Unloading Credit Risk

Credit derivatives aren't just for banks anymore, but the new instruments aren't without their own faults.
Christopher Watts and Simon BougheyNovember 1, 1998

Confident about your company’s ability to weather a downturn, but not so sure how your customers or suppliers would fare?

You could reduce the risk they pose to your business, or even hedge your exposure to an entire market, if a new type of financial derivative gains wider acceptance. The instrument, known as a credit derivative, has recently become popular among banks that want to reduce their exposure to a borrower’s creditworthiness. And credit derivatives are starting to find application within corporations as well.

Explains Robert Reoch, managing director and global head of credit derivatives at Bank of America: “Say an automaker buys all its tires from Company B. If Company B goes bankrupt, the cost to the automaker is the time taken to find a new supplier. This could be a week or more of lost production. The possible economic loss could be hedged by buying default protection.”

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“Corporations have huge risks of concentration,” adds Satyajit Das, an author and consultant on risk management and financial derivatives. “Aircraft sellers can sell only to buyers of aircraft, not to anyone else.”

But, says Das, “they still don’t think of this as a credit risk.” One banker, who asked not to be identified, says he can count “less than a dozen” companies that have used credit derivatives in the past three years. But the prospect of recession spreading from emerging markets to more-developed countries could lead to much wider use, assuming regulators go along.

Consider The ABB Group’s experience. The Zurich-based Swiss-Swedish engineering firm is particularly vulnerable to credit risk because of its dependence on infrastructure projects in emerging markets. So, since 1995, it has been using credit derivatives known as default swaps to hedge its credit risk in certain countries. Says Ann Larsson, senior vice president at ABB, “The more tools available to us to hedge the risk, the better.”

Who Owns Your Credit?

Granted, other companies may have much less, if any, use for these instruments. “Corporations don’t like to admit they’re worried about the fortunes of their best customers,” notes Reoch. And some have found that credit derivatives are not problem- free. Cadbury Schweppes Plc, the British confectionery and beverage company, considered using credit derivatives when it sold a business to Coca-Cola Enterprises Inc. (CCE), the U.S.-based Coke bottler, in February 1997.

CCE paid more than half of the price tag in notes, and when Cadbury wanted to hedge that exposure through credit derivatives, CCE threw in a letter of credit from a bank to assuage Cadbury’s concern. CCE “wanted to have control over its name being hawked around the credit market,” says Tim Owens, director of treasury at Cadbury. CCE declined to comment.

There is also some fear that companies could hurt the financial condition of their competitors by buying up their credit, though bankers dismiss such concerns out of hand.

Yet Das cites another potential caveat: Companies may face a significant trade-off if they give up collateral along with credit risk. Suppose a contractor buys a credit derivative from a bank to cover the contractor’s loan to a subcontractor that’s building a factory for the contractor in an emerging market. If the subcontractor defaults, the bank may take over the rights to the factory. But the contractor may find that the rights to the factory are much more valuable than the protection it got from the risk of the subcontractor’s default.

For the moment, most finance executives seem happy to see banks themselves using these derivatives, even if that involves their own companies’ credit. “It’s healthy that they manage their exposure to us,” says Chris Vallance, corporate treasurer of Imperial Chemical Industries Plc, the British chemicals giant. “We expect them to manage risk just as we do.”

To be sure, companies besides Coca-Cola Enterprises might disagree. “Banks may no longer be as committed to a company, because they have less at risk,” notes Cadbury’s Owens. But others believe credit derivatives could strengthen a company’s relationship with its banks. Stephen Crompton, deputy finance director and senior vice president of tax and treasury for British pharmaceuticals firm SmithKline Beecham, notes that to the extent that credit derivatives help banks manage their credit exposure, the contracts “make it easier for us to continue our relationship- banking strategy more cost effectively.”

One thing is clear: Credit derivatives have suddenly emerged from obscurity. While bankers began making grandiose predictions about the potential of the market as far back as 1996, volumes and liquidity remained slim until about nine months ago. But the market has since taken off. Current estimates put the notional value of contracts outstanding at roughly $200 billion, according to data from the Office of the Comptroller of the Currency (OCC), an agency of the Treasury that regulates national U.S. banks and U.S. branches of foreign banks, and the British Bankers Association (BBA). Consultant Das predicts that figure will reach $1 trillion by the year 2000.

Thank Asia

Why the explosion in use of this device by large commercial and investment banks? In a word: Asia. For years, credit risk had been all but disregarded, as lenders focused on the threat of inflation rather than recession. But the sharp downturns in emerging-market economies have raised the very real possibility that an increasing number of debtors will not be able to repay their loans. “Asia did more in three months than I had done in four years of marketing,” admits Reoch.

But significant hurdles block wider acceptance. For one thing, regulators have been slow to encourage the use of credit derivatives despite aggressive lobbying by banks. Currently, lenders are often required to set aside the same amount of capital whether or not they have hedged their risks.

“The old rules are anachronistic,” says Reoch. “We need to move to a whole new platform.”

So the International Swaps and Derivatives Association (ISDA), a derivatives-industry trade group, is campaigning for changes to the capital reserve requirements of the Bank for International Settlements, a central bank in Switzerland that oversees other nations’ central banks. Those changes would make it easier for banks to set aside less capital if they’ve hedged their risks through derivatives. But until hedgers win more regulatory credit for their apparent prudence, the use of credit derivatives is likely to remain limited to large, well-capitalized institutions and corporations like ABB, which is using credit derivatives to hedge country risk, a more liquid part of the market.

In the United States, where regulators are just starting to study credit derivatives, industry advocates worry that the Commodities Futures Trading Commission’s apparent efforts to regulate the derivatives market in general will stifle development of that segment devoted to credit.

Welcome to Paradox

Judging from recent public statements, in fact, regulators may not share the industry’s view that the use of such derivatives is necessarily a display of prudence. Within days of the Federal Reserve­arranged rescue of Long- Term Capital Management LP, a major U.S. hedge fund that used derivatives to make hugely leveraged, hugely unprofitable bets on bonds, Nancy Wentzler, director of economic analysis at the OCC, cautioned that credit derivatives had not been tested in a period of economic distress and that they need to be as carefully monitored as loans.

If nothing else, Long-Term Capital’s near- bankruptcy is yet another reminder that, paradoxically enough, derivatives can increase risk instead of reduce it, simply because of the leverage often built into their structure. Credit derivatives are no different in this respect, says consultant Das.

At this point, a tiny percentage of global credit risk is covered by derivatives, so the market has a long way to go before it can provide protection for all comers. And while that could change if credit derivatives prove their mettle during the current financial turmoil, finance executives who cannot take advantage of these instruments now would find such timing painfully ironic. After all, their greatest use seems to lie in coping with that very turmoil. * Simon Boughey is a freelance writer based in New York. Christopher Watts is a staff writer for CFO Europe.

Variations on a Scheme

A rundown on the basic types of credit derivativeshere are four basic types of credit derivatives: default swaps, total return swaps, credit-spread options, and credit- linked notes. The first two are the most common and are, therefore, the easiest to attain.

Default swaps. In a default swap, a buyer pays an annual fee or up-front payment to the seller in return for a specified amount if a certain “credit event” occurs. The British Bankers Association (BBA) found that these arrangements accounted for 52 percent of the contracts outstanding at the end of last year. In a default swap’s most common use, a bank that’s exposed to a worsening credit pays a fee to another bank for the assurance that if the borrower defaults, the first bank will recoup its losses from the second. Default swaps can be structured around a country, a company, or a number of companies. For instance, say a company is making an investment in an emerging market and fears the political environment may worsen. It can enter into a default swap on that country’s sovereign debt so that the company is compensated if the country defaults or the value of its debt plummets.

Total return swaps. Here the total return of a bank loan or other credit-sensitive security is exchanged for cash flow from a more creditworthy counterparty. Buyers typically exchange all the return for a periodic interest payment (usually LIBOR plus several basis points) and compensation for any decline in the market value of the underlying asset. These instruments accounted for 16 percent of the agreements outstanding at the end of 1997, according to the BBA, and are most common in the United States because the secondary market for the loans they are based on is very liquid.

Credit spread options. These come in diverse forms, but generally pay buyers if the spread between the yield on a risky security and the yield on a safer one changes beyond a specified level. These options account for 13 percent of the market, a share that should grow if borrowing costs threaten to become more volatile.

Credit-linked notes. Unlike the other instruments described here, this derivative does not pass on credit risk from one party to another via an off-balance-sheet arrangement. Instead, a company wanting protection embeds a credit swap into a plain-vanilla bond or note. If a credit event occurs, the redemption value of the note is reduced by the amount due under the credit swap. This arrangement represented 14 percent of the market at the end of last year.

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