Credit Default Swaps Regulation: in medio stat virtus 

Di  Michele Cea [1], Law degree - Universita' Cattolica del Sacro Cuore, Milano LL.M. Banking, Corporate & Finance Law - Fordham University School of Law, New York

27 Gennaio 2011

Table of contents

I.      Introduction

II.      Credit Default Swaps Function

1.     Description

2.     Functions

III.      Credit Default Swaps Nature

1.     Credit Default Swaps and insurance products

2.     “Empty creditor” theory

IV.      Central Counterparty

1.      Clearinghouse mechanism

2.      AIG’s “clinical death”

V.      Credit Default Swaps in the Dodd-Frank Act

VI.      Conclusion

I.                   Introduction

It was 1994 when some of the sharpest JP Morgan minds came up with the idea of creating a new financial tool, Credit Default Swap (“CDS”)[2].  Thanks to it, the banking institution managed both to comply with the so-called Basel I rules, which required that banks hold eight percent of their capital in reserve against the risk of outstanding loans, and to cover potential damages resulting from the 1989 Exxon Valdez oil spill[3].

Within the last ten years, lawmakers and news media have abruptly shifted their opinion about CDSs.  It is useful to quote Alan Greenspan on July 30, 1998, before the Senate Agriculture committee’s hearing room:  “Regulation of derivatives transactions that are privately negotiated by professionals is unnecessary and hinders the efficiency of markets to enlarge standards of living.”[4]  With this statement, Greenspan replied to the former Commodity Futures Trading Commission Chairman, Brooksley Born, who had been calling for regulation on the Over The Counter derivative market.   The former Chairman of the Federal Reserve and other policymakers feared that a strict regulation would have highly endangered the U.S. financial market’s competitiveness.

On the other hand, some commentators have recently proposed banning this derivative tool.  Take two of the world’s greatest investors for example.  Warren Buffet has repeatedly dubbed derivatives as “financial weapons of mass destruction.”[5]  Similarly, George Soros, in an article published in the Financial Times on January 29, 2009, said that the CDSs are toxic and should be employed only by prescription.[6]  By suggesting using them only to insure actual bonds, the Hungarian-American financier implied that the so-called “naked” CDSs had to be banned.

The financial turmoil of the last years partly explains such a shift.   Specifically, the CDS market has been deemed as the main culprit of AIG’s woes,[7] which have led the Federal Government to make the largest bailout of a private company in the U.S. history in order to avoid massive financial chaos.  It is understandable that these exceptional measures taken to the detriment of taxpayers cannot be accepted in the home of capitalism.  However, the answer of Blythe Masters,[8] one of those JP Morgan bright minds who conceived of CDSs in 1994, to a journalist of “The Guardian”[9] after the outburst of the crisis seems to be balanced and sound: “ I do believe CDSs have been miscast, much as poor workmen tend to blame their tools.”  Indeed, the JP Morgan derivative team hardly employed CDSs and other instruments in the mortgage market.  They smelled a rat.  The data available to calculate default rates and responsibly price the insurance were not enough and were confusing.  As a result, the Morgan team chose not to guess what a real housing bust would look like.  In particular, in a Wall Street Journal’s article[10] that reports excerpts of a book of Gillian Tett, Fool’s Good, it is interesting the picture of the JP Morgan’s team who created CDSs:   

…A tribe of bankers who were not mad, evil orgrotesquely greedy. Their culture was a meritocracy; talent was rewarded regardless of race, sex or social pedigree.  The tribe’s leader, the cerebral Peter Hancock, made certain that compensation was tied to Morgan’s long-term success. The Morgan derivatives team, though paid less than employees at rival firms, enjoyed the intellectual challenge of solving financial problems. They developed complicated models to predict loan-default rates and never believed that the models were infallible…

It does not seem to be a team who was about to devise a “financial weapon of mass destruction”.  Supposedly, other people subsequently turned a useful tool into a toxic one.

This paper discusses some of the most important issues tied to CDSs and tries to point out some elements that need to be changed and others that do not.  It will be proposed a stance that it is equidistant from reckless deregulation and the opinion of people who call for banning CDSs entirely.  Indeed, as the old Latin saying goes:  in medio stat virtus.[11]

This work is divided into four sections:  the first one illustrates CDS and its functions.  The second section deals with the age-old issue regarding the “nature” of this financial tool.  In particular, it explains why CDSs should not be deemed insurance contracts.  Afterwards, the section also illustrates the fundamental and interesting topics of  “naked” CDSs and “empty creditor” theory.  The third part of the work discusses and endorses the opportunity of chartering a clearinghouse for the CDS market.  A brief summary of AIG’s crisis and bailout has been encompassed in this section in order to point out system’s deficiencies caused by the lack of a central counterparty.  The paper will finally examine the section of the Dodd-Frank Act dealing with these issues. 

II.      Credit Default Swaps functions

1.   Description

Credit Default Swaps are derivative contracts.  As such, they are financial instruments whose value is based on something else.  Specifically, CDSs are contracts in which a protection buyer pays a fee to a protection seller in order to be compensated if the reference entity experiences a credit event.[12]  Bankruptcy and other events, such as failure to pay, restructuring, repudiation, obligation acceleration, obligation default and moratorium may be encompassed in this category.  The credit event is designated by contracting parties.  The goal of this financial tool is to transfer the risk and to increase liquidity across markets, enabling investors to protect their portfolios.[13]  CDSs clearly resemble insurances in that they are contracts that pay off if the investment tied to the reference entity goes bad.  However, CDSs are not insurance[14] even though there are some undeniable similarities between the two products.

It is important to present some statistics to clarify the terrific phenomenon dealt in this paper.  This financial tool appeared in the markets in 1994.  Although the total CDSs outstanding did not reach a trillion of dollars in 2000, it was already close to ten trillion of dollars by 2004.  It eventually peaked the sizeable amount of 62 trillion of dollars[15] before the outburst of the crisis in 2007.[16]  

2.   Functions

Although CDSs attractiveness stemmed mostly from the lack of rules given by the Commodity Futures Modernization Act of 2000,[17] it is fundamental to point out all the precious uses of CDSs, which let them to be highly desired by investors.  In fact, these are often blamed to be only a wild speculation tool.  This is not true.  They can be employed for hedging, speculation (which might eventually turn out to be wild indeed) and arbitrage.

Hedging is the first and basic CDS function.  Doubtless, CDSs are great tools to cope with the risk of default that arises by holding debt.  Investors owning bonds of a company deal with the risk of the latter’s bankruptcy or other events.  By giving a premium to another entity available to pay off if the company experiences default or the other credit event settled, investors insure[18] – or hedge – the risk.  The effectiveness of CDSs as hedging tools is unquestionable.  Other ways to reduce risk, such as selling dodgy loans, have clear drawbacks[19].  Let us recall the event that led JP Morgan to create CDSs.  Had not come up with it, most likely the bank would have been forced to divest – at least partly – its exposure towards Exxon.  This would have brought about negative backlash with such a good client.

In addition, CDSs are employed to speculate by exploiting the changes in spread.  That is possible because there is a negative correlation between the CDS spread and the company stock price.  This entails that if the credit-worthiness of the reference entity worsens, the CDS price increases and vice-versa.  Some people strongly blame this practice.  Although this usage is not the real function that led CDSs to be devised, it should not be disregarded its usefulness.  An investor with a positive outlook on a specific company can sell protection rather than spend a great deal of money to load up on the company’s bonds or equity.  On the other hand, an investor with a negative outlook on a specific company can buy protection for a relatively small fee and get a huge payoff if the company experiences the credit event settled in the contract.[20]

Finally, CDSs may be used as tools in an arbitrage strategy.  This is based on the formerly stated negative correlation between the CDS spread and the stock price of the reference entity.  However, it happens that sometimes this correlation freezes for a while due to market inefficiencies.  In such cases, sharp investors try to exploit any slowness of the market to reply to signals.  They shoot for gains by entering into CDS contract and waiting for the realignment of the correlation. 

III.      Nature of CDSs

1.   Credit Default Swaps and insurance products

Maybe the oldest issue regarding CDSs is the one regarding their nature.  By stating this, the first and main discussion is whether CDSs should be considered insurance contracts or not. 

Doubtless, CDSs share a variety of similarities with insurance products.  Some of them were underscored by the National Association of Insurance Commissioners (NAIC) in 2003.  The association issued a Draft White Paper, whose conclusions suggest encompassing CDSs in the insurance category.[21]  It is clearly visible that both CDSs and insurances guarantee compensation to the buyer for a specified loss in return for payment of a periodic premium to the seller.  In addition, advocates of the assimilation CDSs/insurance products underscore the risk transfer from one entity to another for a fee without giving much importance to the means utilized for obtaining risk transfer.[22]  To sum up, some commentators say that the differences are only “cosmetic”.  Therefore, CDSs should be deemed insurance products and should be controlled by state law[23].  Otherwise, transactions would merely aim at escaping regulation under state insurance regimes.[24]

However, there are many differences that prevent lumping CDSs into insurance category.  The main one is that insurance products require an “insurable interest”.  In other words, only a person who has an economic interest in preserving a property can take out an insurance contract[25].  On the other hand, a protection CDS buyer is not required to have such an interest.  Those CDSs lacking an “insurable interest” are called “naked”.  Actually, many commentators who call for encompassing CDSs in the insurance category also consistently propose to ban “naked” CDSs.  However, the soundness of “naked” CDSs, which will be explained in this paper, should be affirmed.

Another blatant difference is that CDSs are easily transferable without affecting the protection seller in that the protection buyer does not influence the credit event.  Differently, insurance are personal contracts[26] and insurers care about the identity of the insured.  It is clear that if a wise middle-aged man transfers his car insurance to his alcoholic young son, the possibilities of a car accident soar.  An insurer will hardly accept it, unless a higher premium is arranged.  Furthermore, while the insured must show “proof of loss” to get coverage, the protection CDS buyer must submit only the credit event notice and will recover even if he/she had not actually suffered any losses.[27]  Finally, while insurance contracts merely transfer the risk, CDSs and other derivatives “reduce risk through trading, matching counterparties with complementary and offsetting risk profiles.”[28]

As previously mentioned, some commentators would want, at least, the “naked” CDSs to be banned.  These are the ones without an “insurable interest” of the protection buyer.  “Buying a naked CDS is like taking out an insurance on your neighbor’s house and then burning it down” is the evocative sentence employed to support this opinion.  However, the soundness of “naked” CDSs should be affirmed.  Indeed, these are great hedging tools even in some situations where there is not an insurable interest.  An investor, for instance, might realize that he/she is too exposed to a given market and may wish to buy a protection despite the fact that he/she does not own any insurable asset.[29]  A “naked” CDS, in such a case, allows the protection buyer to hedge a position without divesting another one.[30] 

2.   “Empty creditor” theory

Similar critics have elaborated on the theory[31] of the “empty creditor.”[32]  Basically, this blames creditors who might profit more from a failure of the debtor than from its solvency because of a remarkable insurance position that pays off in the event of utter devastation.  Therefore, the theory concludes, these empty creditors might be more inclined to push a company towards bankruptcy.  Suppose, for instance, that a hedge fund holds 200 $ million of a company’s bond, but it is also “long” a 500 $ million notional amount in CDSs on this debt.[33]  The investor has an incentive to act to cause the company to fail – for example, to oppose an out-of-court restructuring – because it will profit more from its “swap position” than it will lose from its bonds.[34]

Two recent cases highlight the discussion. The first is the one regarding the coverage position that Goldman Sachs held towards AIG. David Vinier, Goldman’s Chief Financial Officer said that such a position was “non material” in a conference call held in March 2009 in order to clarify trading relationships between Goldman and AIG.[35]  Although on March 15, 2009 AIG disclosed that it has paid $7 billion of its government’s loan to satisfy obligation to Goldman, the investment bank was not too concerned about a possible AIG default in September

2008.[36] Why? Goldman was an “empty creditor” thanks to a hefty CDSs coverage position. As such, Professor Henry T. Hu says that the investment bank might have had weaker incentives to cooperate with the troubled AIG.[37]  Instead, creditors generally want to keep solvent firms out of bankruptcy and to maximize their value.[38]  To sum up, Professor Hu’s analysis clearly implies that financial tools like CDSs alter regular relationships between debtor and creditors, triggering

a wicked behavior of the latter that would push to the failure of the first.

Similarly, Greek politicians have pointed to some fierce CDSs speculators as causes of the southern European country’s downturn.  Greece’s Prime Minister George Papandreou spoke out in a CNN interview and told Fareed Zakaria[39] that he: “is considering taking legal action against U.S. investment banks that might have contributed to the country’s debt crisis.”[40]  In an effort to deflect government irresponsibility[41], Papandreou[42] accused CDSs buyers, both creditors (“empty” ones) and speculators (“naked” CDSs buyers) to have pushed the country towards default.   Indeed, they brought about spreads on the underlying bonds to widen, making borrowing more expensive and bringing default closer.[43]

This is a clear attempt to find a scapegoat: the only responsible for the Greek debt is the Greek government, whose attitude toward borrowing and spending is much like that of US consumers who leveraged their homes without worrying about how they would pay off the loans.[44] It is true that aggressive CDSs buying could create a problem by damaging confidence.  However, James Mackintosh sharply observed in an article on the Financial Times: “Is a loss of confidence causing the problem, or is the Greek economy like souvlaki totally skewered?”[45]

Although the empty creditor theory illustrates some tough and important issues, it is based on incorrect premises.  An “immaterial position”, such as Goldman’s position towards AIG, is only the result of a good hedging strategy.  Moreover, it is highly unlikely that speculators would buy other CDSs when a company is close to default.  In fact, such a position would be extremely expensive.  The point is well-explained by David Mengle in “The Empty creditor hypothesis”:

One may reasonably question the plausibility of the “empty creditor” hypothesis on the basis of how the credit default swaps market treats distressed credit. If an investor were actually to try to build up a negative economic ownership position through overhedging, the strategy would be expensive and unlikely to yield a high return. Setting aside the possibility of trading on insider information, which is itself illegal in most jurisdictions, an overhedging strategy is likely to be profitable only if an unusually prescient hedger were to foresee accurately the failure of an investment grade company while the company’s credit default swaps still traded at a low spread. In such a case, the gain might be regarded as a windfall but would not lead to behavior that might affect the functioning of credit markets. And if the anticipated bankruptcy did not occur, the large hedge position could lead to large losses.[46]

IV.      Central Counterparty

1.   Clearing house mechanism

The goal of this paper, as stated in the introduction, is to maintain an equidistant stance from either a reckless deregulation or an excessively tough regulation.  The former section of this work does not recommend following the opinion of people who call for a CDS banning.  Instead, this section takes a pro-regulation side by supporting the idea of chartering a clearinghouse system for the CDS market.  CDSs have been trading in the Over The Counter Market (OTC), where one party enters in a bilateral contract with another party.  On the other hand, parties trade through facilities chartered for this purpose in the Exchange Trading Market.  Specifically, the facility that carries out such a task is a central counterparty, also called clearinghouse.  This is an institution that stands between the two contracting parties and provides clearing and settlement in order to reduce the risk of parties failing to honor their obligations.  In this system, the parties enter in a contract with the clearinghouse, which acts as buyer and seller at the same time.  Essentially, it is an institution that acts as guarantor and can reduce the systemic risk by interposing itself as a counterparty to every trade, performing multilateral netting,[47] and providing various safeguards to ensure that the failure of a Clearing Member (CM) to the clearinghouse does not affect other members.[48]  The key functions of a clearinghouse that would help keep the system safer may be summarized:  A) Determining payment amounts at the beginning of each interest period.  B) Daily valuations of all derivative contracts for collateral[49] requirement purposes.  The clearinghouse monitors, reexamines all posted collaterals, and applies “haircuts.”[50]  C) Monitoring counterparty creditworthiness and compliance with all the terms of the contracts.  This includes determining whether to exercise settlement rights if an event of default or termination occurs, and recovering or making net final payments.  D) Keeping relevant records and producing various reports.[51]

The Commodity Futures Modernization Act of 2000[52] opted not to clear the CDS market, but those were years in which talking about regulation was heretic.[53] As mentioned in the introduction, policymakers were concerned about losing the flourishing and profitable derivative market. 

It is true that a clearinghouse would hardly work as smoothly in the CDS market as it does in the futures one where the contracts are easily standardized.  Moreover, some people point out a problem of asymmetric information between investors and a central counterparty[54].  The latter, indeed, would not have the same bulk of information as private parties.  Finally, it has been said that a central counterparty would not reduce the risk, but it simply would concentrate it,[55] creating thus a dangerous “too big to fail” entity.  Although these are arguably sound and rational concerns, a different conclusion that stems from an elementary consideration can be drawn here.  The prior bilateral system, indeed, has failed crudely.  The risk of asymmetric information should be carefully considered.  Therefore, the central counterparty needs to be granted considerable risk management’s powers.  In addition, a well-capitalized clearinghouse should be able to cover losses stemming from a default of a clearing member.  In other words, a “strong” – not only financially - clearinghouse would work properly.

In the privately negotiated Over the Counter CDS market, dealers are on one side of every trade and do not customarily post initial margin because investors have historically viewed dealers as secure counterparty credit risk.[56] Unfortunately, the notorious events of the recent financial crisis events have showed that even those capital-supervised entities were insecure.  A clearinghouse would require all firms to post sufficient collaterals, regardless of their reputation, rating and alleged financial soundness.[57]

Another shortcoming of the bilateral system has been underscored by the Lehman failure:  when the buyer posts initial margin to a dealer, that margin is not held in trust or in some other way segregated from the dealer’s assets. It is instead commingled with the dealer’s working capital, and thus subject to bankruptcy of the dealer.[58]

The sharp words of Nouriel Roubini in one of his last works endorse this analysis:

Moving most trading from OTC markets that rely on market makers/dealers to exchanges would reduce these distortions but, more important, would radically reduce the counterparty risk that makes the financial institutions too interconnected to fail. Indeed, the more the transactions occur on exchanges, the less the system becomes interconnected as counterparty risk is significantly reduced. Not only do we need to reduce the “Too Big ToFail” problems by making each institution smaller, we also need to unbundle financial services within financial institutions to reduce the too-interconnected-to-fail problem: with exchanges, broker dealers would be involved only in the efficient execution of trades for clients, not in market making/dealing, which is rife with conflict of interest, lack of price transparency, and large and systemic counterparty

risk.[59]

2.   AIG’s “clinical death”

Dealing with the CDS’s topic leads unavoidably to a digression about AIG’s crisis and bailout.  The discussion has been embedded in this section because the weakness of the bilateral system has been extremely blatant in AIG’s case, and therefore the opportunity of chartering a clearinghouse is even enhanced by the following analysis.

It might sound difficult to figure out how a giant as AIG has reached such a dire situation.  It is widely known that the losses stemmed from huge CDS positions as a protection seller.   However, this was not AIG’s core business.  AIG used to operate its CDS business through its subsidiaries, AIG Financial Products Corp. (AIGFP) and AIG Trading Group, Inc, and the other branches were still profitable and sound.[60] The bulk of the financial subsidiary CDS portfolio was comprised of protection on “super senior” tranche[61] of various types of asset backed securities[62] (ABS).[63]  While protection buyers entered in such contracts to provide their capital a regulatory relief (i.e. to comply with Basel Accords’ rules), AIG acted as protection sellers to make money.  A great deal of it.  Writing CDSs was deemed “gold” and “free money” because AIG’s risk models indicated that the underlying securities would never go into default.[64]  Here we are, we got the main problem:  risk management’s offices did not assess any risks.  In hindsight, it is easy to say it, and supposedly it was more difficult to foresee certain dangers years ago.  However, this analysis aims only at proving that the former bilateral risk management’s system did not work, and it needs to be modified.

The principal cause of AIG’s cash woes was the collateral posting obligations in AIGFP’s CDSs sector:  in 2008 summer, after the downgrades of its securities, AIG agreed to post $ 6 million in collateral.[65] In September the cash situation even worsened: first, AIG was essentially shut out of the commercial paper market because its subsidiaries were unable to roll over their commercial paper financing; soon after another downgrade, AIG made a last desperate effort to raise capital.[66]  As it is well-known, those efforts were useless, and the U.S. Government felt compelled to intervene and bail out AIG in order to avoid an out-of-hand chaos.

It would be misleading to state that a clearinghouse would have avoided AIG’s crisis.  However, a central counterparty guarantees greater certainty about collaterals, those that have led AIG to a “clinical death”.  It is fundamental to highlight again that the giant insurer was been bailed out not for a traditional liquidity crisis, but rather for a sudden and massive obligation to post collaterals.  Most likely, a clearinghouse would have required posting collaterals sooner. Accordingly, uncollateralized exposures would not have been given the chance to build to levels that became systemically critical.[67]  Put in simpler terms, a clearinghouse would have said to AIG: “Either abide by rules or do not play.”  If nobody sets forth and checks the rules, players hardly abide by them.

VII.      CDSs in the Dodd-Frank act

Inevitably, the recent financial reform could not evade handling the issues tied to CDSs.  Since they had been pointed out as one of the main culprits of the financial turmoil, it was easy to predict a legislative shift in this field.  The real question was not “whether or not”, but rather “how”.  Even now, a few months after the huge “Dodd-Frank Wall Street Reform and Consumer Protection Act”[68] has been enacted it is not easy to answer.  The Section dedicated to derivative contracts is Title VII.[69]  Overall, it is possible to underscore that lawmakers did not follow the populist anger that had been directed at the derivatives area.  Specifically for the CDS market, the Dodd-Frank Act does not take into account the requests of those who had been calling for a banning of CDSs or at least the “naked” CDSs.  In addition, the Act expressly prohibits swaps and security-based swaps (categories in which CDSs are encompassed) from being regulated as insurance contracts under state law.[70]  On the other hand, a fundamental goal of the legislation is to push as many trades as possible into clearinghouses.[71]  Thus, the Act requires the clearing of all swaps that the Securities and Exchange Commission (SEC)[72] or Commodity Futures Trading Commission (CFTC)[73] determines should be cleared.  Another interesting provision is the one regarding holding and segregation of collateral.  In a cleared transaction, the collateral held must be segregated, and the use of such collateral will be subject to rules to be issued by the CFTC or SEC; in addition, although these requirements do not apply to uncleared swaps, initial margin must be maintained in a segregated account with an independent third-party custodian if a counterparty on an uncleared swap requests such a segregation.[74]

To sum up, Title VII of the Dodd-Frank Act seems to place itself in that middle stance endorsed by this work.  Has everything been fixed?  Unfortunately no.  The law still needs to be implemented:  the Fed and the Securities and Exchange Commission have been preparing and promulgating more than 240 rules.  Therefore, it is impossible to judge this law now.

 Moreover, Title VII of the Dodd-Frank Act is confusing on some definitions (such as “swap”) and between the split of powers of SEC and CFTC.  Furthermore, it should not be disregarded that it is a massive act, created in short time though.  Haste often leads to lack of quality.  Generally speaking, it may be said that the direction is right, but the road is long and impervious.

VI.   CONCLUSION

A brief conclusion might be helpful for the reader. Unfortunately, CDSs have become – like other derivatives - a good target for those of various political stripes although they were not the root cause of the recent financial meltdown.[75]

This work strongly suggest not banning CDSs – even the most criticized type: “naked” CDS - in that they are a precious hedging tool. Instead, those recent decisions of implementing a set of rules are opportune in order to enable CDSs to play their proper role. CDSs are financial tools very effective for certain financial strategies. As such, investors should employ CDSs by strictly following instructions. A hammer is a great tool if it is employed to assemble some pieces of furniture. On the other hand, it turns out to be a deadly tool if it is used to settle arguments among people. In this latter case, however, we would obviously blame people who use the hammer improperly but not the hammer itself. Similarly, instead of blaming CDSs itself, we should blame those who used them improperly.