As the financial crisis continues to evolve, a number of esoteric financial instruments have taken center stage as the markets seek to understand what caused the financial meltdown. One primary area of focus has been credit default swaps (also known as CDS contracts).

In light of the increasing prominence of CDS contracts, here we will provide our list of the “five things” every director should know about credit default swaps:

1. Credit Default Swaps are credit risk transfer vehicles. A credit default swap is a bilateral financial contract traded in the over-the-counter market and used to transfer credit risk of an identified reference obligation or reference entity by hedging risk of loss from agreed events.

In a CDS contract, one party (the protection buyer) makes either a single payment or a series of periodic payments in exchange for the promise by the other party (the protection seller) to pay up to a stated amount (the notional amount) if certain specified events occur during the term of the CDS contract. The amount actually payable by the protection seller will be determined by reference to the value of one or more loans, bonds or other financial instruments (the reference obligations) issued or guaranteed by a third party (the reference entity).

The CDS contract will specify the terms upon which the protection seller must pay the protection buyer. Typically these payments are made upon the occurrence of significant events of loss such as either a payment default or bankruptcy by the reference entity or other agreed events such as a material ratings downgrade or an amendment of terms materially adverse to the holders of the reference obligation (credit events).

CDS contracts can be highly tailored to the protection buyer’s needs, and may reference one or a group of reference entities or reference obligations. Also, in addition to serving as hedging devices to mitigate risk of loss, CDS contracts can be purely financial contracts (referred to as “naked” CDS contracts) meaning that the protection buyer does not own or have any exposure to the risks of the reference entities or reference obligations.

2. Credit Default Swaps are becoming increasingly relevant in assessing credit worthiness. Credit default swap spreads1 signal the market’s view on a reference entity’s or reference obligation’s likeliness to experience a credit event. With the recent focus on these instruments and given their ability to contemporaneously and accurately reflect financial distress of reference entities, it is likely that market participants in the coming years will rely more heavily on CDS spreads to assess credit worthiness than on traditional indicators such as credit ratings. As evidence of this trend, lending syndicates have sought to price revolving and term loans based on formulas taking into consideration both the CDS spread of the borrower and the agent bank.

3. Credit Default Swaps are a significant (and growing) sector of the derivatives market. Credit default swaps have seen explosive growth over the past few years and now represent a significant and very active part of the over-the-counter derivatives markets. According to the International Swaps and Derivatives Association’s (“ISDA”) semi-annual survey for the first half of 2008, the notional amount outstanding of credit default swaps stood at $54.6 trillion. While some proponents of public-sector regulation have used this number to argue for strict federal oversight, ISDA has sought to address this as a “misconception”, explaining that the amount at risk in the CDS marketplace is only 3% of the notional value (a number closer of $1.6 trillion).

4. Credit Default Swaps trading activity will need to be disclosed in financial statements. The Financial Accounting Standards Board recently issued FASB Staff Position No. FAS 133-1 and FIN 45-4, which will require that protection sellers disclose detailed information regarding their financial positions under credit derivatives that are subject to SFAS 133 (which includes CDS contracts). This increased disclosure regime comes into effect with reporting periods ended after November 15, 2008. In addition to these disclosure requirements for protection sellers, protection buyers should also review their disclosure requirements. SEC reporting companies also need to be mindful of their disclosure obligations, particularly in the MD&A section of their periodic reports.

5. Credit Default Swaps are currently the subject of intense regulatory scrutiny. As the federal government continues to address the crisis in the credit markets, many market participants and regulators have petitioned for increased regulation as a means of providing greater transparency and risk mitigation in the CDS marketplace. This call for regulation has resulted in a few swift developments and on-going investigations and discussions about further oversight. The regulatory scrutiny can be divided into four areas:

  • Investigations. To date, the SEC's Division of Enforcement and a joint New York state and federal taskforce have announced two major investigations into the use of CDS contracts to perpetrate market abuse crimes. Both of these investigations are focusing on market manipulation through “naked” CDS contracts. 
  • Regulation. In mid-September, the New York State Department of Insurance announced steps aimed at regulating certain protection sellers. Using its authority to regulate the insurance industry, the Department of Insurance announced its intention to interpret certain types of “covered” CDS contracts (where the protection buyer reasonably expects to own the reference obligation) as the “doing of an insurance business” under NY law. Consequently, qualifying protection sellers would be required to obtain a license as an insurance company prior to selling such CDS contracts. 
  • Efforts to increase transparency. In addition to financial statement footnote disclosure, which is aimed at providing more transparency of risks related to credit derivatives’ activities, the Depository Trust & Clearing Corporation recently announced that starting this month it will post on its website a weekly announcement of the outstanding gross and net notional values of CDS contracts of the top 1,000 reference entities, together with an indication of confirmed trading volume for each name. 
  • Efforts to mitigate counterparty risk. The private-sector has also been seeking a private-sector solution to the call for increased risk mitigation through the development of private clearinghouse trading platforms. The proponents of this approach argue that exchange-traded CDS contracts would offer the increased transparency and information the market needs, without interfering with the freemarket efficiency currently available to market participants. Over the past few years, ISDA in cooperation with key market participants has developed an auction settlement process to facilitate the settlement of CDS contracts where significant amounts of credit protection have been sold on a single reference entity. The smooth settlement of a slew of recent credit events, including the settlement of $500 billion in notional value of CDS contracts linked to Lehman Brothers, went a long way toward illustrating that CDS contracts in the over-the-counter market can be effectively managed. In addition, the dealer community through a number of industry initiatives has worked diligently on reducing the notional amounts outstanding in credit default swaps by cancelling offsetting trades, and thereby significantly reducing operational, legal and capital costs for industry participants.

No concrete regulatory action has been implemented at this point and it remains to be seen whether regulation will ensue on a state-by-state or federal level. For more information on the status of CDS regulation, read our “Update: Issues and Implications of the Race to Regulate Credit Default Swaps” at http://www.paulweiss.com/resources/pubs/detail.aspx?publication=2104  and for more information on disclosure obligations for SEC reporting companies see “Coping with the Credit Crisis: Certain Considerations for Boards of Directors and Senior Management” at: http://www.paulweiss.com/en-US/resources/pubs/detail.aspx?publication=2092