Andria van der Merwe

The Informational Content of CDS Spreads

We review the empirical academic literature on the informational content of credit default swap (“CDS”) spreads. Most of this literature posits and empirically documents that CDS spreads generally: (i) contain valuable information about the probability and severity of adverse credit events that the underlying reference entities may experience during the life of the CDS; (ii) reflect a risk premium that protection sellers demand to compensate them for reference entity-specific and systematic risks (both credit-related and non-credit-related); and (iii) are anticipatory and contain information regarding future announcements about the credit risk and financial condition of the underlying reference entity.

Loan-Only CDSs

We discuss the underlying market for broadly syndicated leveraged loans that characterize the deliverable loans on which most loan-only CDSs (“LCDSs”) are based. We then review the significant distinctions between single-name CDSs (typically based on bonds issued by reference entities) and LCDSs with loan-specific deliverable obligations. Such distinctions include reference entity credit events that trigger LCDSs, the timing of coupon payments on LCDSs, the specific obligations underlying LCDSs that are deliverable into LCDS-specific auctions or physical settlements, and the embedded cancellation options in LCDSs corresponding to prepayments on underlying broadly syndicated term loans.

Interconnectedness and Systemic Risk

The empirical literature regarding financial institution interconnectedness and potential systemic risk has burgeoned in the last decade. Broad conclusions from this research pertaining to credit default swaps (“CDSs”) include the following: (i) Single-name CDSs on corporate, banking, and sovereign reference entities are a source of interconnectedness and contain information that may be valuable to policy makers in measuring potential systemic risk, but there is a dearth of empirical evidence to indicate that single-name CDSs are systemically destabilizing; (ii) single-name sovereign CDSs are transmission mechanisms for economic shocks but not generally a cause of those shocks; and (iii) a “sovereign-bank” loop integrates the financial condition of the banking sector with sovereign credit risks.

Single-Name CDSs

Single-name credit default swaps (“CDSs”) are financial instruments that facilitate the transfer of credit risk on a defined universe of debt securities issued by an underlying reference entity from credit protection purchasers to sellers. Underlying reference names include corporations, sovereigns, and other borrowers. Payments by protections sellers to purchasers are based on the occurrence of any of several credit events, as defined in the documentation governing single-name CDS transactions. We describe here the significant economic terms of single-name CDSs, the evolution of the documentation of single-name CDSs, and several specific actual and would-be credit events that have generated significant discussion regarding CDS documentation and the viability of single-name CDSs as price discovery and risk transfer instruments.

Inter-Market Basis Relations

No-arbitrage relationships characterize relative prices of credit default swaps (“CDSs”) vis-a-vis bonds and equities issued by the same reference entities. We review the empirical academic literature on which of the three markets is the Primary Price Discovery Market (“PPDM”) and find that CDS spreads lead corresponding cash bond prices in price discovery. The PPDM is more empirically ambiguous when comparing CDSs and equities. We also review the empirical evidence on the impact of the introduction of CDSs on bond and equity markets’ liquidity, which broadly demonstrates that the introduction of single-name CDS trading initially has adverse impacts on the liquidity of related debt and equity markets, but that those effects are transitory and may be later reversed as the related markets reach a joint equilibrium.

Implications of CDS Listings for Reference Entities and Creditors

Empirical academic research regarding the impact of credit default swaps (“CDSs”) on lenders to reference entities and reference entities themselves yield the following general results: (i) CDSs are generally used by lenders to fine-tune their desired risk/return profiles; (ii) the impact of CDS availability on banks’ credit exposure monitoring is bank-specific; (iii) the availability of CDSs positively impacts the supply of credit to reference entity borrowers, impacts the design of syndicated loan facilities, and affects reference entity borrowing costs differently based on the credit characteristics of borrowers and structures of their loans; (iv) the availability of CDSs influences capital structure and financing decisions of reference entity borrowers; and (v) creditors with significant CDS-hedged exposures can impact the bankruptcy decisions of borrowers both positively and negatively.

Potential Costs of CDSs

Credit default swaps (“CDSs”) can give rise to potential costs: (i) lenders hedging borrower credit exposures could use CDSs to justify extending riskier loans, not doing sufficient up-front due diligence, and/or underinvesting in ongoing credit risk monitoring of borrowers; (ii) lenders hedging the credit exposure of borrowers could be biased toward forcing borrowers into bankruptcy in lieu of pursuing debt restructurings; (iii) speculators with synthetic shorts in reference entity obligations could precipitate excessive price volatility; and (iv) systemic linkages across financial institutions resulting from CDS counterparty exposures could exacerbate the spillover effects and severity of major financial firm’s failures. We discuss here these potential costs of CDSs.

Potential Benefits of CDSs

Credit default swaps (“CDSs”) can benefit market participants in various ways. CDSs can benefit lenders to CDS reference entities in the credit risk management process. By supplementing loan sales and securitizations with another credit risk management tool, CDSs give lenders flexibility in choosing a preferred credit risk transfer solution, which can free up capital and facilitate additional lending to reference entity borrowers. CDSs can also benefit investors by enabling them to make synthetic investments in the unfunded reference entity’s bonds. Finally, CDS prices can provide useful information to CDS users and other market participants about the expected default risks, recovery rates, potential interconnectedness, and other aspects of underlying reference names. We discuss here these potential benefits of CDSs.

Multi-Name and Index CDSs

Credit default swaps (“CDSs”) based on more than one reference entity include bespoke portfolio CDSs with customized reference portfolios, basket CDSs with individualized reference portfolios and engineered payoffs (e.g., Nth-to-default CDSs and excess-of-loss CDSs) designed to reduce the cost of credit protection while tailoring such protection to the particular needs of protection purchasers, index CDSs based on a standardized set of underlying reference entities, and tranched index CDSs based on both a standardized set of underlying reference entities and pre-defined cumulative loss rates. The mechanics of these types of multi-name CDSs are summarized here.

Asset-Backed CDSs

Credit default swaps (“CDSs”) based on asset-backed securities (“ABSs”) (including residential mortgage-backed securities (“RMBSs”), home equity loan-based ABSs, and tranches of collateralized debt obligations (“CDOs”)) are not amenable to the same ISDA credit definitions applied to single-name CDSs based on specific reference entities. To address the specialized nature of CDSs backed by ABSs, ISDA published in 2005 and 2006 “pay-as-you-go” documentation that was better suited to the cash flows of ABSs and complications raised by the issuance of ABSs by special purpose entities (“SPEs”). Although such asset-backed CDSs (“ABCDSs”) have virtually disappeared since the outbreak of the credit crisis, the fundamental idea behind pay-as-you-go ABCDSs is sound, and such products could well re-emerge again (albeit not necessarily based on US subprime mortgage-based ABSs).