The bankruptcy of Lehman Brothers and the federal government’s rescue of Bear Stearns and AIG brought the credit default swap market into sharp public focus. The CDS market is huge (the notional value of the CDS market has been estimated at $36 trillion as of the end of 200954) and is largely unregulated, and because there are no disclosure requirements, the identity of the institutions bearing the market risk of these transactions, and the magnitude of the market risk, are difficult to determine. As a result of the controversy surrounding CDS, there are a number of pending proposals for new regulation at the federal and state levels in the U.S. In addition, the Greek debt crisis in the first quarter of 2010 and the role of CDS contracts on sovereign debt has resulted in international attention from politicians and new demands for legislation in Europe curbing speculative investment.

How Credit Default Swaps Work

A credit default swap protects the buyer against the loss of principal on a bond (or loan) in case of default by the borrower/issuer. The protection buyer pays a premium, either an upfront payment or a periodic payment, over the life of the contract. If, during the term of the contract, a “credit event” occurs (events such as dissolution, bankruptcy, failure to pay, obligation acceleration; and in some CDS transactions, debt restructuring), then the contract is settled and terminated. The settlement can be physical (i.e. delivery of debt obligations) or cash. In a cash settlement, the protection seller pays the protection buyer an amount equal to par value of such obligation minus the market value of the reference obligation. In either case, the settlement amount is intended to compensate the protection buyer for the loss that it would have incurred if it had owned the notional amount of the reference entity’s debt.55

There is no requirement that either the buyer or the seller of protection have an interest in the underlying reference obligation. When the buyer of the CDS protection does not own the underlying obligation, the swap is referred to as a “naked swap”, and when the buyer does own the underlying obligation, the swap is referred to as a “covered swap”.

The amplification of losses resulting from “naked” CDS contracts was illustrated by the numbers in the Lehman Brothers bankruptcy case. Lehman defaulted on debt in the approximate amount of $600 billion; in addition, according to market estimates, there were CDS contracts of about $400 billion to $500 billion in which Lehman was the reference entity. Market estimates suggest that only about $150 billion of the CDS contracts actually hedged underlying debt. The remaining $250 billion to $300 billion of CDS contracts were not hedging underlying debt. The losses on these CDS contracts were in addition to the $600 billion of actual debt. Thus, the CDS contracts amplified the losses by up to 50%.56

The Role of CDS in the Financial Crisis

The government bail-out of Bear Stearns and in particular, the government rescue of American International Group (AIG), brought a focus on the role of CDS in the financial markets. In the case of Bear Stearns, its OTC derivatives counterparties reduced their exposure to Bear Stearns as news of its weakness spread. They moved their derivatives positions to other dealers, and withdrew the cash collateral they had posted with Bear Stearns, reducing Bear Stearns’ liquidity and accelerating its failure.57 In the case of AIG, it had sold approximately $447 billion in credit insurance, primarily insuring collateralized debt obligations (CDOs) backed by subprime mortgages. AIG’s exposure under these contracts prompted the U.S. government to bail out AIG in four rounds of assistance during the period from the fall of 2008 through the first quarter of 2009. U.S. regulators were concerned that if defaults were triggered on the CDS contracts, and AIG failed to meet its obligations to post collateral, the results would be far reaching and devastating.

The CDS contracts required AIG to provide its counterparties collateral as the market value of the underlying CDOs, AIG’s credit rating, or the credit rating on the underlying assets declined. As part of the government’s assistance package, a new entity name Maiden Lane III LLC was formed to purchase from the CDS counterparties the CDOs referenced in the CDS. The par value of those CDOs was $62 billion, and they were purchased at their current market value, approximately $20 billion. The purchase of the CDOs was funded in part by a loan of approximately $24 billion from the Federal Reserve Bank of New York and a $5 billion equity contribution by AIG. In addition, the counterparties retained collateral in the amount of approximately $35 billion that had already been posted by AIG. In return, the counterparties agreed to terminate the CDS, relieving AIG of further obligations thereunder, including obligation to post collateral.58

At the time of the rescue, the identity of the CDS counterparties was kept confidential, which led to considerable controversy. AIG eventually revealed that the leading recipients of the Federal money were international bank groups led by Societe Generale and Goldman Sachs. Critics of the Fed have charged that it should have demanded that the banks take a discount on the value of the reference securities. Congress held hearings in February 2010, and on this point the House Committee on Oversight and Government Reform questioned Fed Chairman Bernanke as follows:

Question: “In deciding on how FRBNY would pay AIG's CDS counterparties in return for tearing up their CDS contracts, did Federal Reserve officials take into consideration the financial health of the counterparties themselves?”

Chairman Ben Bernanke’s response: “Because of its concerns about the stability of the financial markets during this period, the Federal Reserve was monitoring the financial condition of major banking and investment banking participants in the markets, which included many firms that were not counterparties to AIG’s CDS and some that were. However, the overriding motivating factor in structuring the payments to the counterparties was to relieve AIG of the destabilizing drains on its liquidity caused by the requirement to continue to post collateral as required by the CDS contracts. All counterparties were treated the same for payment purposes. Whether the individual counterparties were in relatively sound financial condition or not was not a factor in the decision regarding the amount paid to the counterparties or whether concessions should be sought form them.”

The bail-out of AIG and questions over the New York Fed’s disclosure of documents to the SEC “have become focal points for an angry political response that unites liberals and conservatives in Congress”, and the New York Federal Reserve is being investigated by Neil Barofsky, the special inspector general overseeing the troubled assets relief program, over its disclosure of documents relating to the AIG bailout.59

Proposals for Federal Regulation

After the Lehman, Bear Stearns and AIG crises, U.S. Federal regulators and the Obama Administration have pushed strongly for new legislation to regulate CDS and other over-the-counter derivatives.

As of press time for this article (March 2010), reform proposals are pending before Congress that would regulate CDS, but to date none have been enacted. The three principal derivative reform proposals being considered are the plan proposed by the Treasury Department, the Frank-Peterson proposals and the Waxman-Markey Act. These proposals are intended to reduce the risks to the financial system, and reduce the potential for fraud, insider trading, and other abuses in the market. This would be done by enacting new requirements for centralized clearing, improved price transparency, improved position transparency, migration of over-the-counter trading to exchanges, speculative solicitation limits, and improved corporate governance in the areas of risk management. Standardized OTC derivatives would be centrally cleared through an exchange regulated either by the Commodity Futures Trading Commission (CFTC) or the SEC regulated exchange or though some type of alternative facility regulated by the CFTC or the SEC. In addition, non-standardized OTC derivatives would be subject to higher capital and margin requirements to promote increased use of standardized derivatives and encourage use of the central clearing exchanges.60

The bill passed by the House of Representatives would require that standardized CDS contracts be cleared through a government regulated clearinghouse. Additionally all standardized and cleared swaps would have to be executed on a board of trade, securities exchange or a “swap execution facility.” Standardized CDS not cleared through such facilities would nevertheless be required to report to a repository or regulator so that federal regulators would be able to ascertain the identity of those holding CDS and in what amounts. Potential legislation would exempt many CDS from these requirements.61

The Chairman of the Senate Banking Committee released a proposed draft of legislation that included similar provisions but the Senate has not yet acted. While the timing and the final form of regulatory reform is still unclear, many expect the final form to include provisions regulating credit derivatives such as those included in the House bill.62

One of the controversial provisions in the Waxman-Markey bill that has received considerable attention is the proposal to curb speculative trading. The bill would ban “naked CDS”, i.e. purchase of a CDS would be prohibited unless the purchaser has an associated commercial business exposure to the borrower named in the CDS. Critics have said that this measure is seriously flawed because if enacted, an investor that does have a commercial hedging need for CDS protection would often face difficulty finding a suitable counterparty because apparently the counterparty would also be legally required to have a commercial need to hedge against the default of the same borrower. One critic noted that this rule would be analogous to prohibiting insurance companies from selling hurricane protection insurance. Insurers have no natural hedging motive in selling this insurance.63

Proposals for State Regulation of CDS as Insurance

There has also been a movement at the state level to regulate CDS as insurance. In December 2009. the National Conference of Insurance Legislators (NCOIL) announced that it had “acted boldly to fill a regulatory void created by a decade of federal deregulation” and had unanimously adopted Credit Default Insurance Model Legislation, which prohibits “naked” CDS and establish a state regulatory framework for “covered swaps”, now to be overseen in the states as credit default insurance (CDI). In December the NCOIL President wrote to Congressman Barney Frank, Chair of the U.S. House Committee on Financial Services and Congressman Collin Peterson, Chair of the U.S. House Committee on Agriculture, to reaffirm its position on the regulation of credit default swaps. The NCOIL said:

“The National Conference of Insurance Legislators (NCOIL) continues to believe that credit default swaps are insurance products and should be treated as such. We also assert – as evidence in our recently adopted NCOIL Credit default insurance Model Legislation – that “naked swaps” significantly contributed to the ongoing financial crisis and should be banned … Our legislation – which was adopted unanimously by state legislators from across the country on November 22 – would establish a state regulatory regime to oversee the CDI market. The legislation is modeled after New York State financial guaranty insurance law and contains requirements regarding company licensing; contingency, loss, and unearned premium reserves; policy forms and rates; and reinsurance, among other things. Its provisions define authorized CDI and prohibit an penalize parties that engage in unauthorized CDI.

NCOIL spent over a year developing the CDI bill … When we began our process, like you, we were told that the markets were self-regulating and that national regulation was not appropriate. We, as you, saw that this was not the case and began the model law drafting process.”64

The NCOIL’s model legislation has been criticized by the Securities Industry and Financial Markets Association (SIFMA) and the International Swaps and Derivative Association (ISDA). These groups warn that the proposed legislation would adversely affect market participants who use CDS for legitimate risk management purposes, and as a result might cause financial institutions to either incur greater credit risk in their operations or move business offshore, and would threaten to bring to a halt the CDS market or encourage regulatory arbitrage. SIFMA and ISDA complain that the promulgation of a state model law “threatens to undermine” the approach to the regulation of over-the-counter derivatives articulated in the Treasury Department’s proposal. They maintain that it would be a mistake to replace a market where CDS are actively traded with a “non-transparent, illiquid market limited to insurance companies as sellers of protection.”

Finally, SIFMA and ISDA disagree with the NCOIL’s fundamental premise that CDS constitute insurance. They point out that whereas insurance requires an insurable interest, CDS are often purchased by buyer that is not hedging a specific underlying risk; insurance is purchased and held, whereas CDS are frequently traded; insurance pays only when the party incurs a loss, whereas CDS provide for payments to protection buyers upon the occurrence of a credit event.65

Voluntary Industry Initiatives

In response to urgings by federal regulators and in preparation for likely regulation, the industry has voluntarily taken steps to reduce risk and increase transparency in the CDS market. Federal regulators have urged the industry to establish a central counterparty (“CCP”) for CDS, and have taken the position that a CCP could be an important step in reducing the counterparty risks inherent in the CDS market, thereby helping to mitigate potential systemic impacts. By clearing and settling CDS contracts submitted by participants in the clearinghouse, the clearinghouse would serve as a CCP, substituting itself as the purchaser to the CDS seller and the seller to the CDS buyer. The counterparties to CDS would no longer be exposed to each others’ credit risk. The SEC has highlighted that a CCP could serve the important functions of reducing risk as well as preventing and detecting manipulation and other fraud and abuse in the CDS market by serving as a source of records regarding CDS transactions, including the identity of each party that engaged in one or more CDS transactions.66

In March 2009, ICE Trust U.S. LLC (“ICE Trust”), a central counterparty clearing service for CDS, was form by IntercontinentalExchange, Inc. (“ICE”), an operator of global futures exchanges, clearing houses and over-the-counter markets. ICE Trust is a New York limited liability trust company and a member of the Federal Reserve and is supervised by the Federal Reserve and the New York State Banking Department. Ten major banks signed on as initial clearing members of the new clearinghouse: Bank of America, Barclays Capital, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, J.P. Morgan, Merrill Lynch, Morgan Stanley and UBS AG. ICE Clear Europe began processing European CDS in July 2009. Both ICE Trust and ICE Clear Europe process CDS indices and single-name CDS.67

A second entity, CME Group, which describes itself as the world’s largest and most diverse derivative marketplace, began clearing CDS trades in December 2009. The dealer founding members of CME were Barclays Capital, Citi, Credit Suisse, Deutsche Bank, Goldman Sachs, J.P. Morgan, Morgan Stanley and UBS. The buy-side founding members were Alliance Bernstein, BlackRock, BlueMountain Capital Management, Citadel, the D. E. Shaw Group and PIMCO. In addition, Bank of America Merrill Lynch and Nomura Group are CDS clearing member firms.68

Market participants have assured Congress that a significant portion of CDS have become standardized and that they expect the significant majority of dealer-to-dealer CDS to be cleared through a centralized clearing facility.69 In a letter dated March 1, 2010 submitted to U.S. and foreign regulators, a group of twenty-six major institutions affirmed their commitment to market improvements such as standardization of instruments, central clearing and reporting of information in order to assure greater transparency.70

The “Empty Creditor”

The “empty creditor” hypothesis was used in reference to CDS in a 2008 report by two University of Texas professors, including Professor Henry Hu, who in September 2009 became Director of the SEC’s newly-created Division of Risk, Strategy and Financial Innovation.71 The study, titled “Debt, Equity and Hybrid Decoupling” addresses the risks posed by CDS in corporate debt restructurings and the resulting potential risks to the financial system. The study was described in an SEC press release as “pioneering articles on the "decoupling" of debt and equity, its impact on corporate and debt governance and world systemic risk, and possible disclosure and substantive responses.”72

Professor Hu’s study notes that traditionally creditors desired to maximize their value by keeping solvent firms out of bankruptcy, thus keeping the package of economic rights conveyed by debt ownership bundled together. However, CDS have changed the potential dynamics of a restructuring effort or a bankruptcy as creditors who have purchased CDS may have weaker incentives to work with debtors. Some have argued that if a creditor holds enough CDS he may have an incentive to cause the company to fail because the return under the CDS would be greater than in a restructuring.

The International Swaps and Derivatives Association published a Research Note analyzing the “empty creditor” theory. The ISDA Note concluded that “the empty creditor hypothesis appears to be based on an analogy of dubious validity with the idea of empty equity ownership. Although appealing on the surface, the empty creditor hypothesis is not consistent with either the way credit default swaps work nor with observed behavior in debt markets Further, the lack of compelling evidence calls into question the validity of the hypothesis.”73

The ISDA Research Note points to the expense of buying bankruptcy protection in the credit derivatives market, and concludes that the data does not support the premise that a CDS holder can profit easily when a company enters into bankruptcy. The ISDA Report also analyzes data pertaining to restructurings that occurred during 2008 and the first half of 2009 and said it found no correlation between the presence of CDS and the likelihood that the restructuring would fail and bankruptcy would follow. It also points out that the ratio of bankruptcies to out of court restructurings has not picked up since the CDS market boom began.74

How Do CDS Affect Lenders’ and Bondholders’ Behavior?

Over the past several months the debate has intensified as to whether CDS adversely affect the ability of borrowers to restructure their debts and avoid bankruptcy. The question is whether a creditor who owns credit default protection has an incentive to hasten a company’s decline so that the creditor can collect on the credit default swap contract it holds. If the company needs an extension of maturity or loosening of covenants to avoid default and/or bankruptcy, if a bondholder or member of a lending syndicate owns CDS and will be paid under its CDS in the event that the issuer/borrower defaults or files for bankruptcy, will that lender or bondholder have an incentive to work with the borrower to avoid default under the bond indenture or credit agreement?

The issue is further complicated by the fact that neither the borrower nor the other lenders or bondholders will know which members of the lender syndicate, or which bondholders, have purchased CDS. As a result, a borrower can often only guess which creditors have purchased CDS by the actions of the creditors. As one CEO noted, “[i]t’s really difficult to tell who has CDS and how much they have. You can never be certain.”75

There have been a growing number of reports that creditors with CDS have influenced the outcome of a restructuring or bankruptcy to the detriment of the debtor. Investor George Soros linked CDS and the bankruptcies of General Motors and Canadian paper manufacturer AbitibiBowater and said, “Consider the recent bankruptcy of AbitibiBowater and that of General Motors. In both cases, some bondholders owned CDS and stood to gain more by bankruptcy than by reorganization. It is like buying life insurance on someone else's life and owning a license to kill him. CDS are instruments of destruction that ought to be outlawed.”76

Media reports have identified creditors as holding up the restructurings of a number of companies, including General Motors, YRC Worldwide Inc. (best known for its Yellow and Roadway trucking brands), Six Flags, Inc. and Gannett Company (the publisher of USA Today). Some companies managed to reach an agreement on a restructuring plan with the creditors who owned CDS while others were forced into bankruptcy.

In the case of General Motors, the financial press reported that “hedge funds and other investors stand to make billions of dollars on credit insurance contracts if GM declares bankruptcy, a prospect that is complicating efforts to persuade creditors to agree to a restructuring plan for the automaker.”77 GM had proposed that bondholders exchange debt with a face value of $27 billion for a ten percent equity stake in GM. According to DTC, at that time investors held an estimated $34 billion of CDS on GM. Once off-setting positions were considered, it was estimated that the holders of CDS on GM would make a net $2.4 billion profit in the event that GM defaulted. Ultimately, pursuant to a bankruptcy plan supported by the Obama Administration, a better offer was made to the bondholders (giving them warrants for 15% of the equity of the restructured company, in addition to 10% of the stock). The Treasury Department negotiated with the institutional bondholders directly and a majority of bondholders accepted the revised offer.78

In contrast to GM, Chrysler’s debt package consisted of $6.0 billion in bank loans, on which there were reportedly few CDS. “Chrysler looks like a simple two-car funeral compared to the traffic jam of assets and liabilities and contracts at GM,” one credit research boutique was quoted as saying.79

Another widely reported example of a troubled company negotiating with creditors who hold CDS was YRC Worldwide Inc. In December 2009, YRC launched a plan to exchange 90% of its equity for bonds in the amount of $536.8 million. YRC was unable to locate the owners of nearly 10% of the bonds, and reportedly it began to suspect that certain bondholders were holding out their consent because they held more valuable CDS positions. These same creditors without CDS were likely to receive nothing in bankruptcy. One of the advisors to YRC alleged that “certain fund managers ‘were trying to destroy YRC on purpose.’” Ultimately, YRC obtained bondholder consent, but only after an organized effort by the Teamsters union to lobby holdout bondholders. 80

The failure of Six Flags, Inc. to obtain bondholder consent to a debt-for-equity exchange was attributed by the press to “bondholders who stonewalled the settlement offer” because they “had a secret weapon – credit default swaps.” In an effort to avoid bankruptcy, Six Flags had offered bond holders an 85 percent equity stake in the company. However, bondholders rejected the offer and the company filed bankruptcy, thereby presumably triggering a credit event on the swaps and a payment to the holders of CDS.81

CDS have also been cited by some as the reason that Gannet Co’s proposed debt exchange was not approved by bondholders. Facing over $3.5 billion in debt maturing during 2011-2012, Gannett offered to exchange 5.75% and 6.375% notes for two tranches of new 10% notes with later maturities, with guarantees from the same companies that guarantee its bank debt, and early-participation payment. However, only about a quarter of the eligible bondholders tendered before the deadline. One observer noted that this low participation rate likely means “bondholders are saying that they’re hedged and that they basically want the company to die.”82

In a recent speech, CFTC Chairman Gary Gensler, called for Congress to consider legislation requiring CDS-protected creditor of bankrupt companies to disclose their positions, and to specifically authorize bankruptcy judges to restrict or limit the participation of “empty creditors” in bankruptcy proceedings.83

Sovereign CDS are the “New Political Villain in Europe”

Sales of Greek sovereign CDS spiked this year, and politicians blamed hedge funds for driving up the cost of funds and “exacerbating the financial crisis in Greece by panicking investors … The drama has triggered complaints that some ruthless investors are manipulating these markets to deliberately sow panic so that they can benefit through clever trades.” In 2007 the cost to insure $10 million of Greek debt was $5,000 annually over 5 years. In 2010 this cost went as high as $425,000. German Chancellor Angela Merkel and French Prime Minister Francois Fillon are demanding an immediate investigation by the European Commission of the role and effect of speculative trading in CDS in the sovereign bonds of European Union member states, a ban on naked swaps, a ban on any derivative transactions that are not cleared through exchanges, electronic platforms or centralized clearing houses, and mandatory access by regulators to a register of derivatives that identifies all trading. As a result of this turmoil, sovereign CDS have been described as the “new political villain in Europe”.84

Hedge funds reportedly bought in 2009 large amounts of “naked” CDS tied to Greek sovereign debt. When confronted with allegations of speculation, representatives of the funds explain that they were not seeking to profit from a default by the Greek government, but instead they were anticipating that the banks holding the approximately $300 billion of Greek government bonds would be seeking to purchase credit default protection, and the hedge funds want to be in a position either to write the CDS at a significant premium or buy the bonds at a significant discount. In fact, an analyst at Citigroup has pointed out that rather than speculators driving the price up, they have in fact done the opposite – kept the price down. The problem, however, is that “politicians have little time for the details of the complicated CDS market.”85

The Greek government’s distrust of hedge fund investors was so intense that in March 2010 it directed its bankers not to allocate any of its new 10-year bond issuance to hedge funds. Government bond managers expressed their preference for traditional “buy and hold” investors such as asset managers, pension funds and life insurance companies, and said that hedge fund investors can cause sharp swings in prices and they buy and sell to make fast profits.86

The Greek sovereign debt crisis has also resulted in scrutiny of various complex financial transactions that have been used “sometimes in secret – to hide the true size of debts and deficits.”87 In headline articles with titles such as “Debt Deals Haunt Europe”, financial industry writers report that European governments using the euro currency commonly use “aggressive bookkeeping” and “exotic maneuvers” so that they can satisfy rules capping debt levels at 60% of gross domestic product and annual budge deficits to no more than 3%. Transactions used to meet these tests have included selling state assets to raise cash, bundling expected future payments into securities and selling them, excluding large portions of military spending from deficit calculations on the grounds that they are confidential, use of unconventional currency derivative structures and controversial accounting of such derivatives. European Union rules did not require that governments include swaps in their debt or deficit calculations until 2008.88

Recently the details of a controversial “off-market” currency swap designed by Goldman Sachs for the Greek government have become public. EU regulators reportedly were not aware of the transaction, which has been described as a complex and long-dated arrangement that allowed Greece to reduce its outstanding debt by converting the debt into euros and then restructuring the debt at more favorable rates. A company called Titlos PLC was created in February 2009 and issued approximately $6.96 billion in notes (rated A1 by Moody’s). In December 2008 the National Bank of Greece had entered into an interest rate swap transaction with the Greek government (the “Hellenic Swap”). When the notes were issued, NBG novated the Hellenic Swap to Titlos, and the purchase price paid by Titlos under the Novation Agreement was equal to the proceeds of the issuance of the notes. At the same time, Titlos entered into a Hedge Agreement with NBG comprising two swap transactions to exchange its cashflows from the Hellenic Swap for cashflows matching the interest and principal payments under the Notes plus a margin to pay Titlos’ ongoing expenses. Titlos, NBG and the government also entered into a Re-novation Agreement pursuant to which NBG has the right, but not the obligation, to have the Hellenic Swap novated back to it.89