As regulators in the U.S. and Europe tighten their gaze on the controversial credit default swaps market, most of the debate — and consensus — has centered around the need for a new central clearinghouse for the over-the-counter derivatives being blamed for everything from Lehman Brothers Holdings’ sudden implosion to Greece’s near-death experience.
But the outspoken chairman of the U.S. Commodities Futures Trading Commission is taking things one step further: Gary Gensler is hinting at a possible overhaul of U.S. bankruptcy rules.
The swap agreements enable investors to buy insurance against events such as bankruptcy and default, and can pay off big time if the company or country in question goes under. What’s come under increasing scrutiny of late are the motivations of the so-called naked CDS participants — those with no economic stake in the underlying asset. Are they building positions to benefit from a company’s demise?
Gensler seems poised to investigate the impact of CDS holders who are in a position to benefit when a company defaults because they hold CDS that exceed actual credit protection. “It’s important to look at the empty creditor issue very closely and see if it would require modifying our bankruptcy code, particularly as it relates to prepackaged bankruptcies,” says Gensler. In other words, “how someone with CDS might have different motivations.”
While he admits there is no legal evidence to show that these empty creditors manipulate companies for their own benefit — hedge funds have been bearing the brunt of such accusations — he says that shouldn’t prevent reform. “When you say, Show me the case, did it happen? There are certainly more anecdotal stories than fully litigated and researched cases. What I believe is that credit default swaps allow you to separate economic interests from beneficial rights.” One way to address this problem, he says, is to require CDS-protected creditors of bankrupt companies to disclose their positions or to let bankruptcy judges restrict or limit the participation of empty creditors in bankruptcy proceedings.
Brian Yelvington, director of fixed-income research at Knight Libertas in Greenwich, Connecticut, says this part of the CFTC reform platform could pose potential problems, including slowing down bankruptcy proceedings, which would delay the time a company could return to health and repay its creditors, or causing asset managers to back away from using CDS. “The large manager might be tempted to stave off losses with CDS but, because he thought a workout was inevitable, would likely not elect to do so because of the appearance of impropriety or the inability to serve on a workout,” says Yelvington. “Thus, the customer suffers.”
If Gensler’s bankruptcy proposal strikes some as impractical, the CFTC chairman looks like the paragon of pragmatism next to European peers who are baying for a ban on speculative trading in CDS — with some calling for an outright ban on all swaps. Gensler has backed off from such a call, saying it would be technically difficult to impose. Instead, he’s pushing for changes that he believes have a more realistic shot at being enacted. For instance, he wants to see CDS handled through central clearinghouses and put on trading platforms to improve transparency and provide real-time price information. He also wants to restrict bank capital relief for CDS and crack down on potential manipulation — such as the speculative runs that some say triggered the downfall of financial firms like Bear Stearns Cos., Lehman Brothers and American International Group.
“We have to address the legitimate issues about manipulation, and I think that’s what the Europeans are really trying to say,” Gensler explains. But what constitutes manipulation? Many insist that CDS actually serve as an important early warning system when companies are having problems, and shouldn’t be blamed for those problems. Case in point: Greece blamed hedge funds for aggravating its debt crisis by using these trading activities to bet on a government default, but others argued that CDS participants were merely reacting to preexisting problems.
Moreover, critics say new restrictions on the CDS market won’t prevent future bankruptcies. “If you look at the bailout actions taken by the government, the only one that had to do with derivatives was AIG Financial Products Corp., and that didn’t have anything to do with the type of derivatives that will now be cleared. It was primarily fallout from CDS on [asset-backed securities],” says John Williams, a partner in the New York derivatives and structured finance practice within law firm Allen & Overy’s international capital markets department. Under current plans, a central clearinghouse would only clear standardized single-name and index CDS. They won’t clear CDS on structured products like mortgage-backed securities or collateralized debt obligations.
As for sovereign crises, skeptics say the CFTC’s proposed rules wouldn’t prevent another Greece situation because swaps didn’t cause it to begin with. The bigger problem, they argue, is ignorance. “I think if there had been more transparency, people would have understood that what happened in Greece was not a speculative run,” Yelvington says. “Blaming the fallout on CDS is like blaming the thermometer for the temperature outside.”
Williams argues that swaps actually worked in the case of Greece because it was the rising credit spreads visible in the CDS market that first alerted people to Greece’s fiscal troubles. Gensler says he’s heard these arguments before but won’t sway from his belief that changes are needed. “Some on Wall Street have said, ‘Well, CDS wasn’t the center of the crisis. Why are you addressing this?’ But I think most would agree that transparency provides confidence and price discovery in the markets,” he says. “Right now the market is opaque and dark.”
A CDS exchange would arguably shine a light on the U.S. market, much the way TRACE (trade reporting and compliance engine) did when the NASD introduced the system in July 2002 to increase price transparency in the U.S. corporate debt market. “TRACE provided the ability to measure liquidity and measure it by the bid-ask spread,” Gensler says. “Spread compression comes with transparency.” Which is why, he says, Wall Street doesn’t like it: Spread compression means less profit.
