Coping with Credit in a Climate of Default

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


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.

" 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.

END OF EXCERPTED ADAPTION


Janet Tavakoli is the president of Tavakoli Structured Finance, a Chicago-based firm that provides consulting to financial institutions and institutional investors. Ms. Tavakoli has more than 20 years of experience in senior investment banking positions, trading, structuring and marketing structured financial products. She is a former adjunct professor of derivatives at the University of Chicago's Graduate School of Business. She is the author of: Credit Derivatives & Synthetic Structures (John Wiley & Sons, 1998, 2001), Structured Finance & Collateralized Debt Obligations (John Wiley & Sons, 2008).

Janet Tavakoli's book on the global financial meltdown is Dear Mr. Buffett: What An Investor Learns 1,269 Miles From Wall Street (Wiley 2009).

Clients of Tavakoli Structured Finance have the benefit of proprietary consultation, which is not available in any other paid or public forum. Clients also commission proprietary research and analysis.

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