Credit (Default) Swaps

The Credit Swap or "Credit Default Swap" illustrated in the below chart is a bilateral financial contract in which one counterparty (the Protection Buyer) pays a periodic fee, typically expressed in basis points on the notional amount, in return for a Contingent Payment by the Protection Seller following a Credit Event of a Reference Entity. The definitions of a Credit Event and the settlement mechanism used to determine the Contingent Payment are flexible and determined by negotiation between the counterparties at the inception of the transaction. The International Swap and Derivatives Association (ISDA) has completed a lengthy project to produce a standardized letter confirmation for Credit Swaps transacted under the umbrella of its ISDA Master Agreement. The standardized confirmation allows the parties to specify the precise terms of the transaction from a number of defined alternatives. The evolution of increasingly standardized terms in the credit derivatives market is an important development because it has reduced legal uncertainty that, at least in the early stages, hampered the market's development. This uncertainty originally arose because credit derivatives, unlike many other derivatives, are frequently triggered by a defined (and fairly unlikely) event rather than a defined price or rate move, making the importance of watertight legal documentation for such transactions commensurately greater.

A Credit Event is commonly defined as bankruptcy, insolvency, receivership, material adverse restructuring of debt, or failure to meet payment obligations when due; coupled, where measurable, with a significant price deterioration (net of price changes due to interest rate movements) in a specified Reference Obligation issued or guaranteed by the Reference Entity. This latter requirement is known as a Materiality clause and is designed to ensure that a Credit Event is not triggered by a technical (i.e., non-credit-related) default, such as a disputed or late payment, which would not, presumably, be accompanied by a material price deterioration in the Reference Entity's obligations.

The Contingent Payment is commonly effected by a cash settlement mechanism designed to mirror the loss incurred by creditors of the Reference Entity following a Credit Event. This payment is typically calculated as the fall in price of the Reference Obligation below par (or some other designated reference price or "strike") at some pre-designated point in time after the Credit Event. Counterparties typically wait from one week to three months after default in order to give the Reference Obligation's price time to settle at a new level, or take an average over a similar time period. Typically, the price change is determined by reference to a poll of price quotations from dealers in the Reference Obligation. Since most debt obligations become due and payable in the event of default, plain vanilla loans and bonds will trade at the same dollar price following a default, reflecting the market's estimate of recovery value, irrespective of maturity or coupon. Alternatively, the Contingent Payment may be fixed as a predetermined sum, known as a "binary" settlement.

Another alternative for the settlement of the Contingent Payment is for the Protection Buyer to make physical delivery of a specified Deliverable Obligation in return for payment of its face amount. Deliverable Obligations may be the Reference Obligation or one of a broad class of obligations meeting certain specifications, such as any senior unsecured claim against the Reference Entity. A key distinction between physical delivery and cash settlement is that, following physical delivery, the Protection Seller has recourse to the Reference Entity and the opportunity to participate in the workout process as owner of a defaulted obligation. The physical settlement option is not always available since Credit Swaps are often used to hedge exposures to assets that are not readily transferable or to create short positions for users who do not own a deliverable obligation. Of course, assuming perfect liquidity in distressed debt markets, a Protection Seller in a cash settled Credit Swap could replicate a physically settled transaction by buying defaulted obligations through the dealer poll process, but this assumption cannot be guaranteed to hold, particularly for larger transactions.

It is interesting to note that while Credit Swaps can be triggered by a Credit Event defined as narrowly as a default on a single specified Reference Obligation, they are commonly triggered by default with respect to any one of a much broader class of obligations. Similarly, while the Contingent Payment can be determined with reference to a specific instrument, it is also commonly determined by reference to any one of a broad class of qualifying obligations. Thus, while some credit derivatives closely resemble the risks of direct ownership of a specific underlying instrument, others are structured to transfer more "macro" exposure to a Reference Entity.

Credit Swaps, and indeed all credit derivatives, are almost exclusively inter-professional (meaning non-retail) transactions. Averaging $25 to $50 million per transaction, they range in size from a few million to billions of dollars. Maturities usually run from one to ten years and occasionally beyond that, although counterparty credit quality concerns frequently limit liquidity for longer tenors. Reference Entities may be drawn from a wide universe including sovereigns, semi-governments, financial institutions, and all other investment or sub-investment grade corporates. While publicly-rated credits enjoy greater liquidity, ratings are not necessarily a requirement. The only true limitation to the parameters of a Credit Swap is the willingness of the counterparties to act on a credit view.

Addressing illiquidity using Credit Swaps

Illiquidity of credit positions can be caused by any number of factors, both internal and external to the organization in question. Internally, in the case of bank loans and derivative transactions, relationship concerns often lock portfolio managers into credit exposure arising from key client transactions. Corporate borrowers prefer to deal with smaller lending groups and typically place restrictions on transferability and on which entities can have access to that group. Credit derivatives allow users to reduce credit exposure without physically removing assets from their balance sheet. Loan sales or the assignment or unwinding of derivative contracts typically require the notification and/or consent of the customer. By contrast, a credit derivative is a confidential transaction that the customer need neither be party to nor aware of, thereby separating relationship management from risk management decisions.

Similarly, the tax or accounting position of an institution can create significant disincentives to the sale of an otherwise relatively liquid position - as in the case of an insurance company that owns a public corporate bond in its hold-to-maturity account at a low tax base. Purchasing default protection via a Credit Swap can hedge the credit exposure of such a position without triggering a sale for either tax or accounting purposes. recently, Credit Swaps have been employed in such situations to avoid unintended adverse tax or accounting consequences of otherwise sound risk management decisions.

More often, illiquidity results from factors external to the institution in question. The secondary market for many loans and private placements is not deep, and in the case of certain forms of trade receivable or insurance contract, may not exist at all. Some forms of credit exposure, such as the business concentration risk to key customers faced by many corporates (meaning not only the default risk on accounts receivable, but also the risk of customer replacement cost), or the exposure employees face to their employers in respect of non-qualified deferred compensation, are simply not transferable at all. In all of these cases, Credit Swaps can provide a hedge of exposure that would not otherwise be achievable through the sale of an underlying asset. Simply put, Credit Swaps deepen the secondary market for credit risk far beyond that of the secondary market of the underlying credit instrument.

Exploiting a funding advantage or avoiding a disadvantage

When an investor owns a credit-risky asset, the return for assuming that credit risk is only the net spread earned after deducting that investor's cost of funding the asset on its balance sheet. Thus, it makes little sense for an A-rated bank funding at LIBOR flat to lend money to a AAA-rated entity that borrows at LIBID: After funding costs, the A-rated bank takes a loss but still takes on risk. Consequently, entities with high funding levels often buy risky assets to generate spread income. However, since there is no up-front principal outlay required for most Protection Sellers when assuming a Credit Swap position, these provide an opportunity to take on credit exposure in off balance-sheet positions that do not need to be funded. Credit Swaps are therefore fast becoming an important source of investment opportunity and portfolio diversification for banks, insurance companies (both monolines and traditional insurers), and other institutional investors who would otherwise continue to accumulate concentrations of lower-quality assets due to their own high funding costs.

On the other hand, institutions with low funding costs may capitalize on this advantage by funding assets on the balance sheet and purchasing default protection on those assets. The premium for buying default protection on such assets may be less than the net spread such a bank would earn over its funding costs. Hence a low-cost investor may offset the risk of the underlying credit but still retain a net positive income stream. Of course, the counterparty risk to the Protection Seller must be covered by this residual income. However, the combined credit quality of the underlying asset and the credit protection purchased, even from a lower-quality counterparty, may often be very high, since two defaults (by both the Protection Seller and the Reference Entity) must occur before losses are incurred, and even then losses will be mitigated by the recovery rate on claims against both entities.

A note on terminology

Given that the payout of a Credit Swap is option-like, with the Protection Seller receiving a premium in return for taking the risk of having to make a large (although capped) payout, terminology is frequently a source of some confusion. Why would an option-like contract be referred to as a swap? In fact, while Credit Swap certainly share characteristics with option-like products, they should not be confused with what derivatives traders think of as true "Credit Options"; that is, options on credit-risky instruments, such as a bond or loan, or on credit spreads. In the same way that receiving fixed in an interest rate swap is the duration equivalent of a long (financed) position in a bond, selling protection in a Credit Swap (or, for that matter, being TR Receiver in a TR Swap) is the credit-risk equivalent of a long (financed) position in a bond. The origin of the "swap" terminology derives from this analogy. It is intended to convey the fact that the Credit Swap (and TR Swap) are effectively swaps of positions in credit-risky assets, rather than options on positions in credit-risky assets. The latter are referred to as "Credit Options" and, just like any other option in which the contingency is a market price development rather than a remote Credit Event, they derive their value from the expected forward value and volatility of market prices (i.e., credit spreads). If an institution is capable of "pricing" a position in a loan or a bond, by extension, given financing costs (and counterparty charges), it is also capable of pricing a Credit Swap. To price a Credit Option, on the other hand, requires additional information beyond that required to price a loan or a bond, namely information about volatilities and implied forward credit spreads.