Much has been written recently about whether credit default swaps (“CDS”) played a role in creating or exacerbating the current global financial crisis. Both critics and proponents of these risk transfer instruments agree that to restore market confidence some amount of informational transparency and counterparty risk mitigation will be required in the CDS market. Various governmental bodies and market participants have publicly announced measures to bring this much needed transparency to the marketplace. While many of these measures have been months in the development, the current crisis has lent urgency to addressing the question of how best to regulate CDS contracts and other synthetic credit derivatives.
The purpose of this update is to summarize these responses and highlight certain issues and implications of the current efforts to regulate CDS contracts.
Various Bodies Respond to Call for CDS Regulation
The proposals announced have sought to stabilize the CDS market from three primary angles: disclosure, prosecution and regulation. What is apparent from these proposals is that the efforts lack coordination of objectives and it remains to be determined whether the credit derivatives marketplace will survive relatively intact (subject only to enhanced disclosure requirements, incentives towards systemized trading on a clearinghouse, and increased prosecutorial authority under existing antifraud and market manipulation rules), or whether the authorities will pursue more aggressive measures that would result in a complete overhaul of the CDS market as it exists today. Though we do not expect to see the outright ban of these instruments, what is certain is that CDS contracts and credit derivatives generally will be subject to intense scrutiny as the market repairs itself and that scrutiny will lead to a greater understanding of CDS contracts and the appropriate role for them in the marketplace.
We set forth below a summary of the actions taken to date.
FASB Increases Disclosure Requirements For Credit Derivatives
One of the major contributors to the on-going market seizure is that there is insufficient information available to assess prospective counterparties’ exposure to credit derivatives. The FASB has taken a major step towards addressing this concern with the issuance of FASB Staff Position No. FAS 133-1 and FIN 45-4. Beginning with reporting periods ended after November 15, 2008, sellers of protection will be required to disclose substantially more detailed information regarding their financial positions under credit derivatives that are subject to SFAS 133 (which includes CDS contracts). These increased disclosure requirements will mean that GAAP financial statements will include a description of:
- the nature of the reporting company’s credit derivatives (including, approximate term, reason to entering the transactions, events and circumstances that would require performance, the current status of the payment/performance risk);
- the maximum (undiscounted) potential amount of future payments;
- the current fair value of the credit derivatives; and
- the nature of any recourse and collateral provisions.
Given the complex and often bespoke nature of the credit derivatives transactions, this individualized approach should provide a means for gathering information otherwise unavailable to the marketplace.
It remains to be seen how these new rules will be interpreted and implemented by accountants and reporting companies. Although the accounting treatment of CDS contracts and other credit derivatives is beyond the scope of this update, clients should be aware that (i) compliance with these new rules may prove a significant undertaking to decipher and coordinate disclosure of any reporting company’s exposure to qualifying instruments, and (ii) determining the fair value of a credit derivative will depend on the creditworthiness of both the CDS counterparty and the reference entity, therefore each reporting company will have the responsibility of assessing and accounting for counterparty risks inherent in derivative transactions.
SEC Enforcement Division Expands Market Manipulation Investigation; Chairman Cox Urges Congress to Expand SEC Regulatory Authority
The SEC has been actively pursuing the CDS market on two fronts: ferreting out bad actors and seeking expanded regulatory authority. In mid-September, the SEC’s Division of Enforcement announced an aggressive expansion of its on-going market manipulation investigation, and its approval of a formal order of investigation, which allows the SEC's staff to compel witnesses by subpoena to testify and produce books, records, and other relevant documents.
On the regulatory front, SEC Chairman Christopher Cox testified before the Senate Committee on Banking, Housing and Urban Affairs urging the Senate to expand the SEC’s statutory authority to enable regulation of the CDS market. He warned that CDS contracts should be regulated because of the risks to investors, noting that these instruments “offer outsized incentives to market participants to see a reference issuer in a CDS default or experience another credit event.”
Chairman Cox’s testimony drew a parallel between the CDS buyer and the short seller of securities, stating that “[e]conomically, a CDS buyer is tantamount to a short seller of the bond underlying the CDS”, and going on to argue that without regulation, buyers of protection could effectively “naked short” debt securities without restriction. Following the recent focus on the harms of naked short selling, this argument is likely to garner attention from Congress, and the onus is on market participants and derivatives experts to provide a compelling argument to allow the market to self-regulate and supporting evidence that self-regulation will provide adequate investor protection. Indeed, the smooth 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. The dealer community through a number of industry initiatives also has worked diligently on reducing the notional amounts outstanding in credit default swaps, and thereby significantly reduced operational, legal and capital costs for industry participants.
The SEC’s efforts raise both short-term and long-term implications for clients. In the short-term, clients subject to the SEC investigation should be aware of the ramifications of failure to accurately and sufficiently respond to information requests. Should the SEC use its Section 21(a)(2) enforcement authority, following lessons learned from Worldcom, it will be critically important to respond appropriately to avoid extreme responses from the SEC, which could go as far as to obtain a motion of default providing the basis for revoking a registered company’s common stock listing.
New York State Announces Plans to Regulate Certain CDS Contracts as Insurance
Unlike the FASB and SEC responses aimed at increasing disclosure and prosecuting bad actors, New York State Governor David Paterson announced the first affirmative step towards regulating a portion of the CDS market. Beginning in January 2009, the State of New York will use its regulatory authority to police sellers of certain “covered” CDS contracts on the basis that, under qualifying conditions, these contracts constitute insurance contracts.
According to details set out in Circular Letter No. 19 (Re: “Best practices” for financial guaranty insurers), previous NYSID opinions that exempted CDS contracts from regulation as insurance contracts were based on the conclusion that the payment to the protection buyer was “not conditioned upon an actual pecuniary loss.” Circular Letter No. 19 previews an upcoming NYSID opinion that will bring certain “covered” CDS contracts into the purview of the New York State insurance regulations based on the view that the sale of a CDS contract may be deemed “the doing of an insurance business” if the protection buyer “holds, or reasonably expects to hold, a ‘material interest’ in the referenced obligation.” While there are a number of practical questions raised by the general description provided in Circular Letter No. 19, the NYSID has advised that the new opinion would provide greater clarification and that in the interim protection sellers may seek guidance from the NYSID Office of the General Counsel to assess whether their business would necessitate licensing as an insurer under New York State laws.
Circular Letter No. 19 also sets out stringent new guidelines for existing financial guaranty companies and announces that new regulations are forthcoming. The new regulations will include increased capital and surplus requirements and tighter credit risk monitoring and reporting rules. We will monitor these developments and provide updates as more information becomes available.
New York State and Federal Prosecutors Announce Joint Taskforce
Although no official statements have yet been issued by the NYS Attorney General’s Office or the U.S. Attorney's Office for the Southern District of New York, recent news articles have revealed that the Attorney General of New York and the Manhattan federal prosecutor’s offices have launched a rare joint investigation into market manipulation by trading in CDS contracts.
Federal Reserve Bank and Private Clearinghouses Seek To Establish New Private-Sector Trading Platforms and Derivatives Experts Warn Against Over-Regulation
In the private sector, trade organizations such as the International Swaps and Derivatives Association, Inc. have been warning against the rush to over-regulate, while private clearinghouses have been racing to establish exchange-trading platforms for CDS contracts as a means of self-regulating. The Federal Reserve Bank of New York (the “New York Fed”), and other federal and state regulators, have been meeting with the major players in the clearinghouse market to reach requisite approvals for the creation of new exchanges designed to settle trades through a clearinghouse structure. 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 free-market efficiency currently available to market participants.
Advocates of the clearinghouse structure argue that this solution best suits the concerns of the market by neutralizing some of the systemic risks posed by the over-the-counter CDS market. The clearinghouse structure has three primary benefits, in addition to providing a means to obtain public information about the trades:
- Allows buyer and seller to alleviate (or eliminate) counterparty risk. The clearinghouse would act as an intermediary between the protection buyer and protection seller and effectively guarantee performance by each party through prior vetting and on-going monitoring of positions. While credit counterparty risk would be assessed in trades to members, there is a lack of clarity regarding whether the clearinghouse would require the posting of segregated collateral.
- Enables close scrutiny of changes in mark-to-market value of positions. The clearinghouse will monitor the payment/performance risk by twice-daily margin calls based on the mark-to-market value of positions, which would require the posting of collateral as CDS contracts become more likely to require a payment event.
- Creates real-time policing of buyers and sellers. The clearinghouse would establish rules requiring members to maintain certain amounts of capital in their accounts before they can actively trade on the exchange.
Prominent financial industry members, including Citadel Investment Group, CME Group Inc., IntercontinentalExchange Inc. (parent company of CDS boutique Creditex), NYSE Euronext and Deutsche Boerse, have announced that they are developing centrally-cleared trading platforms for CDS contracts, with some planning to go live in the coming weeks. At least two industry groups have submitted written plans to the New York Fed on proposed central clearinghouses for credit default swaps and regulatory approval for the proposed plans may be forthcoming as early as mid-November.
DTCC Announces Weekly Posting of CDS Values and Turnover
In response to the market’s demand for more transparency, the Depository Trust & Clearing Corporation (“DTCC”) has announced a major step towards providing public disclosure of CDS spreads. Starting November 4, DTCC will post on their a website a weekly announcement of the outstanding gross and net notional values CDS contracts of the top onethousand reference entities at the end of each week. This posting will also include the weekly turnover for each name, reflecting the confirmed trading volume of each name.
Current Developments in Loan-Pricing Linked to CDS
In one of the most interesting market developments in the CDS arena, lenders have been restructuring their loan pricing formulas to take into account the borrower’s CDS spreads as well as those of the lenders’ themselves. Citing various factors such as the failure of credit ratings to accurately reflect the health of the borrower in a timely fashion and the failure of LIBOR to accurately reflect the lenders’ borrowing costs, lenders have been presenting CDS-based pricing as a means to create a more robust pricing mechanism that would reflect real-time valuations of the credit risk posed by the borrower.
There are obvious concerns with this pricing mechanism as it would make funds increasingly expensive just when the borrower needs them the most, and we would expect that if this pricing model gains traction more parameters and limitations would be introduced to better manage the upside potential – perhaps through the introduction of CDS-spread caps in the fashion of LIBOR-floors that have been introduced into loan pricing in the last twelve months.
What has become clear from the recent rush to regulate CDS contracts is that in order to restore stability and confidence in the marketplace, market participants will need to be able to fairly account for prospective counterparties’ exposure to CDS contracts and other credit derivatives. The market is demanding information on who is party to these contracts, on what terms (especially payout and collateral terms), and at what cost. As information comes to market, it will become more apparent whether the clearinghouse structure, coupled with changes to GAAP accounting and generalized oversight by the federal authorities will provide sufficient information and protection against bad actors, or whether a sweeping regulatory overhaul will be necessary to regain market confidence.
As the mainstream marketplace gains more understanding of and insight into esoteric credit derivatives, we can expect greater scrutiny and public disclosure of the terms and conditions of these instruments. It seems the first steps will be increased reporting and a soon-to-be established exchange-trading platform. We will continue to monitor developments and supplement this update with material developments in this area.