The Cost of Credit Swaps When a Nation Defaults

The fear is that issuers are making promises they can’t keep

Jamie Dimon was all about reassurance on July 14 as the chief executive officer of JPMorgan Chase announced second-quarter earnings. He said that the bank’s gross exposure to sovereign and other debt in Greece, Ireland, Italy, Portugal, and Spain was $100 billion. Its net exposure, Dimon said, was only $15 billion. The difference? Collateral posted by borrowers, which it can seize in a default, offsetting loans, and credit default swaps—insurance that pays off when a borrower defaults.

Credit default swaps are a source of pride for Dimon. His bank invented CDS in the 1990s and is the world’s largest dealer in them. Hedging with credit default swaps allows JPMorgan to keep lending in Europe, Dimon said: “We’re not going to cut and run.” Yet credit default swaps, like any insurance, are only as reliable as the company promising to pay. If the banks that sell protection to each other all start to suffer loan losses, they’re like drowning men offering to save each other. Keeping the benefits of swaps while reducing their potential for trouble is tricky business. Regulators are only partway to a solution—and some fixes could make matters worse.

Consider how a credit default swap works. You own $100 million in Italian government bonds, and you’re worried Italy might not pay. So you enter a contract with someone—typically a large bank or hedge fund—to buy what amounts to insurance. If Italy defaults in the next five years, the other party must make you whole. You get the difference between the bonds’ face value and whatever they’re trading for post-default. You can buy this insurance even if you don’t have any exposure to Italy, in which case you’re simply speculating on default.

The beauty of the swaps is that they transfer risk from people who don’t want it to people who are happy to bear it, for a price. They’re also an early indicator of trouble. “They make a lot of things transparent that would otherwise be hidden,” says René M. Stulz, an economist at Ohio State University’s Fisher College of Business.

At the same time, CDS can distort creditors’ incentives. An investor holding a company’s bonds normally wants to see the company work its way through trouble. A bondholder who bought protection with CDS might be indifferent to the borrower’s bankruptcy. It’s what University of Texas School of Law professor Henry T. C. Hu dubs the “empty creditor” problem. In the extreme, Hu says, an empty creditor might even have an incentive to thwart a restructuring.

Regulators also worry that sellers of protection are making promises they can’t keep. Executives of American International Group’s London-based financial products division foolishly sold loads of underpriced protection on overrated American mortgage-backed securities. The federal government—American taxpayers—had to prevent a default meltdown by stepping in with that $182 billion rescue.

In truth, cascading failure from credit default swaps is unlikely. The “net notional exposure” of protection sellers to Greek sovereign default is just $4.6 billion, according to data collected by the Depository Trust & Clearing Corp., a New York-based firm that serves as the bookkeeper of finance. Decoded, that means that even if the value of Greek bonds fell to zero (which won’t happen, because the Greeks can pay at least part of their debt) and all the exposure were on the books of a single bank (which it isn’t), the most that bank would be out would be $4.6 billion. The corresponding systemwide exposure to Italy is $24 billion.

Sometimes, though, the fear of the unknown matters more than the reality. European negotiators live in fear that the Credit Derivatives Determinations Committee of the bank-controlled International Swaps and Derivatives Assn. (ISDA) will declare the next Greek restructuring a trigger event for credit default swaps.

Regulators are seeking a framework that would disclose where risks lie; expose who the “empty creditors” are; and ensure that sellers of default protection can fulfill their promises. The first part is under way: Investors are reporting swap deals to special data repositories, so we now know who’s on the hook if Greece, for example, defaults. That’s already demystifying swaps, while greater awareness of empty-creditor issues is helping in restructurings, says Hu. The hardest part, though, is regulating clearinghouses, mandated under the 2010 Dodd-Frank Act, that guarantee the fulfillment of swaps contracts. Last month, still uncertain what to do, the five-person U.S. Commodity Futures Trading Commission voted to miss its July 16 timetable for rules to carry out Dodd-Frank. Its new deadline is Dec. 31.

Clearinghouses predate modern regulation—before there was a Federal Reserve, the New York Clearing House was American banking’s de facto regulator and lender of last resort. Dodd-Frank and similar rules in Europe call for interposing a super-strong intermediary in every transaction. As a condition for guaranteeing trades, the clearinghouse demands that every clearing member be financially strong. It updates the collateral that must be posted on a contract as conditions change. Even before the government specifies how clearinghouses should work, big banks are using them for more than 90 percent of new, eligible credit default swap contracts (though few if any contracts on sovereign debt).

As clearinghouses become a key valve in the world’s financial plumbing, they also become a new point of failure. While Federal Reserve Chairman Ben Bernanke lauded clearinghouses in an April speech, he warned of “the concentration of substantial financial and operational risk in a small number of organizations, a development with potentially important systemic implications.”

There’s pressure on regulators to crack open the insiders’ club of big banks that dominate derivatives trading. (The ISDA says the world’s biggest dealers held 90 percent of credit derivatives last year.) The Commodity Futures Trading Commission says clearinghouses should accept members with as little as $50 million in capital. But that’s a fraction of what private players have concluded is a safe threshold. ICE Clear Credit, which clears credit default swaps, requires members to have $5 billion in capital. Likewise, clearinghouses need to be big and broad to capture all of firms’ activities and set collateral correctly. But regulators are allowing clearinghouses to proliferate. Countries such as South Korea and India are setting up their own national clearinghouses.

In his April speech, Bernanke paraphrased Mark Twain’s character Pudd’nhead Wilson: “If you put all your eggs in one basket, you better watch that basket.” The clearinghouse basket needs more attention.

Before it's here, it's on the Bloomberg Terminal.