Less Credit
On the other hand, a ruling in favor of the Enron investors could have troubling implications for CFOs and corporate treasurers elsewhere. Fans of swaps argue that they encourage bank lending, an assertion that isn't reflected in loan data (see "More Protection, Fewer Loans," at the end of this article). But if they're right, then a serious setback for the market cannot help but make banks less willing to extend credit, particularly to companies in financial straits.
Quite apart from the Enron case, CFOs and treasurers of troubled companies have reason to fear that banks' efforts to protect themselves against default will complicate their plans. That fear was crystallized earlier this year when primary lender Citigroup rejected troubled energy company Mirant Corp.'s efforts to reorganize without a Chapter 11 proceeding. Citigroup insisted that it turned down Mirant's reorganization plan because the bank found the plan unlikely to restore the company's solvency for long. But other creditors suspected that Citigroup had bought credit default swaps against Mirant, which might have given the bank a greater interest in seeing the company file for bankruptcy than in helping finance a restructuring.
Ultimately, Citigroup testified that it held no credit insurance against Mirant at the time it rejected the restructuring plan. But the fact that the issue came to a head in court indicates just how suspicious other creditors have become of the proliferation of credit default swaps.
"Banks are supposed to be the corporate treasurer's friend," comments Dialynas of PIMCO. What's more, the Enron and Mirant bankruptcies are not the only examples of restructuring efforts complicated by credit default swaps. While the ISDA has gone a long way toward establishing documentation and legal standards for the terms of swap contracts, squabbling among creditors is likely to continue, says Dialynas. "There are a lot of unresolved questions as to what constitutes a credit event," he notes. As a result, he says, "an impartial judge is the only body that can make a [fair] judgment."
Not surprisingly, some large corporate-banking customers do not share Dialynas's concerns. "I've seen no evidence nor do I have absolutely any reason to believe" that banks use credit default swaps to profit on inside information, says Malcolm Macdonald, treasurer of Ford, the corporate borrower most widely referenced by credit default instruments. But Macdonald worries about the possibility nonetheless. He says Ford's funding efforts could be complicated "if news of a major transaction we were doing" got out prematurely.
For their part, bankers deeply involved in the credit default swap market are also quick to defend it. "The Enron case is an anomaly," asserts a spokesman for one such bank.
Yet concerns about the default market won't disappear with a favorable outcome (see "Systemic Risk?" at the end of this article). The ISDA says it continues to develop industry guidelines to improve liquidity and transparency in the market. But if those guidelines don't go far enough to forestall critics' worst fears, the Fed and the OCC will have to conclude that self-regulation in this market doesn't work.
Ronald Fink is a deputy editor of CFO.
Systemic Risk?
Ironically, a court decision in the Enron case that calls into question the efficacy of credit-linked notes could be a blessing in disguise. Critics contend that banks' reliance on credit default insurance and other forms of risk transfer leads to poorer credit oversight, as it shifts the responsibility from those with the most intimate knowledge of a borrower's financial position to those with less.
One such skeptic is Chris Dialynas, a managing director at PIMCO, the nation's largest bond-investment firm. Dialynas wrote a report last November about the perils posed to the financial system by credit transfer as well as by prevailing political and macroeconomic trends. He wonders "why banks exist if all they're going to do is transfer risk to someone else."
Further skepticism about credit default insurance is found in a survey conducted in August 2003 of 231 bankers and their customers, regulators, and observers by the Centre for the Study of Financial Innovation, in London. The respondents cited credit default swaps and other complex financial instruments as the biggest risk currently facing the global financial system.
And none other than Warren Buffett was worried enough about the extensive portfolio of credit swaps and other derivatives held by Berkshire Hathaway's insurance subsidiary, General Re, to close down the company's derivatives operations.
General Re's exodus has been joined by that of other large insurers. Chubb, for one, has reduced its portfolio of credit default swaps to $11.6 billion in notional value, from a peak of $43 billion in 2001.
Yet the insurance companies' departure from the market is hardly reassuring. Hedge funds, which exhibit much greater risk tolerance (at least for now), are taking the insurers' place. But "were this trend to continue," observed analyst Michael Gerity and other authors of a report on the market in early 2003 by Fitch Ratings, "it might heighten concerns related to poor disclosure and counterparty risk."
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