CREDIT DEFAULT SWAPS
As commercial loans, certain collateral debt obligations, and intercompany loans grew in size, the need for lenders to hedge or offset their risk grew also. Some of these huge multimillion-dollar loans were fragmented; other loans, which required periodic payment of principal, had the payment periods sold; still others sold some or all of the interest payments. Several investment firms saw an opportunity, and for a fee guaranteed payment should the borrower of a loan or part of loan fail to do so. Enter the credit default swap.
A credit default swap (CDS) is similar to an insurance policy, where the buyer pays a fee to the seller to cover a certain obligation in case a third party defaults on a particular event. As with an insurance policy, the buyer pays a premium and the seller has to react only if certain events occur. These events are referred to as “credit events.” Here’s a basic example: Party A and Party C enter into an agreement by which Party A acquires an asset from Party C. The asset is to pay Party A a periodic return over time. At the end of the contract, the asset pays Party A the predetermined amount outlined in the contract. (Think of a bond that pays semiannual interest and at its maturity date pays the required principal amount.) To protect the investment, Party A enters into an agreement with Party B that should Party C default on any of the payments, Party B will pay the amount owed. For this protection, Party A pays Party B a fee known as a premium.
There is some unique terminology associated with this product. The terms “buyer” and “seller” could refer to the protection under consideration. The seller or writer is offering to sell protection to the referenced asset owner in return for a fee or premium. The referenced asset owner is buying the protection. However, the term “buyer” is also applied to the acquirer of the asset who sells the risk to another and pays the risk buyer a fee to take the responsibility. To confuse the issue even more, both parties to the transaction are called counterparties.
The negotiation of the fee is based on the level or amount of presumed risk and the duration of time the credit default swap will be in existence. As the CDS exists in a dynamic environment and as time erodes the risk period, the value of the CDS changes. It is therefore a tradable instrument. As the perceived possibility of default diminishes, the premium on the default diminishes; as the possibility of risk increases, the premium increases.
Here’s an example: Party A enters into an investment project with Party C. The project is to last five years. Party A is to pay Party C a lump sum payment on day one. The one-time payment will be used by Party C to fund the project. Party C is to make five consecutive annual payments that are scaled upward, so that the last payment is the largest payment. This is because all the parts or units should be operational and generating revenue. With that last payment Party C should have fulfilled the obligation as required by the original contract. Each annual payment is obtained from parts of the project that begin to generate revenue as they become operative.
Party A knows that there are events that could occur during the contract’s life that would cause late payments, partial payments, or no payments at all. While the risk is slim, Party A doesn’t want to have to face that risk should any of the events occur. Party A enters into a contract with Party B, which stipulates that for a fee (premium), Party B will make Party A whole for any shortfall. The amount of the fee is negotiated between the two parties based on their assessment of the risk.
What outcomes face Party B? There are four probable outcomes. From best to worst they are:
There is indeed a market for these credit default swaps. Initially, Party A would “shop” the risk around to various contra-side financial institutions to obtain the lowest premium cost for the assumed risk. The proposed parties on the opposing side are performing their own risk analysis on Party C, and/or the asset itself, to determine the degree of risk they are looking at. Once the risk analysis is performed, a fee or premium is set.
For long-term contracts, the risk may diminish or increase during the CDS’s existence. If it diminishes, the premium initially demanded by the risk inherent in the CDS will decrease, and in the above case, Party B could try to trade out of the obligation for a lower premium than they received when they accepted the risk. The difference between the premium they received when they originally accepted the risk and what they paid to get out of the contract would be a profit to them. Conversely, should the risk increase, Party B may not want that exposure to risk and may close the position to another party for a higher premium, thereby incurring the loss, rather than maintaining the position and being exposed to an even larger loss.
On the other side of the CDS, Party A, who sold the risk to Party B (or who bought the CDS), paid a premium based on the observed risk and agreed to credit risk assessment at that time. Should the risk increase over time, the value of the CDS would increase too. As this is all occurring in a dynamic marketplace, where events are affecting even Party A itself, should Party A decide, for whatever reason, to close the position by selling it out, it would have a profit. For example, should Party A decide to sell the referenced investment itself, it wouldn’t have need of the CDS any longer. Conversely, if the perceived risk should dissipate, the premium would dissipate also. Then Party A would perceive the level of risk as manageable and could sell off the CDS and recoup some of the original cost.
Remember, the party receiving the premium is obligated to perform the activity being covered. Therefore should there be a default, the owner of the CDS must make good on the defaulted amount. We will discuss recourse later in this chapter.
So far, the process seems very straightforward. However, the negotiations are rather detailed. Many questions must be answered before the agreements become active. For example: What constitutes default? What constitutes late payment? Each party is trying to clarify the terms so that there cannot be any misunderstanding at a later time. The main component parts of a credit default swap are:
The question “Whom am I dealing with?” becomes ever more important, as the value under consideration is millions of dollars. First and foremost, what do you know about the counterparty firm’s finances and faculty? What is known about the firm?
Culled from The Washington Post, February 29, 2012:
Referencing Greece restructuring its debt could cause a credit event:
“It will be the first time that the obscure but influential International Swaps and Derivatives Association has made such an inquiry into a sovereign government’s actions, and the possibility that Greece could be found to have wronged its creditors is something European officials have worked for two years to avoid.
“Such an outcome could leave the entire euro zone with the unwanted stigma of being a region where governments stiff the people who lend it money, and could trigger payouts under thousands of bond insurance contracts known as credit default swaps.”
The swap agreement has been through several iterations over the years. Now, under the auspices of the International Swaps and Derivatives Association (ISDA), the contract comprises five parts that collectively form one agreement. The five parts are:
The intent of the master agreements is to avoid conflicts or misunderstandings at a later date. There are two forms of the ISDA master agreement. The first is the single jurisdiction/currency, and the second is the multiple jurisdiction/currency version. Some of the more pressing issues are highlighted below:
1. Who are the parties to the swap?
a. Authority
i. What authority gives this entity the right to enter into the swap?
ii. By whose authority does this (these) individual(s) enter into this agreement?
iii. What is the counterparty’s reputation?
iv. Is this contract legal under state or other law?
b. Financial
i. What source was verified concerning the counterparty’s financial condition?
ii. What is their financial history?
iii. Were their year-end financial statements signed off on by:
1) The proper officer of the counterparty
2) An approved or acceptable certified public accounting firm?
iv. How active are they in the swap market?
2. Notional Amount
a. What is the notional amount?
b. What is the actual amount that interest and other such computations will be based on?
c. Does the amount stay the same over time or is depreciation or accretion applied?
3. Interest
a. What interest rate or rates are in effect?
b. Under what terms do they change?
c. What basis is used to accrue interest?
d. Do holidays or other nonworkdays affect the interest calculation?
e. What is the payment frequency?
f. What is/are the payment date(s)?
g. Is it a level payment or day count payment?
h. If the payment date falls on a nonworkday,
i. When is the payment due?
ii. Is there an adjustment to the payment for the nonworkdays?
4. Fixed vs. Floating Rate
a. Under what conditions, if any, may the fixed rate be changed?
b. What is the floating rate based on?
i. What is the spread between the referenced rate and applicable rate?
ii. Under what conditions does the spread change?
iii. When are the reset dates?
5. Currency
a. What currency is to be used?
b. What form is the currency to take?
c. Where are the payments to be made?
6. Early Termination
a. What are valid causes for early termination?
b. What penalties, if any, are applied?
c. Parties to the agreement
7. Force Majeure
a. What constitutes force majeure?
b. Responsibilities of the parties under force majeure.
c. Failure of parties to honor responsibilities.
8. Default
a. What constitutes default?
b. What recourse is available?
c. How is restitution determined?
9. Maturity
a. What are the parties’ obligations?
b. When are they to be performed?