The controversy over what constitutes a "credit event" in the world of credit derivatives appears to have put a chill on the rapid growth of the nascent market.The notional value of credit derivatives on the books of U.S. banks dropped 17.3% in the first quarter to $352 billion, according to the Office of the Comptroller of the Currency. It was a sharp reversal of the trend in which the notional value of credit derivatives had been doubling annually over the last few years. The decline raises questions about the future of the young and complex financial tool, but most experts expect the market to rebound.
Generally, banks employ derivatives to hedge risk in their loan portfolios and to help meet regulatory capital requirements. Usually, there are two parties to a credit derivative. One sells protection against a loss on the credit, while the other buys protection. Partly because the tool is fairly new, definitions have not been fully worked out and there have been disputes over whether a "credit event" has occurred that would trigger a call on the seller of protection.
Last year, a bitter dispute erupted over whether a restructuring of debts owed by Conseco Inc. constituted a credit event, which would have required the sellers of credit protection to pay up. That dispute was resolved earlier this year, and the International Swaps and Derivatives Association wrote new guidelines to help avoid similar conflicts in the future.
Deutsche Bank and Switzerland's UBS also got into a squabble over credit derivatives and initiated lawsuits, but eventually settled out of court.
The Comptroller's Office cited the dispute over the Conseco restructuring as a possible reason for the decline in activity. "There had been some concerns about restructuring, which is one of the definitions of a 'credit event,'" says Michael Brosnan, OCC deputy comptroller for risk evaluation. "As these concerns are resolved, we expect to see this product begin growing again."
The vast majority of activity in credit derivatives is confined to a handful of banks, as is true with derivatives in general. According to the OCC, "the top seven commercial banks...account for 96% of the total notional amount of (all types of) derivatives in the commercial banking system." (See chart.)
J.P. Morgan Chase sits at the center of the derivatives universe among banks. "J.P. Morgan is the firm that kicked off the market and could be synonymous with credit derivatives," says Linda Bammann, chief risk management officer of Bank One Corp. "They built a big business around it and were the ones promoting education of the product," she adds.
At the end of the first quarter, J.P. Morgan Chase held credit derivatives that, according to OCC data, had a notional value of almost $227 billion, or 64% of the total for all U.S. banks. (The "notional" amount refers to the volume of the loans upon which the credit derivatives are based.)
Citibank and Bank of America are the second and third biggest holders of credit derivatives. A spokesperson at BofA says the bank "uses credit derivatives to hedge the underlying risk in our portfolio. We evaluate whether it's best to sell the exposure outright or use credit derivatives to handle the exposure that way."
The notional exposure of all other U.S. banks, aside from the Big Three, amounts to only $18.4 billion.
Bank One, which started using credit derivatives only late last year, had $635 million in derivative contracts at the end of the first quarter. Credit derivatives, says Bammann, enable banks to support their customer base in a way that's consistent with how a bank has traditionally done business, but without carrying all the risk associated with holding large positions.
The most popular credit derivative is a credit default swap, in which a lender pays a counterparty for credit protection. That provides a number of benefits. First, it reduces the lender's risk. Next, it tends to please the lender's client, which often doesn't want to see its name in numerous loan portfolios, and if and when problems arise, the borrower generally prefers dealing with the original lender than with a group of unknown investors.
"You support your customers with the use of your balance sheet, even when you aren't necessarily the most efficient holder of that risk," says Bammann. "Credit derivatives allow us to distribute risk across other platforms and markets."
Bammann adds that, "borrowers traditionally think of their loans from banks as private transactions. They don't want them exposed and have everyone know they have borrowed."
A bank also might use a credit default swap to offset the risk of being too heavily invested in loans to one industry, or even one company. They do this either by "buying" risk in a portfolio of loans by other lenders or by "buying" protection for their own loans. The contract for the two lenders amounts to a "swap" of credit risk of default - a credit default swap.
Credit derivatives are more popular among European banks than they are in the U.S. because selling loans across national boundaries, even within the European Union, could be extremely complicated and can involve getting authorization from the borrower. Use of credit derivatives enables banks to sell the risk anywhere and avoid cross-border complications. The notional value of credit derivatives among European banks is estimated to be $1 trillion, about three times the amount in the U.S.
Meanwhile, in the U.S., although the biggest banks account for a huge percentage of credit derivatives, some medium-size banks also make use of them. Cincinnati's $15 billion-asset Provident Financial Group last year paid about $2 million to limit its potential loss on a $1.8 billion auto lease portfolio, according to its quarterly report. But the loss protection will kick in only after Provident absorbs the first 2% of losses, which would be about $36 million.
More often than not, the credit derivatives market is not available to medium-size banks that are seeking protection for the loans on their books. That's because their customers tend to be smaller companies that are unknown to most investors. As a result, sellers of protection are reluctant to provide coverage on loans to those companies. In contrast, the largest banks tend to lend to huge corporations, which are rated and are well known to most investors.
Provident was able to get credit protection because it was looking to reduce its risk on auto-leasing receivables, which are secured and have a credit rating.
Some experts say the market may open to lenders which serve smaller companies, but can't say when that may happen.
Worldwide, between 500 and 1,000 corporate names "are actively traded in the single-name credit default swap market," according to the British Bankers Association.
As Cameron Mitchell, senior vice president and managing director for derivatives at NatCity Investments, puts it: "How do you put a price on a middle-market bank loan? It's very difficult." NatCity is the securities unit of Cleveland-based National City Corp.
Smaller banks can participate in loans to big publicly traded companies, but, "generally, don't play in that market," says Christopher Carey, chief financial officer of Provident. "It's not how midsize banks make money," he says.
"If you wanted in on a Ford Motor Co. credit, the minimum participation would probably be bigger than any that the largest banks would want," says Carey. Whether their use will expand "is a 'stay-tuned' kind of a situation," he adds.
There are other reasons why so few banks use credit derivatives. For starters, many are content doing business the old-fashioned way, making money off the deposit-loan spread. It's a "big cultural shift to intermediate away that risk," notes Bammann.
Another factor is that credit derivatives cost money. "The problem with most credit derivatives from NatCity's point of view is," says Mitchell, "if we want to buy exposure to someone, we find the price more expensive than we could get otherwise, and if we're selling it we find it too cheap. The pricing hasn't made sense to us."
The "more substantial reason," though, that the bank hasn't gotten more deeply into credit derivatives is that National City's lending niche is "middle and upper-middle market companies-generally not public companies, so there's no traded debt, and without the existence of a reference security, it's very difficult to structure a credit derivative."
Yet, says Mitchell, "the concept of credit derivatives is fabulous."
Nevertheless, according to the OCC, "although the current volume of credit derivative activity in U.S. banks is quite small, many banks have begun to evaluate these products as tools for credit risk management." The OCC uses bank call reports to track derivatives use. The $74 billion drop in notional value of credit derivatives is only the second time they decreased since the agency began reporting on them in 1997.
There is confidence, though, that the market will become more liquid and grow.
"The more liquid the market becomes, the more it will expand. The more these derivatives are used, the more assets will become part of the market. How far it will expand, I don't know," says Bammann.
Mitchell agrees. He predicts that National City will one day be bigger in the credit derivatives market, adding, "I don't say this for any particular reason except that that has been the history of the derivatives market. It starts at the high end of the market and works its way downward. I think it will be more difficult to do that in the case of credit derivatives, but I'm sure it will happen, though I don't know exactly how."
In fact, credit derivatives have only been used in any volume in the last few years. "They were around about 10 years ago, but have developed only over the last five years. They're still not very liquid, but are more friendly than they were," says Bammann.
Much depends on experience. The fracas over the Conseco refinancing appears to have cooled interest in credit derivatives, but market participants believe that the new guidelines put out by the ISDA have calmed the fears. Overall, the experience over the past five years has been mainly positive.
For the most part, they have worked well. "Before that, credit derivatives were a good concept but there wasn't the data to support what worked and what didn't," says Bammann.
A continuing problem is the ambiguity of terms. That's largely because credit derivatives have not been around long enough to have the courts and others create clear definitions.
One gray area is the issue of "moral hazard," or the problem of taking the buyer of protection's word that a default as defined by the derivative contract has occurred. "If you had car insurance, the insurer isn't going to trust you entirely when you say you had an accident," says Jeff Tolk, an analyst who specializes in derivatives for Moody's Investors Service. The insurer is "going to want to see a police report, a mechanic's report, something to prove the amount of damage. Yet in some cases that's what banks are asking investors to do: 'we're not going to tell you what the name is, we're not going to tell you exactly what happened to the name, and we're not going to tell you how we valued the loss on the name - just trust us.'"
Also, to many the word "derivative" conjures up an image of a high-risk, arcane financial instrument, one requiring "rocket scientists" to understand what they're about. In fact, though, depending on the type of derivative, participants, including bank regulators, today view credit derivatives as just another risk management tool.
Some, though, see a potential problem in credit derivatives hurting the overall soundness of the market by shifting credit risk away from the originators of loans, when it's the originators who are most likely to have the best knowledge of the loans.
"I would say that's a reasonable question to raise, but I wouldn't put it any stronger than that," says Alastair Clark, executive director for financial stability at the Bank of England.
Meanwhile, a softening economy will be putting pressure on loan portfolios-and the derivatives covering them. "Credit events tend to be bunched. The prospective weakening in the global economy and consequent rise in credit risk might present a significant test for participants in the credit derivatives market," says David Rule, a senior manager in the financial stability area at the Bank of England and the author of a report on credit derivatives.
In any case, the market for credit derivatives, which hardly existed five years ago, is tiny relative to the notional volume of all derivatives held by banks, which grew 8.3% to $43.9 trillion in the first quarter, according to the OCC.
Capital regulatory relief is a key reason banks employ credit derivatives and a big question is how regulators are going to quantify the capital relief a bank earns by using credit derivatives. "Regulatory recognition of risk transfer by banks using credit derivatives has been and remains important to the growth of the market," says Rule.
The OCC says it has no problems with such use so long as the banks employ the same prudent approach as for any investment. The agency continues to refer to credit derivatives as "new and largely untested," noting that "valuation methods for transactions are not as analytically developed as they are for other financial instruments."
Nevertheless, the OCC thinks credit derivatives, like other financial derivatives, can provide banks with substantial benefits, particularly as they offer banks a way to reduce "concentration" risks. "Banks can adjust their credit profile by purchasing protection (i.e. hedging risk) against borrowers in an industry where an undesired exposure exists and selling protection (i.e. acquiring risk) in another," notes the OCC.
"Under the current risk-based capital regime, a bank with corporate exposure that it transfers to another financial institution will reduce the amount of capital they have to hold for that exposure," says Kathryn E. Dick, director for the treasury and market risk division at the OCC. The agency decides on a case-by-case basis if the use of credit derivatives by a bank is appropriate and exactly how much capital relief to grant.
"If one of our banks is interested in trying to reduce its capital requirements, it will bring the proposed transaction to us. We have a capital steering committee that makes a determination whether or not the proposal complies with the risk-based capital regime," says Dick.
As the OCC sees it, default swaps pose many of the same credit risk management issues as loans. Before entering into a credit derivative transaction as a seller of protection, a bank should conduct a complete credit review of the reference asset and, as necessary, the counterparty, says Dick. "That review should be similar to the process of granting a loan or providing a letter of credit," she says.
The exact amount of risk a bank lays off using credit derivatives is difficult to quantify, which is a reflection of how new these instruments are.
"The amount of capital relief a bank should get by doing a particular deal is something Moody's is looking into," say Tolk. "We are working on a methodology on that, on measuring how much a credit derivative contract frees up in additional capital for a bank."
The OCC looks upon credit derivatives much the same way it does any other risk management products, says Dick, and, in general, the OCC welcomes new tools to manage risk. "We certainly encourage banks to think about and prudently manage the risks they have in their portfolios," she says. At the same time, any national bank using such products would have to have in place policies and procedures ensuring these instruments are safely employed.
The market is growing, she notes, "which is a good thing, because the deeper the market the more liquid it is." Further expansion of the market to smaller players, she says, will depend on how the market evolves and whether banks can come up with ways to write credit derivatives on underlying assets that correlate with loans to midsize companies.
The number of defaults in the first quarter were way up, which could prompt banks to boost their use of this credit insurance. "It's largely been a market that's focused on investment grade names, but this year we've seen at least four or five investment grade names default, so there could be a pick-up in activity in the volume of swaps," says Tolk of Moody's.
Biggest Players in U.S. March 31, 2001