The credit derivatives market is undergoing its biggest overhaul in a decade with proposals to make sure that bondholders can be compensated for losses imposed as part of bank rescues.
Flaws revealed during Europe’s debt crisis prompted the International Swaps & Derivatives Association to propose changing rules governing credit-default swaps so the contracts explicitly insure against debt writedowns, exchanges or conversions into equity. The Dutch government’s expropriation of SNS Reaal NV’s bonds this year exposed investors to losses, fueling concern that swaps offered inadequate protection.
The shake-up in the $25 trillion derivatives market prompted investors to shun existing swaps on speculation future contracts will be more valuable. The Markit iTraxx Financial Index of swaps linked to the subordinated debt of 25 banks and insurers is near the lowest in almost three years.
“We’ve moved into a new world and need a new product to deal with this,” said Saul Doctor, a credit strategist at JPMorgan Chase & Co. in London. “Investors were moving away from sub CDS because there was a realization that it doesn’t hedge against some of the actions taken by government authorities.”
Markit’s subordinated index is one of Europe’s least liquid, in part because of questions about the effectiveness of credit-default swaps. Contracts on the current version of the benchmark covered a net $4.5 billion of debt as of May 24, according to the DTCC, down from $4.8 billion four weeks ago and $7 billion on the equivalent measure last year.
The change being proposed by New York-based ISDA will mean that bail-ins, when investors are forced to contribute to company rescues, are added to the list of credit events that trigger payouts of default swaps, alongside bankruptcy, failure- to-pay and restructuring.
Swaps on Utrecht-based SNS Reaal were triggered when the Dutch government nationalized the country’s fourth-largest bank to prevent it from collapsing under bad real estate loans. Payouts on the lender’s swaps covered as little as 4.5 percent of losses on the seized bonds.
Opposition to government money being used to save failed banks is being led by Michel Barnier, the European Union’s financial services chief. He’s proposing regulators be given the power to impose losses on a crisis-hit lender’s unsecured bondholders, or convert that debt to equity, once capital has been wiped out.
In the meantime, individual governments are undermining confidence that existing insurance contracts cover new risks. ISDA had to accelerate settlement of default swaps on Anglo Irish Bank Corp. in 2010 before the government eliminated the nationalized lender’s subordinated securities. Cyprus in March became the first euro-region government to force higher-ranking bank creditors to share losses.
“The patchwork of legislative regimes around Europe has resulted in different and unpredictable results that has proved challenging to CDS holders,” BNP Paribas analysts led by Belle Yang in London wrote in a note to investors. “With the emphasis on bail-in type instruments as the preferred governmental option for distressed credit institutions, CDS contracts would need to change to remain effective hedging instruments for both senior and subordinated bondholders.”
As part of the swaps overhaul, ISDA has also proposed plans to ease settlement of contracts triggered by a sovereign debt exchange to address concerns raised by Greece’s restructuring. Dealers are again offering credit-default swaps on the nation’s bonds after contracts paid out last year, though they’re no longer among the top 1,000 entities captured by the Depository Trust & Clearing Corp.’s central registry for the market.
It now costs $3.5 million in advance and $100,000 annually to insure $10 million of Greek debt for five years, signaling a 49.4 percent probability of default, according to CMA, which compiles prices quoted by dealers in the private market.
ISDA doesn’t have a timeframe for implementing the changes, according to Mark New, the industry group’s assistant general counsel in the Americas. “We’re looking for market feedback to make the product as good as we can,” he said.
Analysts at JPMorgan and BNP Paribas expect the updates by September, when indexes roll into new series. Indexes are changed every six months when companies are added or dropped depending on their ratings, cost of protection and ease of trading.
Markit’s subordinated financial index dropped to a 31-month low of 177 basis points last week from 319 in March. It’s now just 1.42 times higher than the senior measure, down from more than 1.62 times on May 15. The ratio peaked at 2.12 times at the height of the financial crisis in March 2009 and is near the all-time low of 1.39 times just before the credit crunch started in July 2007.
A basis point on a credit-default swap protecting 10 million euros of debt from default for five years is equivalent to 1,000 euros a year. Swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements.
“The new contract will probably become a good systemic hedge for Europe,” said Doctor at JPMorgan. “Market participants want this.”
Editors: Michael Shanahan, Jennifer Joan Lee