Coping with Credit in a Climate of Default

Updated and adapted May 2005. - Originally published in Corporate Finance by Angus Foote March 2002

Corporates have a huge amount of credit exposure. Yet while hedging of currency and interest rate exposure now takes place as a matter of course, credit risk remains largely unhedged.

But now, after a series of profits warnings, coupled with increased speculation about possible defaults, dealing with credit risk has taken on a much greater significance.

And the events of September 11 have accelerated this trend, with banks reporting increased interest from corporates in the whole subject of credit default protection.

The use of swaps is one of the principal means of hedging currency or interest rate exposure. For corporates looking for some form of protection against credit risk, credit derivatives are the logical instruments to use.

So far, however, these instruments have failed to really take hold. Banks say this is partly because they have not been entirely understood by corporates, partly because there are barriers due to the complications surrounding these products and partly because the market has lacked the tools and liquidity necessary to provide the kind of service corporates require.

Niche product

Until now, the mainstays of this market have been the banking, insurance (hedge funds) and reinsurance sectors. Among corporates the more common derivatives are now widely used as risk-management tools, but specialized instruments such as credit derivatives have been used to fill specialist roles.

Companies with exposure to a specific country or to a small number of key customers in a specialized business use credit derivatives as protection against the risk of default by either customer or sovereign.

Financial institutions have been trying to encourage corporates to make greater use of derivatives, but the process is extremely sllow. In an environment where profit warnings and talk of possible defaults are making the markets ever more nervous, the idea of credit default protection starts to look very attractive.

Credit Default Swap Mechanics

The credit default swap is just one type of credit derivative, but it is the most widely used. The simplest type of credit default swap is an instrument that would see regular payments by the buyer to the seller. In return the seller undertakes to make a one-off payout in the event that a specified third party – the reference entity – defaults on its obligations.

If a default does occur, the buyer gets either a cash settlement or a physical settlement. And the payout is designed to reflect the losses incurred by creditors of the buyer, who are owed a specific amount by the reference entity.

Risk managers can use credit default swaps to reduce their exposure to any existing counterparty without closing out any of their contracts with that counterparty – a move which might jeopardize the buyer's relationship with the counterparty.

Size of the Credit Derivatives Market

BBA figures based on surveys which put the total notional volume of the credit default swaps market at $180 billion in 1997. For 1998 the figure was $586 billion and projections show a continuing rise, to $900 billion for 2000 and $4.8 trillion for 2004. The BBA expects the market to grow to $8.2 trillion by 2006.

Although the big banks are highlighting the attractions of credit derivatives as a risk management tool, until now many corporates have clearly not been convinced. In 2002, Goldman said that 61% of corporates review credit limits on an as-needed basis, with only 31% conducting an annual review and 77% extending credit to counterparties beyond established credit limits.

Corporate credit exposure takes many forms – trade receivables, loans, lines of credit, derivatives, financial leases, tax commitments, rental deals, promissory notes. Janet Tavakoli, president of Tavakoli Structured Finance (as of March 2003), offers the following summary of how credit derivatives can be used: "Credit derivatives are bilateral financial contracts that isolate credit risk from financial instruments and make it transferable without balance sheet implications."

The concept of disaggregating risk is not a new one and credit derivatives provide a set of tools that allow the isolation and management of credit risk from all other components of risk. For the corporate looking at this area of risk management, Goldman Sachs highlights a number of issues.

First, the corporate must recognize the credit risk inherent in its business before a credit event occurs. The next step is understanding the tools that can be used to limit credit risk.

Economic Disruptions

Tavakoli says credit derivatives are particularly useful in existing market conditions. "Our current credit environment has shown we have multiple names being downgraded not one but several notches," she points out.

That credit environment has created an atmosphere where there is a widespread fear of default. "There are a lot of people asking about credit derivatives since the events of September 11," Tavakoli acknowledges. This is mainly because the credit markets have become "a lot choppier", she says, indicating the levels of downgrades and worries about default. Events like the Railtrack collapse in the UK have added to general concerns about creditworthiness.

The quarter that ended in September 2001 was the second worst ever in terms of dollar volume of speculative-grade corporate bond defaults, according to Moody's Investors Service. Total default volume for the three-month period was $21.9 billion by 48 issuing companies and Moody's also reiterated its prediction of continued credit deterioration until late in the first quarter of next year.

David Hamilton, vice president and director of default research at Moody's, says: "It is worth emphasizing that the factors driving the default rate higher were in place before the atrocities of September 11, the economic shock waves of which reinforced an established trend."

" Six months ago it was a very, very good idea to look at credit default protection," says Tavakoli. At that time, however, many potential users were put off by the pricing levels. But if those users had bought credit default protection at that time, Tavakoli says, they would now be extremely happy.

She believes the wariness with which many corporates regard these types of instruments has been a factor limiting the spread of their use. Corporate treasurers may sometimes need the product explained to them, she says, but once they hear the explanation they recognize it as a tool they have probably used before.

Needed Infrastructure

In the US, one of those requirements is the FAS 133 accounting rule. This requires the holders of credit derivatives to mark them to market in quarterly earnings statements. Accounting practice requires that users need an independent benchmark price to do this, rather than the price set by an individual counterparty. Until now, independent price data has not been easy to find. Mark-it-Partners provides mark-to-market pricing on actively traded credit default swaps. Bloomberg also provides credit default swap prices to subscription users. GFInet, the internet business of interdealer broker GFI, introduced a mark-to-market service for credit derivatives. Although GFI caters primarily for financial institutions, the group is looking to aim a version of its service at the corporate user.

"There are varying degrees of savviness among corporations," says Tavakoli. For medium-sized corporates, she says, she "would not be surprised" to have to use some kind of primer explaining the basics of how a credit default swap works.

The International Swaps and Derivatives Association lists standard swap confirmation definitions which provide an indication of what constitutes a credit event:
• Bankruptcy
• Failure to pay
• Obligation acceleration
• Repudiation or moratorium
• Restructuring.

All our sources are agreed that the amount of credit exposure corporates have is huge. Hence the potential market for credit derivatives – and credit default swaps in particular – is also huge.

Tavakoli says the number of professional players is increasing, but until now there have been educational and systems barriers. This is reflected in the fact that of the top 10 banks in the US, there are probably three who dominate the field, she says. But the barriers to entry – for example the systems and accounting costs – can be formidable.

In 2005, PIMCO (Pacific Investment Management Company LLC) said that it took years to properly integrate credit derivatives into their portfolio management systems.