Corporate Finance : Corporate Debt

Growth in Credit Derivatives Begins Attracting the Attention Of Policymakers, Regulators


cfart01aThe Federal Reserve Bank of New York invited 14 major participants in the credit-derivatives market, primarily investment banks, to a meeting on September 15 to discuss market practices in the fast-growing industry.

Credit derivatives, which are linked to the probability that a company will pay its debts and which have become popular hedge-fund investments, have been growing so quickly that regulators worldwide have expressed concerns about delays and errors in processing trades. Hedge funds are so big and do so much trading that they have changed the dynamics of the corporate bond market. These sometimes highly leveraged funds are the biggest users of credit derivatives.

There were $8.4 trillion of credit default swaps outstanding at the end of 2004, a nine-fold increase in just three years, according to the International Swaps and Derivatives Association, or ISDA, the global trade association of the privately negotiated derivatives industry. A credit default swap is an agreement by one party to accept a premium at regular intervals in return for making a larger payment if a specific company defaults, goes bankrupt or suffers a negative credit event.

Price swings in the credit derivatives market following the downgrades of Ford Motor and General Motors debt in May caused hedge funds to lose between $1 billion and $2 billion and raised fears of a wider financial meltdown, similar to the collapse of Long-Term Capital Management in 1998. While that didn’t happen this time, the New York Fed wants to help make sure it won’t have to launch more rescue missions.

Representatives from the US Securities and Exchange Commission, the Office of the Comptroller of the Currency, the New York State Banking Department, the UK’s Financial Services Authority, Germany’s Federal Financial Supervisory Authority and the Swiss Federal Banking Commission also were invited to attend the New York meeting. Despite the presence of so many financial supervisors at the gathering, industry participants say regulatory and legislative restrictions on over-the-counter derivatives

are unnecessary and are unlikely to be imposed.

Andrew P. Cross, associate and member of the investment management group at international law firm Reed Smith’s Pittsburgh, Pennsylvania, office, says the sharp growth in the credit derivatives market, and in over-the-counter derivatives in general, has been very exciting. “A key success factor will be controlled and sustainable growth,” Cross says. “While the industry has embarked on a new journey, the over-the-counter derivatives market is not an unmanned ship. Very skilled and qualified leaders are looking out at the horizon and guiding the industry,” he says.

One reason the growth has been so rapid is because there has been thoughtfulness on the part of market participants, through participation in industry groups such as ISDA, according to Cross. He commends the New York Fed and the Counterparty Risk Management Policy Group, or CRMPG, chaired by E. Gerald Corrigan, managing director in the office of the chairman at Goldman Sachs, for acting in a pro-active manner. The CRMPG, which includes senior officials from financial institutions, recommended the September 15 meeting to address certain documentation issues before they got to the point of becoming a problem, Cross says.

In a report released on July 27, the Corrigan-led group examined the challenges faced by market participants with regard to the management and use of highly complex financial instruments. “The deals can get complicated, but they are able to be understood,” Cross says.

Market Depth Untested
Andrew Large, deputy governor of the Bank of England, warned in a speech on May 18, following turbulence in the market caused by the downgrade of GM and Ford Motor debt, that credit derivatives could add to the risk of instability in financial markets. “Credit risk transfer has introduced new holders of credit risk, such as hedge funds and insurance companies, at a time when market depth is untested,” Large told an international conference of financial regulators in Turkey. About two-thirds of the trading in the credit derivatives market takes place in London.

The British central banker’s remarks followed a similar warning by Federal Reserve chairman Alan Greenspan on May 5. “The rapid proliferation of derivatives products inevitably means that some will not have been adequately tested by market stress,” according to Greenspan, who described credit derivatives as the most significant development in financial markets over the past 10 years. “A sudden widening of credit spreads could result in unanticipated losses to investors in some of the newer, more complex structured credit products, and those investors could include some leveraged hedge funds,” the Fed chief said.

The CRMPG said in its July 27 report that the financial services industry has very limited experience with settling very large numbers of transactions following a credit event, such as a major corporate default.

Back-Office Problems

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Stephen Jancys, vice president, Trenwith Securitie
The policy group called for urgent industry-wide efforts to cope with serious back-office and potential settlement problems in the credit default swaps market. It also called for an end to the practice whereby some market participants assign their side of a trade to another institution without the consent of the original counterparty to the trade. “Among other things, this practice has the potential to distort the ability of individual institutions to effectively monitor and control their counterparty credit exposures,” the report said.

Robert Pickel, CEO of ISDA, says the trade association has made progress in confirmation of assignments, or novations, as they are sometimes known, and will be introducing a protocol that will make a big impact on derivatives-assignment processing. “ISDA has put confirmation of assignments front and center of its agenda; its forthcoming protocol goes right to the heart of that issue,” Pickel says. “The weight of the full ISDA membership is behind continued improvements to confirmation processing,” he adds. The protocol will facilitate a change of the consent requirement on assignment of trades from written to oral and expedite the process, according to ISDA.

The association released a survey in June showing that there had been an increase in the automation of confirmations, or documented evidence of trades, to 40% from 24% in last year’s survey, while the backlog of confirmations was reduced to 11.6 days from 17.8 days. Error rates in processing, including changes in trade details, fell to an average of 9% of transactions, from 18% last year. Pickel says these results of the survey were encouraging, particularly in light of the increased volumes in credit derivatives trading. The association’s target is to automate 70% of trade confirmations by the end of this year.

GM Bonds Find Home
cfart01cKingman Penniman, director of research at Montpelier, Vermont-based KDP Investment Advisors, a firm that provides research and pricing services on high-yield bonds, says General Motors was one of the best-performing bonds in June and July. “GM has given a firmer tone to the high-yield market,” he says.

While GM and Ford Motor are two of the largest issuers of corporate debt, with a total of about $475 billion outstanding, including the bonds of their profitable financing units, they were easily assimilated into the high-yield sector of the bond market, Penniman says.

Moody’s Investors Service cut its ratings on Ford and GM to below investment grade on August 24, citing the difficulty the automakers face in cutting their high fixed costs to become competitive. However, Moody’s kept an investment-grade rating on Ford’s finance arm, which issues most of the company’s debt. Moody’s was the last of the three major rating services to cut GM to below investment grade, following downgrades in May from Fitch Ratings and Standard & Poor’s.

Ford’s bonds fell slightly in reaction to the latest downgrade, which placed the company in the high-yield market, effective September 1. Nevertheless, the automaker’s debt was assimilated more smoothly than expected. “There is a great demand for yield,” Penniman says. Meanwhile, the yield on the 10-year US treasury bond fell to 4% at the end of August.

The implications of the devastation on the Gulf Coast from Hurricane Katrina, including high prices for energy, could dampen US economic growth, Penniman says. The consumer will feel a bite, and the Federal Reserve sees no reason yet to pause in raising short-term rates, he says.

Overall corporate bond issuance fell 6.9% in the first six months of 2005 from the same period a year earlier, as credit spreads widened and borrowing costs rose through much of the second quarter in the wake of the rating downgrades of GM and Ford, according to the Bond Market Association. Credit spreads rallied late in the second quarter and into the third quarter.

“Going forward, it’s unlikely we’ll see much of a jump in issuance for either treasury or corporate securities,” says Michael Decker, senior vice president and head of research and policy at the association. “The federal budget deficit should continue to shrink, and even though the corporate sector has improved lately, borrowing costs will probably continue to rise as benchmark yields go up and credit spreads widen,” Decker says. Corporate bond issuance could be greater than expected, however, if corporate investment growth picks up or mergers and acquisitions heat up, he adds.

 

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Gordon Platt

 

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