When Delphi filed for bankruptcy protection on October 8, it triggered frantic activity on Wall Street to find ways to deal with open credit derivatives contracts that tracked the performance of its corporate bonds and needed to be settled. By yesterday afternoon just 69 entities - including more than one unit with some groups - had agreed to go along with the banks' proposal for an auction that is designed to set an agreed price for Delphi's bonds.
The more that sign up for the proposals, the more efficiently these are likely to work. Institutions that agree to be bound by the outcome of the auction, scheduled for Friday, will then settle contracts with simple cash payments. That would avoid a scramble to buy and hand over the company's bonds on which the derivatives are based.
The market for credit derivatives has exploded to the point where there are far more in circulation than the value of the underlying bonds. As a result, activity in the derivatives market can move bond markets. In addition, the need to settle credit derivatives contracts with actual bonds could create extreme shortages of the bonds. Yet the market lacks any permanent cash settlement mechanism. As with Delphi, this is still agreed on a case-by-case, voluntary basis.
The signs from earlier, though simpler, occurrences of a similar kind are encouraging. Last month, for example, it took just five minutes for seven investment banks to set a price for the bonds of Northwest, the bankrupt US airline, in a rapid-fire online auction conducted by Creditex, an electronic credit derivatives trading business, and Markit, an asset valuation specialist. The result meant that thousands of contracts could be settled with cash rather than by delivering bonds.
But Delphi's default - the largest in US automotive history - followed a steep decline from an investment-grade credit rating at the end of last year and is the first to have implications across the full range of credit derivatives instruments. It thus marks the first real test of the credit derivatives industry's ability to craft a lasting method for cash settlement and address other market inefficiencies.
Thanks to Delphi's popularity as a so-called reference entity in credit derivative transactions, tens of thousands of separate deals, worth tens of billions of dollars, now need to be partially or fully settled. That comes at a time when big dealers are already trying to meet their commitments to clean up existing backlogs.
The direst predictions of a massive squeeze on Delphi bonds and a seizure of the market appear unlikely to be borne out. But the ad-hoc nature of the solutions being developed serve as a reminder that, despite its huge size, the credit derivatives market has little experience of shocks. The lessons learned from Delphi could prove particularly valuable if, as most analysts expect, corporate default rates and debt market volatility begin creeping upwards.
The bulk of growth in the sector has occurred in a benign credit environment, with low corporate default rates, low borrowing costs and high levels of liquidity thanks to strong demand for assets from hedge funds and other investors. In less friendly markets, complex derivatives and other structured financial products might not always behave in the way investors expect.
Credit derivatives, which scarcely existed 10 years ago, allow investors to buy and sell a type of insurance against the bankruptcy of one or more companies without having to trade in their less liquid bonds and loans (see above right). This flexibility to disperse credit risk is one of the benefits credit derivatives bring to the financial system and one of their attractions to investors. The total notional outstanding value of all such contracts has grown from an estimated $600bn in mid-2001 to more than $12,000bn at the end of June (the most recent figure available from the International Swaps and Derivatives Association) and is still roughly doubling every year.
Initially, banks wanted to hedge exposure to borrowers, so credit derivatives began as hedging tools. But other investors saw a chance to speculate; the use of the products is now often unrelated to any bond or loan exposure. Credit derivatives allowed investors for the first time to go short on a company's credit risk, meaning they would make money if its credit deteriorated. Hedge funds were also attracted by the instruments' inherent leverage: potential gains and losses on derivatives can far exceed their cost.
The headlong growth has alarmed some who worry that investors, and even dealer banks, may not understand complex derivative instruments fully. In the past, only big commercial bank creditors and institutions that owned bonds would have been exposed to Delphi's credit. Now, hedge funds, pension funds, insurance companies and others across the world own little pieces of Delphi credit risk.
"The original concern was that [risk] was not being more efficiently distributed, but distributed to institutions with weaker accounting," says Richard Herring, a finance professor at Wharton Business School. Although opacity remains over where the risks are, owing in part to limited information on market volumes and prices, "insurance companies have learned their lesson and regulators have become much more savvy".
Regulators including the UK's Financial Services Authority and the Federal Reserve Bank of New York have also taken aim at the mountains of incompletely documented trades. This stems from the pace of growth of the sector that has left back-offices and systems unable to keep up with new trades, let alone fix errors in previous ones.
"The growth in volume and complexity of new instruments . . . has adÂÂvanced, as it typically does, ahead of improvements in the trade processing infrastructure and risk management and control practices," Timothy Geithner, head of the New York Fed, said in a recent speech.
Credit derivatives transactions involve financial commitments that can last five or even 10 years - making a clear understanding between the parties to the trades particularly important and an accumulation of inadequately documented trades potentially dangerous. If the market moved sharply, or if any participant collapsed, such uncertainties could generate nasty legal arguments or even cause the market to seize up. Further complicating the situation, many financial players have been assigning their side of trades to third parties without telling the original parties.
The New York Fed last month extracted from 14 leading Wall Street credit derivatives dealers a set of pledges to cut trade processing backlogs, put in place better practices and invest in automating the market. The commitments broadly reflected action called for in an influential report on market practices published in July by a group under the leadership of Gerald Corrigan, a former president of the New York Fed and a managing director at Goldman Sachs.
Progress had been made since the report in reducing backlogs, tightening market practices associated with assigning trades and improving settlement procedures, Mr Corrigan says. As one example, a new set of procedures for handling trade assignments took effect this week.
In their letter to the New York Fed, the dealers had warned that "one or more major credit events affecting large volumes of contracts could significantly impact our ability to meet the described deadlines". Although widely anticipated, Delphi's bankruptcy filing - only four days after the banks made their pledges - was just such a "credit event".
One of the quirks of credit derivatives is that while they refer to a company's credit, using them does not necessarily involve ownership of any of the company's bonds or loans. But because of their origins as hedging tools, the settlement of credit derivatives trades does typically call for the delivery of actual bonds. If that had happened with Delphi, there would not have been enough bonds to go around. The notional amount of derivatives outstanding when the company filed for bankruptcy was estimated at more than $20bn, compared with just $2bn of Delphi bonds outstanding. If the dealers' proposal is widely accepted, the chances of a bond squeeze should be reduced. So should the likelihood that thousands of essentially identical credit default swap index contracts would be settled in varying ways - making them suddenly different and potentially hurting market liquidity.
Negotiations continue among market participants. While some instruments look likely to be cash-settled by much of the market, it might not be possible to reach agreement for all types. That could result in some bond shortages but, says one senior banker, the risk of a big problem is low.
Wall Street has found other ways to minimise the Delphi problem. For example, dealers have used the services of TriOptima, a financial technology company that runs what it calls a "multilateral mass unwind service". It collects trade data from dealers and identifies offsetting transactions that can be terminated, leaving dealers with a similar net exposure to trading partners but a much lower total exposure.
The process works because big dealers still buy and sell the bulk of most types of credit derivatives. In the case of single-name credit default swaps - the simplest credit derivative instruments - TriOptima estimates it has helped unwind some 70 per cent of all outstanding Delphi-related contracts in recent weeks, eliminating 5,300 trades and reducing outstanding contracts by more than $10bn.
Pairs of dealers have also been holding bilateral meetings known as "lock-ins" to cancel or finalise outstanding trades, some of which involve Delphi, as part of their broader efforts to reduce paperwork backlogs. But however successful these measures may ultimately be, dealing with Delphi's default is proving a labour-intensive and somewhat patchy business. That suggests the market has yet to find an efficient, repeatable way to deal with credit events that affect so many derivative instruments.
Aside from the task posed by Delphi, the market experienced a different test in May when Standard & Poor's cut the credit ratings of General Motors and Ford, both huge corporate borrowers, triggering turmoil in the bond and credit derivatives markets. According to the Bank for International Settlements, the credit derivatives market came close to failing - even though the market was spared an actual default.
These events "may be just the right-sized shocks," says Prof Herring, who notes that a much smaller credit derivatives market had also weathered the Enron and WorldCom crises in 2001 and 2002. "That is how markets and institutions evolve - you want something that exposes vulnerabilities but is not entirely destructive."
Events in May gave market participants a taste of more turbulent times. Investors who had sold short GM equity and bought its debt were dealt a one-two punch by Kirk Kerkorian's acquisition of a stake in the company followed, a day later, by the downgrade of the carmaker's debt. In the credit derivatives market, the downgrades of GM and Ford led to the hurried selling by some investors in tranches of synthetic collateralised debt obligations, themselves constructed from credit derivatives and at a further step removed from actual bonds.
One losing bet was a so-called "correlation" trade, which made money if the market value of the debt of a broad range of companies moved in concert. Instead, activity turned out to be narrowly focused on GM and Ford, triggering unexpected moves in the prices of the derivative instruments. The effects of Delphi's default may also have surprised some investors in synthetic CDOs. Standard & Poor's said a third of the more than 2,000 synthetic transactions it rates had exposure to Delphi.
Janet Tavakoli, an independent industry consultant, also worries about how dealers hedge their side of synthetic CDOs, which are often tailored to specific customers' needs. Banks typically hedge their portfolios of credit derivatives based on correlation models. But correlation is not the most significant risk factor, according to Ms Tavakoli - especially if default rates start rising. More important are the probability of default by individual companies and the proportion of their investment that creditors would recover in such an event, she says. "Yet people have spent all their money on correlation traders and analysts."
Delphi notwithstanding, the New York Fed's recent scrutiny may persuade dealers to improve the market infrastructure. "The backlog has gone from a joke to something to be taken seriously," says Mas Nakachi, lead analyst at Calypso, a derivatives technology company. Leading credit derivatives dealers are understood to be spending large sums to upgrade their systems.
Better market infrastructure alone, however, is unlikely to clear the credit derivatives industry of its opacity. As occurred with interest-rate and other derivatives, new products tend to be traded on a private, bespoke basis before maturing into more transparent, standardised instruments. That makes a period of uncertainty about risk allocation "inevitable", says Prof Herring.
But he adds that a narrow focus on derivatives could miss the point. A broad swath of the credit markets, including loans and bonds as well as derivatives, could face upheaval in the event of an unanticipated spike in company bankruptcies. Credit spreads - the risk premiums demanded by investors over risk-free interest rates to own corporate bonds or loans - remain near historic lows, despite recent signs of rising corporate default rates and increasing market volatility.
"Maybe a greater systemic worry is how low all these credit spreads have gone," says Prof Herring. "The market is pricing in a very placid view of the future."
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