practice, the riskier the loan, the more capital needed to be reserved against it on balance sheet. This could limit banks’ capacity to support new business unless they disperse risk by hedging more of their loans. CDS instruments provide a facility for banks to do this. By transferring credit risk to protection sellers, lenders are able to minimise the level of regulatory capital that is required under Basel II. This frees up greater volumes of recyclable capital.
Although CDS contracts closely resemble a type of insurance, the concept is different because a swap buyer does not need to own the underlying loans or to have suffered a loss. Debt owners are able to protect themselves against the risk of default, while third-party investors can speculate about the likelihood of a borrower running into trouble. “CDS allow anybody to ask for insurance on the possibility of any asset defaulting,” says Lee McGinty, head of European credit derivatives strategy at JP Morgan Chase. “The borrower won’t necessarily know anything about it.” Those who buy protection can scoop healthy profits if the event does occur, since the value of the swap will rise sharply.
Betting on the prospect of credit default is a lucrative business and CDS positions are sometimes much larger than the value of the underlying loans. But the exploitation of what is essentially a risk management tool could damage the traditional relationship between lenders and borrowers. “If banks have insured against the risk of default, they are less likely to support clients through the bad times,” says Stacey. “Some lenders actually have a strong economic interest in their clients going bust.”
Hedge funds have become a major force in the credit derivatives market, although their share of the volume of credit protection sales and purchases is dwarfed by that of banks, who constitute the bulk of the industry. Almost two-thirds of banks’ derivatives volume is from trading and a third is from the management of their loan books, according to the British Bankers’ Association.
