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A dispute in the Enron bankruptcy case highlights troubling questions about credit default insurance.
Ronald Fink, CFO Magazine
October 1, 2004
It's no secret that banks' use of credit default swaps relies on an inefficiency in markets. Indeed, the elucidation of this inefficiency won economist Joseph Stiglitz a 2001 Nobel prize.
The inefficiency, which Stiglitz defined as "asymmetric information," arises whenever a buyer or seller has more information about a product or service than his counterpart does — which can provide the better-informed party with considerable economic advantage. And informational asymmetry is often inevitable when one party has conflicting interests in the transaction.
Nowhere else in finance are such conflicts as fundamental as when banks buy or sell credit default swaps, derivative instruments that serve as insurance against a borrower's default. When the borrower involved fails to make timely payments of interest and principal, the buyer of the protection can exchange the debt it holds for cash from the seller of the swap. But when commercial banks are involved in the deals, the party on the other side has to worry that the lenders can profit from the use of information they have privately gleaned from borrowers in the course of assessing their creditworthiness.
While some might argue that there's nothing essentially wrong with such a zero-sum game, critics worry that the asymmetry inherent in credit default swaps contains the potential for serious abuse. As a result, banks have taken steps to strengthen the firewalls between their trading and lending desks.
But these initiatives, organized primarily by the International Swaps and Derivatives Association (ISDA), have been voluntary. And without the intercession of the Federal Reserve Board or the Office of the Comptroller of the Currency, there's no means of enforcing them. So far, the Fed and the OCC have let banks themselves police their use of credit default insurance, as the regulators have done with structured finance and other instances of Wall Street engineering.
In fact, Fed chairman Alan Greenspan has had nothing but praise for the proliferation of credit default swaps and other derivatives. That worries observers such as Chris Dialynas, a managing director of PIMCO, the nation's largest bond-investment firm. "There's no surveillance mechanism," Dialynas warns. "It's very, very difficult to know who's doing what."
Tainted by Enron
Even so — or perhaps precisely for that reason — the market for credit default swaps has been booming. At the end of 2003, the notional value of these instruments had risen to $3.6 trillion, up sixfold in less than three years, according to the ISDA. Yet that could very well represent a high-water mark, thanks to the latest twist in the long-running bankruptcy proceedings of Enron Corp. Indeed, some participants and observers fear that the outcome of this Chapter 11 case could cast a pall over the entire market for credit insurance.
Now at issue is whether buyers of some $2.4 billion in notes tied to Enron's creditworthiness and underwritten by Citigroup will get paid, and if so, how much they will receive and from whom. (Credit-linked notes are a form of default insurance that, unlike a swap, can be sold to multiple investors.) The investors, which include such powerful investment groups as Angelo Gordon & Co., Appaloosa Investment LP, and Elliot International LP, are appealing a July 15 decision by the bankruptcy court for the Southern District of New York to subordinate their claims to those of senior creditors.
Citigroup underwrote these notes in a deal known as Yosemite to reduce its own exposure to Enron. According to the Wall Street Journal, the bank's exposure by 1999 totaled almost $1.7 billion, or four times the bank's internal limit on exposure to the energy-trading company. While the securities these investors purchased were senior unsecured notes, Enron argued in court — and the judge agreed — that they did not deserve senior status. Why? Because Citigroup not only knew about the accounting fraud that brought down the energy company in late 2001, but also helped mislead investors, ultimately paying $101 million in a settlement with the Securities and Exchange Commission.
Enron's recovery plan, approved by the court on July 15, would give senior creditors about 20 cents on the dollar if the proposed sale of Enron's Portland General electrical-generation facility and CrossCountry Energy pipelines is successful. But all bets are off if the owners of the Enron notes convince the New York State Supreme Court to overturn the bankruptcy judge's decision to subordinate their claims. In that event, the investors could demand to have their claims included in the recovery plan, sending Enron's effort to emerge from Chapter 11 back to square one.
But a court decision in favor of Citigroup would cast "a real cloud on the horizon" for the credit insurance market, says Walter Pollard, a partner in the Boston law firm Goodwin Procter LLP who has negotiated credit default swap transactions on behalf of hedge funds. It is one thing for a bank to trade on inside information, says Pollard. In fact, he asserts that the market already takes that possibility into account when pricing credit derivatives. But Pollard contends that a ruling in favor of an underwriter involved in "truly toxic things" such as the fraudulent transactions at the heart of Enron's failure could give rise to "a concern that that will undermine the market" for all kinds of credit insurance. Adds Michael Gerity, an analyst for Fitch Ratings, a credit-rating firm: "It would be a pretty negative precedent."
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.
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."
Granted, insurance companies disclose little information about their holdings to the public, but they are subject to state oversight, while hedge funds fly almost completely under the regulatory radar. The Securities and Exchange Commission is making some noise about changing that, but hedge funds are lobbying hard against added oversight. And judging from Alan Greenspan's hands-off approach to financial regulation, the funds probably have an ally in the Fed. Yet a Chubb analyst warns that big losses in hedge fund holdings of credit default swaps could pose as great a systemic threat to the financial system as Long-Term Capital Management's failure in 1998, which prompted the New York Fed to intervene. —R.F.
More Protection, Fewer Loans
The advent of credit default insurance in the late 1990s led to the widespread expectation that banks would be more willing to make loans to companies, since the banks wouldn't be on the hook for defaults by borrowers.
But a look back at actual practices suggests that those expectations were vastly overblown. While the notional value of credit default swaps soared almost sixfold between 2001 and 2003, from $630 billion to $3.6 trillion, the percentage of bank assets made up of loans to companies fell from 20 percent to 17 percent during roughly the same interval. —R.F.