Stanford Credit-Swap Revamp Seeks to Fix Flaw in Payouts

A Stanford University professor and student are seeking to fix a flaw in credit-default swap contracts that threatens to leave buyers with only part of their losses covered from a sovereign debt restructuring.

Credit swaps payouts after a government debt exchange would be tied to the ratio of the new bonds’ face value to that of the old bonds, Stanford professor Darrell Duffie and student Mohit Thukral wrote in a May 3 report. Using the so-called exchange ratio would prevent scenarios where the new bonds are trading close to par, limiting payments to swaps buyers.

“That exchange ratio matters a lot and it’s simply ignored in the credit-default contracts” as they exist today, Duffie said in a telephone interview. “The more severe the exchange swap ratio, the better off the sovereign is and the worse off the CDS-protection buyer is.”

The report follows Greece’s debt restructuring in March, when bondholders agreed to cut 206 billion euros in Greek debt by 53.5 percent by accepting new debt. Because credit-default swaps were settled by establishing a market value for Greece’s outstanding debt after most of the securities had been exchanged, it was “by luck alone” that the new securities were trading at a low enough price to compensate protection buyers at a level close to bondholders’ losses, Duffie and Thukral wrote in the proposal.

Biggest Test

The International Swaps and Derivatives Association, which sets standard definitions that govern credit swaps, has been discussing the change proposed by Duffie and Thukral, Athanassios Diplas, co-chair of ISDA’s Industry Governance Committee, said last week during a panel discussion at the group’s annual conference in Chicago.

An “asset package” of new bonds to be delivered after a sovereign restructuring is among potential changes to swaps definitions, said Diplas, who is also the global head of systemic risk management at Deutsche Bank AG in New York.

“The proposal makes sense, and these very issues have, in fact, been under consideration by ISDA for some time,” Steve Kennedy, an ISDA spokesman, said in an e-mailed statement. “It was initially raised as a formal question during the determinations committee deliberations on the Greek credit event.”

ISDA is considering the changes after the Greek debt restructuring, the largest in history, posed the biggest test for the contracts since banks including JPMorgan Chase & Co. created the market more than a decade ago.

Credit-default swaps need to be a reliable and correlated hedge to national debt to be effective in the $2.9 trillion sovereign and municipal credit-swap market, Duffie said. Because investors don’t know how a restructuring may unfold when they buy protection, the exchange ratio must be a part of the payment calculation, he said.

Credit traders are accumulating protection on Germany’s debt at a record pace, with yields on the nation’s bonds at all-time lows and speculation rising that it will bear a greater burden toward resolving Europe’s sovereign-debt crisis.

German Swaps Surge

The net amount of credit-default swaps outstanding on German bunds surged by $671 million in the week ended April 27 to $19.8 billion, just shy of the $19.9 billion peak on Nov. 18, and poised to surpass swaps on Italy for the first time, according to the Depository Trust & Clearing Corp.

Under Duffie and Thukral’s proposal, if one old bond is exchanged for two new bonds, a ratio of 0.5 would be applied to the value of the new debt that is determined through auctions that decide how much credit protection is paid to swap holders. If the new debt is valued at 50 cents on the dollar, the settlement value would be 25 cents, meaning credit swap holders would be paid 75 cents on their contracts.

Under the existing contracts, swaps buyers would be paid 50 cents on the dollar, potentially leaving bondholders who had bought swaps as hedges with uncovered losses.

Exchange Scenarios

“Suppose that a Eurozone sovereign has exchanged essentially all of its old bonds for a smaller quantity of new bonds worth 80 cents per euro. Such an exchange might be implemented under a collective action clause, as with the recent restructuring of Greek sovereign debt,” they said. A credit swap holder would be paid about 20 cents in this case.

“But suppose the sovereign had given bondholders only one tenth of a new bond for each old bond, implying an actual recovery to bondholders of only one tenth of the price of the new bond, or 8 cents per Euro of original bond principal,” they said. “This restructuring implies an actual loss of 92 cents per euro of original bond principal, far greater than the CDS protection payment of 20 cents.”

Hedge-fund manager John Paulson, who became a billionaire in 2007 by betting against the U.S. subprime mortgage market, is among investors said to be buying credit protection on European sovereign bonds.

Paulson, of New York-based firm Paulson & Co., which manages about $24 billion, told investors on a call last month that he’s buying swaps on European debt, said a person familiar with the matter, who spoke on condition of anonymity.

Pressure on Europe is mounting as Spain and the U.K. slide into double-dip recessions, while elections in France and Greece may undermine support for austerity.

Duffie and Thukral began discussing the contract flaw and how swaps could be redesigned as part of Thukral’s undergraduate thesis, which became “collaborative research” that ended in their proposal, according to Duffie.

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