On Credit Default Swaps

We just put out a research note on credit default swaps, excerpts of which follow below.  The whole report with charts & notes is available free of charge on the KBRA web site.  Will also go up on SSRN when I get a chance.  

BTW, KBRA's commercial real estate team released a report summarizing projected losses on CMBS conduit deals from the 2005-2008 vintages.  We also posted a draft ratings criteria on private mortgage insurers for comment and an important overview of the aviation finance sector.  Of note, our industry leading ABS and Aviation teams just won an award for their work in the aircraft ABS sector during the past year. And we'll be doing a lot of build out in insurance ratings in '16. 

Now, you could think of this research note as an obituary for credit derivatives given the precipitous decline in volumes.  Also, universal banks which have controlled this ersatz "market" are exiting the space, this even as traditional nonbanks and even exchanges seem ascedant.  We all can think of lots of reasons why CDS should be banned outright, but there is utility to letting bona fide investors hedge real credit exposures.  Let's see if regulators and the markets can salvage the CDS market before it dies from self inflicted wounds.

Safe & happy holiday,


Can the Credit Default Swap Market be Salvaged?  Issues for Borrowers and Investors

Kroll Bond Rating Agency

November 24, 2015 [https://www.krollbondratings.com/show_report/3393



* Trading volumes in credit default swaps (CDS) have fallen by more than 75% since the 2008 financial crisis to less than $9 trillion notional amount outstanding as of June 2015. This dramatic decline in volumes comes, in part, because of new laws and regulations focused on reducing the risk of these over-the counter (OTC) derivatives products. The share of outstanding credit derivatives contracts traded through clearinghouses has risen to 31% from 29% at the end of last year and less than 10% in 2010, according to the Bank for International Settlements (BIS).

* Kroll Bond Rating Agency (KBRA) believes that the decline in CDS volumes is part of a larger trend by large, systemically significant global banks to move away from products and markets that are seen as problematic. In particular, the settlement agreed by some of the world’s largest banks regarding allegations of conspiracy to limit competition in the market for credit derivatives raises some troubling questions for borrowers and investors alike. First and foremost, the secular decline in CDS trading begs the question as to whether the secular decline in trading of credit derivatives since 2008 can or will be reversed. Indeed, even as large banks exit the OTC credit derivatives market, a variety of non-banks are entering and offering trading products and clearing services in direct competition with commercial banks. 

* Despite significant changes in the regulation of these products, KBRA notes that there remain a number of defects in the market structure of OTC credit derivatives, flaws which arguably intensified the impact of the 2008 financial crisis and disadvantage both borrowers and investors. These defects in market structure limit compeition, make it difficult for investors to understand the risks taken by large universal banks, create the potential for the manipulation of borrower credit spreads, and even affect the recognition of when default events occur under CDS contracts.

* One of the most important structural defects in the CDS market is also one of the least discussed, namely the obvious conflict between the role of banks as lenders and underwriters of securities, on the one hand, and as traders of credit derivatives on the other. When large universal banks act as both providers of credit and dealers in CDS, there is obviously the potential – if not the reality -- for conflict. This dual role gives CDS dealer banks both the incentive and the means to use CDS to manipulate the worldwide price and allocation of credit.

* KBRA believes that the simplest way for Congress and regulators to address most of the remaining structural defects in the CDS market is to 1) prohibit cash settlement of credit default swap contracts and 2) require that all CDS exposures be brought back “on balance sheet” with enhanced disclosure. We also believe that Congress and prudential regulators need to look at the potential for conflict of interest when large banks act as both lenders and dealers in securities and CDS.

Conflict of Interest & Market Manipulation  

One of the most important objections to the CDS market is also one of the least discussed, namely the obvious conflict between the role of banks as lenders and underwriters of securities, on the one hand, and as traders of credit spreads on the other. A great deal of attention has been given to the fact that a private industry association controlled by the CDS dealer banks determines when an event of default occurs, but the more troubling issue is the fact that large universal banks act as both providers of credit and dealers in CDS. This dual role gives CDS dealer banks both the incentive and the means to use CDS to manipulate the worldwide price and allocation of credit.  

It is no accident that the securities arms of universal banks now price all new debt deals based on CDS spreads. Issuing CDS allows banks to use the naked shorting activity of hedge funds and other speculators to raise and lower spreads without actually conspiring to fix the spread of each deal (an obvious and direct price fixing for all corporate credit). Uzmanoglu (2015) goes so far as to suggest that that CDS initiation is associated with a reduction in firm equity market valuations, and the effect is more pronounced for firms with active CDS contracts, suggesting that CDSs introduce costs for the underlying firms that outweigh their potential benefits.    

Michael Milken's early control of the junk bond market allowed him to set whatever price he wanted to charge (and to appropriate whatever profits he choose). With CDS, the major universal banks have created a seemingly conflicted situation where all debt and perhaps even equity pricing is based on the CDS market spread used to insure the issuer's debt. 

The Volker Rule enacted with the 2010 Dodd-Frank Act says that banks are banned from engaging in prop trading, but that ban is subject to several exemptions intended to allow banks to facilitate customer trading and hedge their own risks. There is a fine line between bona fide hedging and market manipulation, especially when swaps do not come under the same prohibitions of same that apply to the cash securities markets.  

Allowing banks to trade CDS, even with the restrictions in the Volcker Rule, provides the opportunity to manipulate credit spreads for borrowers, an obvious conflict of interest that is illegal under state and federal laws. Such activity also imposes additional costs on investors, issuers and the economy as a whole. Time after time, investors have seen an issuer's "swap spread" rise just before a bond deal was priced (creating a "cheap" price for the credit) and then fall (creating a "bump" in price for the underwriters resale right after the offering closed).  

The reverse scenario, moreover, consistently occurs as a company is falling toward bankruptcy. As the probability of default rises, CDS prices typically skyrocket, cutting off the obligor from liquidity. The surge in CDS prices allow the naked short CDS positions held by speculators to be closed out at a profit in time to have no interest as of the bankruptcy. Moreover, despite the fact of cash settlement, the market for the sinking firm's bonds will typically skyrocket when a bankruptcy filing is imminent.  


The literature supports the conclusion that CDSs may increase bankruptcy risk (e.g., Subrahmanyam, Tang, and Wang, 2014) and also reduce the liquidity of related securities (e.g., Boehmer, Chava, and Tookes, 2015). This clear opportunity for manipulation of pre-default credit spreads also affords the same CDS issuer banks control of the debtor-in-possession (DIP) finance market post-bankruptcy. Clearly, neither the obligor nor its creditors benefit from this situation.