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Will credit derivatives encourage more lending, or will they harm the interests of borrowers?
Hilary Rosenberg, CFO Magazine
September 1, 2003
If you're unfamiliar with credit derivatives, it's time to get acquainted, as bank are using these financial instruments more often.
Credit derivatives — or swaps — make it possible for banks to limit their credit exposure without selling the loans they want to keep on their balance sheets. In addition to participating in loan syndicates that share the risk of the company's debt, lenders are increasingly arranging to buy credit derivatives on borrowers through insurers.
According to the International Swaps and Derivatives Association, the credit-derivatives market had reached $2.15 trillion by the end of last year. In the most common of these arrangements, the purchase of a credit-default swap, the buyer pays a premium (expressed as basis points on the notional amount) to a counterparty, which guarantees payment of par value if the specified company defaults on its bonds or bank debt.
Some argue that the proliferation of credit derivatives will reduce the cost of capital, if only because they encourage more lending by banks. But at this point, it is hard to tell, because the credit-derivatives market is not as deep or transparent as the secondary bond market.
No wonder many treasurers do not give the credit-derivatives market nearly as much attention as the bond market. "Bond spreads tell me potential credit concerns before anything else, because [the bond market is] a very active and transparent market," says John Blahnik, treasurer of Delphi Corp., which has about $2 billion of bonds outstanding.
Nevertheless, he and other finance executives acknowledge that they are keeping closer tabs on credit derivatives these days. Blahnik himself monitors the market on a weekly basis by asking his banks for data; another treasurer of a major corporation says that about twice a week she obtains pricing data from about six banks on five-year default swaps.
Why watch? However difficult they are to discern, price fluctuations in credit derivatives affect bond and loan prices. And banks' use of these instruments can influence their relationships with borrowers. Not only could they conceivably alter a bank's willingness to lend, but critics warn that credit derivatives can also encourage the disclosure of information that could hurt borrowers' interests.
Appetite for Loans
One basic question is whether banks' use of credit derivatives — either as buyers to hedge exposures or as sellers to acquire an exposure and earn premiums — will make them more or less willing to lend. Proponents contend that the ability to buy protection has increased banks' appetite for loan origination. "By reducing risk capital, banks are able to free up capacity to accommodate additional business," says Blythe Masters, managing director of JP Morgan Chase in New York.
Fitch Ratings study released last spring provides some evidence for that view. The agency found that as of the third quarter of 2002, the global banking system had in essence transferred $97 billion of credit risk — the notional amount of protection purchased in buying a credit derivative — out of the industry. Partly because of that risk transfer, the report stated, "bank asset quality has remained relatively solid in the face of record corporate defaults and a sharp deterioration in recovery values." The bottom line, says Robert Grossman, chief credit officer at Fitch, is that the use of credit derivatives "allows banks to originate more" loans.
The mere fact that a bank is more inclined to keep a company's debt on its balance sheet thanks to credit derivatives is welcome news for finance executives, since it gives companies more confidence that banks won't abandon them during tough times. One Fortune 500 treasurer, who asked not to be identified, says he prefers to work with institutions that hold on to his company's debt. When planning to renew a loan arrangement, the treasurer asks the company's commercial banks whether they are keeping the debt on the balance sheet. "And we say, We don't want you to sell it," he says. "We are direct. We say, 'We want you to hold the position.' " But he's content to see the banks hedge a small portion of the risk through credit swaps.
The treasurer has a similar message for the investment banks with which he deals. Since they do not have the balance-sheet capacity to maintain 100 percent exposure to loans they make, they sell the loan or hedge much or all of it. "We'd rather have them hedge," the treasurer says.
The Flip Side
But if buying derivatives increases banks' lending capacity, what does the selling of these instruments imply? A growing number of banks have been selling derivatives through their trading desks to increase their exposure to corporate credits. While finance executives may welcome the extra commitment such activity reflects, it's clearly possible that the banks may end up substituting such sales for loans. That's because the premiums they can earn by selling credit derivatives may be far more profitable than the interest they earn on loans.
In fact, credit derivatives' prices are higher than loan rates, indicating that loan rates are priced below market. And banks have not raised rates on high-credit-quality loans toward the market price at all. In large part, that's because banks traditionally make loans to large companies at below-market rates as a loss leader to obtain other, fee-paying business. But, says Lisa Watkinson, New York-based executive director at Morgan Stanley, "we're starting to see fairer pricing of bank loans" at higher-risk corporations.
What's more, the use of swaps can increase the spread over Treasury bond yields at which a company's own issues trade at any given moment. How? Unlike bonds, credit-default swaps give investors the ability to easily take either a short or long position on a company's credit. When an investor buys a credit-default swap, the purchase expresses a negative view of a company's credit and, therefore, effectively shorts it. If the company defaults, the investor will be paid par value for the amount of credit hedged.
Conversely, when an investor sells a credit-default swap, it is taking a long position on a company's likelihood of defaulting. But the resultant increase in trading could produce wider variations in spreads, raising a company's cost of funding. Traders claim that because credit derivatives give investors the chance to take either a long or short view on a company's credit, there can be more volatility in bond-spread movements.
But Watkinson says that such volatility may be a temporary phenomenon as the growth of credit derivatives adds liquidity to the credit markets. That liquidity would take the form of capital from an increasing number of market participants. The extra liquidity, she says, "could more than offset the volatility."
Even if new liquidity offsets added volatility and banks don't substitute sales of swaps for loans, there is reason to worry about the proliferation of credit derivatives, because they have the potential for abuse. Credit derivatives are publicly traded, which means that it's possible that the trading side of the bank could receive nonpublic information from the lending side.
That prospect prompted Chris Dialynas, a managing director at investment firm Pimco, to publish a white paper last October on the potential for abuse. Warned Dialynas: "Credit-default markets are a mechanism with which friendly commercial bankers... can profit by betraying and destroying their clients through the use of inside information."
Alarmist? Not to market participants, who responded by creating a system for exchanging information about practices for preventing insider trading on such information. Those practices essentially amount to maintaining a Chinese Wall between lending officers and traders.
"This is a very serious topic and an evolving issue. A perception of unfairness is damaging to the business," says JP Morgan's Masters. "The [Pimco] paper helped prompt me and others to make sure the industry responded in an appropriate way." In May, that group released a paper that lays out guiding principles for compliance with insider-trading laws.
Dialynas, for his part, believes "there appears to be less trading on inside information today." However, he maintains that self-policing won't eliminate the potential for abuse. For that reason alone, finance executives need to pay closer attention to how the credit-derivatives market is evolving. "It should be the duty of every corporate treasurer to track the market pricing of its credit derivatives," says Jeff Wallace, managing partner at Greenwich Treasury Advisors, in Greenwich, Connecticut.
That's not an easy task right now. Among other things, pricing data is not easily available, and banks and other participants do not disclose how credit derivatives alter their risk profiles. "Lack of transparency in the market is the major hindrance to the market's growth," says Fitch's Grossman, "and it has to be addressed."
Yet some treasurers contend the task of monitoring the credit-derivatives market isn't all that daunting. "It's a matter of understanding the interplay of those who use the credit-derivatives market and why," says Christine McCarthy, treasurer at The Walt Disney Co. "The credit derivatives shouldn't come as a surprise if you put all the pieces together."
Too Much of a Good Thing — or Too Little?
Credit derivatives were born in the early 1990s from the financial world's insatiable desire to lay off risk. Of course, banks could already do that by distributing loans through investment syndicates. But by buying credit derivatives, lenders could hedge some or all of their corporate exposures without such syndicates.
In recent years, syndicates have shrunk dramatically as banks have exited the lending business. That in turn has increased the importance of credit derivatives to the remaining lending institutions. Meanwhile, bond investors have bought credit derivatives as an easy means of shorting companies based on their credit quality.
Also behind the market's expansion has been the availability and enthusiasm of counterparties willing to sell the derivatives. Insurance companies and, more recently, banks themselves sell credit derivatives as a means of earning premiums, taking on attractive exposures to diversify their exposures to others.
There's reason to both hope for and fear the further expansion of the market. A study earlier this year by the Bank for International Settlements, a Switzerland-based consortium of central banks, found that most of the activity in the credit-derivatives market was concentrated in the hands of relatively few players. "Some elements of the market appear to be highly concentrated," the report warned, noting that this "might give rise to market disruption if the firms concerned were to come under pressure."
The question is, would spreading the risk among more players increase or decrease the magnitude of such disruption? —H.R.
Inside Insider Trading
The definition of potential insider trading in the credit-derivatives market is the same as it is for any type of security or security-based transaction. The foundation of the law lies in Rule 10b-5 of the Securities Exchange Act of 1934, which prohibits the purchase or sale of a security on the basis of material, nonpublic information about that security or its issuer. But the law has evolved with judicial interpretations of it.
The Joint Market Practices Forum developed by financial institutions to address concerns about such abuse in the credit-derivatives market draws on statutory, regulatory, and judicial definitions of insider trading. The following definitions and guidelines are drawn from the exposure draft of the forum's guidelines for best practices:
Information is material if:
Information is nonpublic if:
Individuals who are prohibited from trading on such information include: