Credit default swaps run out of road

October 15, 2013 9:35 am

Credit default swaps run out of road

By Tracy Alloway and Michael Mackenzie in New York

In 1994 bankers at JPMorgan Chase came up with the canny idea of selling off some of the risk of their loans by striking insurance-like deals with other banks and financial institutions. In return for paying some fees, JPMorgan was able in effect to unload much of its credit risk and save on capital costs. From that humble beginning the “single-name” credit default swap (CDS) was born. By 2008, Wall Street had manufactured trillions of dollars’ worth of the swaps, using the derivatives to increase or reduce their exposure to loans – with sometimes disastrous results.

Single-name CDS are the simplest, and most common, in the default swap universe. They offer protection from default by companies, banks and governments, or a way for traders to speculate against the financial health of those entities. The buyer of the protection makes periodic payments to the seller, and receives a pay-off in the event of a default.

Now, just two decades since their creation, such swaps have come under pressure from regulators, as well as a broader evolution in the behaviour of banks and investors. The amount of such swaps outstanding has shrivelled to less than half of what it once was, fuelling speculation that the market for single-name CDS is on its deathbed.

“Defaults are at historic lows, so there’s just less need for CDS from the point of hedging,” says Michael Hampden-Turner at Citigroup. “A lot of the key single-name CDS business uses have gone away or become less relevant.”

While many regulators and politicians are unlikely to mourn the derivatives’ decline, the lack of a vibrant CDS market could leave big investors – such as the banks – with one less tool to offset or manage specific risks on their balance sheet.

The declining health of single-name CDS stands in sharp contrast to the market’s glory days before the financial crisis. JPMorgan’s creation took off rapidly across Wall Street, with single-name CDS eventually proliferating alongside CDS indices that gave exposure to whole classes of credit instead of just a single loan.

The creation of synthetic “collateralised debt obligations” (CDOs) – a type of derivatives-based securitisation – helped drive growth of the swaps market.

The combination of these CDO structures and banks seeking to offset their loan exposure opened the swaps arena to hedge funds and other traders, making CDS trading a hot ticket across Wall Street. “Synthetic” CDOs would sell credit protection in waves, attracting a host of “correlation traders” who were eager to exploit discrepancies in the prices of the swaps or parts of CDOs.

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Now synthetic CDOs are practically extinct and tougher capital rules mean that banks no longer gain as much relief from hedging their loans with CDS. What fewcorrelation traders remain on Wall Street are said to spend most of their time managing ageing synthetic CDOs.

“Synthetic CDOs or correlation desks were the guys that really drove the growth in single-name CDS,” says one banker. “Since those guys have gone away and their portfolios are winding down, you really don’t need as many single-name CDS as you used to.”

Europe’s recent ban on using sovereign CDS to bet against government debt has also taken out a hefty portion of the single-name market, traders say.

Trading volumes of single-name CDS are said to have dropped accordingly.

If the patient can be kept alive long enough for clearing and SEFs to come on line then there’s a good chance that the product can be brought back to life

– Paul Hamill, UBS

At the end of last year, the notional amount of single-name CDS stood at just $14.3tn, down 57 per cent from its $33.4tn peak in the first half of 2008, according to data from the Bank for International Settlements. While a chunk of that initial decline has come from investors compressing or clearing their swaps portfolios, CDS traders say that liquidity in the single-name market is undeniably lower.

“We still occasionally see some players in single-name CDS, but the market is not as liquid in the absence of synthetic CDOs and banks hedging their loan books,” says Ashish Shah at AllianceBernstein. “Some people do trade the single names against the indices.”

CDS indices have fared somewhat better. With corporate default rates at historic lows thanks to ultra-low interest rates, and with the prices of many asset classes moving together in recent years, the indices continue to attract interest as both a trading and hedging product. The drawback is that using such an index to offset a specific credit risk may not be as precise as using single-name CDS.

There has “been just a bigger focus on macro risk rather than micro risk”, says Mr Hampden-Turner. “When there is macro uncertainty, investors like to take a little risk off with an overlay of index CDS.”

Some CDS traders say that single-name swaps may yet recover as incoming rules come into effect and encourage new players – such as insurers – to enter the market. The move to central clearing and swap execution facilities (SEFs), which regulators have demanded as a way of strengthening the opaque derivatives market, may yet lead new investors to embrace single-name swaps, they say.

While financial reform rules have been formulated for CDS indices, finalised rules for single-name CDS are not expected until next year.

“If the patient can be kept alive long enough for clearing and SEFs to come on line then there’s a good chance that the product can be brought back to life,” says Paul Hamill at UBS. “The longer it takes to get to that place, the more risk that the patient doesn’t come back.”