Wall Street’s system for determining payments on derivatives linked to the debt of defaulted companies is showing cracks less than a year after securities firms changed practices to avoid “Draconian” regulation.
Credit-default swaps tied to Thomson SA, the Paris-based owner of film processor Technicolor Inc., paid some holders 30 percent less than those with contracts expiring a day later. In Japan, owners of swaps on Aiful Corp. haven’t been compensated, though one of its banks said the consumer lender skipped loan repayments. Dealers can’t agree whether to reimburse investors in Mexican cement maker Cemex SAB’s debt swaps.
Disparities are arising in spite of practices adopted in April and July to standardize settlements and curb risk in a market that exacerbated the worst financial crisis since the 1930s by contributing to the downfall of American International Group Inc. Analysts at Bank of America-Merrill Lynch, Barclays Capital and UniCredit SpA say changes are needed as dealers examine how to interpret existing rules to maintain investor confidence.
“The first cracks are being shown in the protocols,” said Edmund Parker, head of derivatives at Chicago-based law firm Mayer Brown LLP in London.
The rules are being tested as the global default rate rises. The rate for companies ranked below investment-grade reached the highest since the Great Depression in October and will peak at 12.5 percent next month, Moody’s Investors Service said Nov. 5.
Flaws in the system may provide ammunition to President Barack Obama and lawmakers who want to rein in derivatives, including credit-default swaps, which rise in price as investor confidence decreases and pay off when a borrower fails to adhere to its debt agreements.
Regulators demanded more transparency after the meltdowns 14 months ago of Lehman Brothers Holdings Inc. and AIG, two of the largest traders, froze credit markets and worsened the first global recession since World War II.
The swaps had been the world’s fastest-growing market, with contracts protecting against defaults on as much as $62 trillion at the end of 2007, almost 10 times the amount of the U.S. government’s debt outstanding, according to the International Swaps & Derivatives Association, a trade group based in New York. The swaps totaled less than $632 billion in 2001 and the figure is $26 trillion now.
Banks are making changes to avoid stricter rules imposed by regulators, said Atish Kakodkar, a CreditSights analyst in New York.
“The risk of over-regulation is real,” Kakodkar said in a Nov. 15 research report. “Self-regulation in the credit derivatives market seems to be driven largely by the need to pre-empt any Draconian regulation.”
Five U.S. commercial banks, including JPMorgan Chase & Co., Goldman Sachs Group Inc. and Bank of America Corp., were on track to earn more than $35 billion this year trading unregulated derivatives contracts of all types as of August, according to data compiled by Bloomberg.
Credit-default swaps are derivatives, contracts with values derived from assets or events, including stocks, bonds, commodities, currencies, interest rates or the weather. Banks, hedge funds and insurance companies use the swaps to insure bonds and loans against default or to speculate on the creditworthiness of countries and companies.
Failure to Pay
If a borrower fails to adhere to its debt commitments, bondholders who own swaps get paid the debt’s face value in exchange for the bonds. Those that don’t own the underlying bonds get the face value in cash minus the debt’s current market value as determined by industry-run auctions where holders of the securities sell them to the highest bidders.
Dealers and investors standardized the contracts this year to make them easier to trade through clearinghouses, which act as buyers to sellers and sellers to buyers, preventing a single default tripping a domino-like financial system catastrophe.
As part of that effort, ISDA formed regional committees of 15 dealers and investors in March to make binding decisions on when contracts are triggered. The committees base decisions on publicly available information such as regulatory filings, press releases and news articles. Swaps usually are triggered by one of three events in most countries: bankruptcy, failure to pay or debt restructuring, including a reduction or postponement in principal or interest. Under the new rules, traders eliminated restructuring as a credit event in the U.S.
Traders successfully auctioned debt to settle contracts linked to 41 companies and Ecuador’s government this year, with about half of those happening since ISDA created the committees.
“The determinations committee provides one place where we can resolve a lot of these issues centrally,” said Athanassios Diplas, global head of counterparty portfolio management in New York for Frankfurt-based Deutsche Bank AG and co-chair of the ISDA panel that wrote the protocols. “Imagine if we were to face all of this in the world where we had to arbitrate potential disputes bilaterally. That would be complete chaos.”
The new protocols helped eased the market’s stigma, with the net amount of protection bought and sold rising to $2.6 trillion as of Nov. 13, the highest since at least February, Depository Trust & Clearing Corp. data show.
Credit-default swaps on the Markit iTraxx Crossover Index of 50 companies with mostly high-yield credit ratings has fallen to 558 basis points, from as much as 1,100 basis points in March, according to JPMorgan Chase & Co. prices.
Thomson provided the first test of the procedures for settling contracts triggered by a restructuring in Europe when it said in August it was deferring payments on $72.5 million of 6.05 percent private notes due this year.
The system for restructurings uses multiple auctions that set different payouts based on swap expiration dates. Dealers couldn’t settle the Thomson contracts with simpler failure-to- pay procedures that produce one recovery value because they were unable to prove the electronics company defaulted.
Asked in a July conference call with investors whether Thomson still owed the money, Chief Executive Officer Frederic Rose responded, “Since I am not a qualified lawyer, I prefer not to answer that question.” Marine Boulot, a Thomson spokeswoman in Paris, declined to comment.
To determine the size of the payouts on contracts covering $2 billion in debt, bonds and loans were split by maturity date ranges into three so-called buckets and sold at auction.
Contracts that expired on June 20, 2012 -- the first bucket’s latest date -- sold for 96.25 percent of the face amount, meaning swap holders received 3.75 percent of the amount covered. Swaps expiring a day later paid 34.875 percent because the debt in that bucket went for 65.125 percent.
Too Few Securities
Holders of June 20 swaps covering 10 million euros in debt got 375,000 euros, while those with June 21 contracts received almost 3.5 million euros. Swaps that terminated after Oct. 24, 2014, paid the most, 36.75 percent.
The disparity was a result of too few securities in the first bucket to settle swaps, according to Matthew Leeming, a London-based strategist at Barclays. “An imbalance of supply and demand for the deliverables can affect the recovery rate,” he said in a note.
Because they were part of industry indexes, swaps referencing the company “dwarfed the amount of Thomson debt,” said Teo Lasarte, an analyst at Bank of America-Merrill Lynch in London.
The more swaps there are, the more investors with stakes in the contracts need bonds to settle them. About 81 million euros- worth of debt was auctioned from the first bucket, compared with 221 million euros and 148 million euros from the second and third, according to data released by auction administrators Markit Group Ltd. and Creditex Group Inc.
Lasarte favors changing rules governing indexes so companies in them have enough debt available to produce settlement auctions that don’t cause distortions.
“To strengthen the robustness of this product, there are some issues to be solved,” said Tim Brunne, a UniCredit strategist in Munich.
Leeming of Barclays said in a report to clients that the Thomson settlement “raises questions regarding the future of restructuring as a credit event.”
Banks that bought contracts on loans to Kyoto-based Aiful aren’t being paid because ISDA’s determinations committee ruled that there isn’t sufficient evidence to trigger swaps as the company and its lenders hold confidential restructuring talks.
Aozora Bank Ltd., one of Aiful’s creditors, said in a statement to the ISDA committee that the company “suspended scheduled payments of loan principal to all of its lenders” on Sept. 30. The committee rejected the request on Oct. 19 because the protocols only allow it to consider “publicly available information.” If the “sole source” of that evidence bought or sold swaps, it isn’t deemed publicly available. Aozora has said it owns some Aiful swaps.
Katsuyuki Komiya, a spokesman for Aiful, declined to comment.
Contracts protecting a net $1.36 billion of Aiful’s debt were outstanding as of Nov. 6, more than any other Japanese company, according to New York-based DTCC. As much as $238 million more of Aiful’s debt is protected through credit swaps based on indexes in which the company is a member. Aiful is meanwhile seeking to secure a credit line from Sumitomo Trust & Banking Co., its main bank, two people familiar with the matter said.
The value of Aiful credit-default swaps that mature in December plunged on speculation they may expire without being triggered. Contracts protecting 100 million yen ($1.2 million) of Aiful debt from default through Dec. 20 dropped to 10 million yen upfront, from 55 million yen on Oct. 15, according to a trader who asked not to be identified because the prices are private.
The Japanese Association of Turnaround Professionals, which is mediating Aiful’s so-called alternative dispute resolution process, is forming a group of bankers, lawyers and government officials to study whether talks between companies and creditors on rescheduling debt payments should trigger swap payouts, said Miyako Hara, an executive secretary for the trade group.
The ISDA determination committee was asked on Oct. 9 to rule that swaps linked to Monterrey, Mexico-based Cemex should be paid out after the company agreed with lenders to extend the maturity on about $15 billion of debt for five years.
After four weeks of deliberations, the committee was deadlocked, and the issue will now be decided by an arbitration panel set up by ISDA. The panel will rule in December.
Struggling With Debt
The biggest cement maker in the Americas has struggled to repay debt since shipments started dropping in the second- quarter of 2006, before it paid $14.2 billion in July 2007 for Australian rival Rinker Group Ltd. Cemex has $19.67 billion of debt, according to data compiled by Bloomberg, and is rated B by Standard & Poor’s, five steps below investment grade.
Cemex spokesman Jorge Perez declined to comment.
The cost of credit-default swaps on Cemex surged as high as 1,500 basis points in March, or $1.5 million a year to protect $10 million of debt for five years, according to CMA DataVision, as the price of its 900 million euros of 4.75 percent bonds due 2014 dropped to 38 cents on the euro.
Credit-default swaps are “not a perfect product,” said J. Paul Forrester, a Mayer Brown partner and co-head of its derivatives and structured products practice. “These are difficult questions, and unfortunately as we continue to use this product and explore it we’re going to find that it has these sorts of issues,” he said.