By: Thomas E. Holber
The credit default swap market continues to pose systemic risks to financial market participants. Over the past few weeks, these concerns have received attention in the financial press. Fearing the consequences of a potential Greek national debt default, protection buyers are seeking better capitalized counterparties willing to novate – or assume – protection sellers’ obligations. This blog post will address three sources of financial market instability related to credit default swaps (“CDS”): Bankruptcy Code provisions granting CDS counterparties special allowances, CDS contracts incorporating rating agency evaluations and the ongoing specter of a Greek national debt default.
A credit default swap, in the most basic sense, is a contract whereby a protection seller provides credit protection for a protection buyer in case an underlying reference entity defaults. Thus, a holder of Greek long-term debt, the reference entity and a protection buyer, can make monthly payments to a protection seller providing enhanced credit protection on the debt. CDS transfer economic risk from the protection buyer to the protection seller. The quality of protection is only as good as the protection seller’s credit risk. And the fact that the risk of a counterparty default is non-trivial is one of the lingering lessons of the financial crisis.
The risks posed by a counterparty default are exacerbated by Bankruptcy Code provisions granting CDS counterparties special allowances. These statutory exceptions contravene the Bankruptcy Code’s traditional concerns with treating creditors fairly and equitably. Under normal circumstances, creditors preferentially or fraudulently raiding debtors’ assets are subject to claw–back provisions permitting bankruptcy trustees to recover unfairly or inequitably procured assets for other creditors’ benefit (11 U.S.C. §§ 548-48). In addition, a debtor’s bankruptcy filing normally precludes subsequent creditor actions against its property (11 U.S.C. §362). Subsequent to the 2005 Bankruptcy Code Amendments, however, CDS counterparties are specifically exempted from these provisions. Thus, payments by credit protection sellers are not subject to claw-back provisions (11 U.S.C. §546(g)) and protection buyers may sue protection sellers for outstanding swap balance regardless of whether the debtor has filed for bankruptcy. (11 U.S.C. §362(a)(17)).
The role played by credit agency ratings in CDS contracts is destabilizing as well. CDS contracts often specify several events triggering an obligation to post collateral to the protection buyer. These triggering events may be related to the underlying obligation – based on a rating agency downgrade or a reduction in accounting value – or to the protection seller – based on the protection seller’s credit rating. Thus, rating downgrades in a falling market can set off a self-perpetuating tailspin as counterparties are forced to post collateral to meet margin calls and liquidate assets to generate cash.
The present disruptions in the credit default swap market may be largely related to the ongoing specter of a Greek default on its national debt. Indeed, there is growing concern that domestic banking institutions are significantly exposed to Greek debt and that the proposed bailout would constitute a “credit event” requiring credit default sellers to make payments on their contractual obligations. In response to these concerns, the derivatives trade body ISDA has announced that the bailout would not constitute a “credit event” for CDS purposes. In ISDA’s view, since the debt restructuring is “voluntary,” it does not constitute a technical default for CDS purposes. Given the scale of the proposed reduction in Greek’s debt obligations, commentators have noted that the bailout hardly appears “voluntary”.
Domestic banking regulators are also taking steps to mitigate the risks posed by CDS counterparty risk. Towards these ends, the Federal Reserve last week granted Bank of America an exception from the company’s §23A affiliate transaction limitations and permitted its Merrill Lynch broker-dealer arm to novate derivative contracts to the retail bank. In the Federal Reserve’s view, supporting derivative contracts with the Bank’s relatively more stable depositor is an appropriate measure to forestall a potential “run on the bank” incited by the circumstances described above. Of course, the Federal Reserve is in the uncomfortable position of granting a special allowance in contravention of FDIC wishes because that section is designed to prohibit such behavior: “Congress doesn’t want a bank’s FDIC insurance and access to the Fed discount window to somehow benefit an affiliate, so they created a firewall,” according to Saule T. Omarova, a law professor at the University of North Carolina at Chapel Hill School of Law.
Risks posed by the credit default market to financial market participants suggest that the market is deficient in several ways discussed above. Two others are worth mentioning. First, CDS counterparties are likely systematically underweighting counterparty risks. Second, the potential non-default on Greek debt indicates that counterparties may be underweighting default risks as well. The second consideration should make CDS protection more expensive and shift costs onto protection buyers and sellers. The first consideration has more troubling consequences. The Federal Reserve’s actions indicate that the risks associated with CDS counterparty defaults are still being implicitly supported by United States taxpayers.
The saying goes that those in power “legislate for the last crisis, but not the next one.” Expectations are low – and they are not being met.