Redesigning Credit Derivatives to Better Cover Sovereign Default Risk

Transcription

1 Redesigning Credit Derivatives to Better Cover Sovereign Default Risk Redesigning Credit Derivatives to Better Cover Sovereign Default Risk PRELIMINARY DRAFT Darrell Duffie and Mohit Thukral Stanford University 1 May 6, 2012 Abstract We propose a redesign of sovereign Credit Default Swaps (CDS). Under our proposal, a notional CDS position of 100 can be settled by the delivery of whatever package of instruments a sovereign gives in exchange for legacy bonds with a face value of 100. To illustrate, suppose a European sovereign restructures its debt by forcibly exchanging each 100 principal of legacy bonds for 50 principal of new bonds. In this case, our proposal would allow a notional CDS position of 100 to be settled by the delivery of new bonds with a principal of 50. We show that CDS protection payouts would then reflect actual losses to bondholders. We explain why the current CDS contract design fails this test, sometimes perversely, with adverse consequences for hedging performance and price discovery. 1 We are grateful for comments from Alessio Farhadi, Alex Katz, Haoxiang Zhu and Thomas Phillippon. 1

2 Redesigning Credit Derivatives to Better Cover Losses at Sovereign Debt Restructurings We propose a straightforward redesign of credit default swap (CDS) contracts that may significantly improve the reliability of CDS as a hedge against sovereign default. Given the current stresses on the Eurozone, this redesign would be timely. The current CDS contract design suffers from a flaw that can become apparent when a sovereign forces bondholders to exchange their legacy bonds for a smaller quantity of new bonds. After the exchange, there may remain few if any outstanding old bonds to be delivered into the auction determining CDS settlement payments. Consequently, the CDS protection payment could be based on the price of the new bonds. If the new bonds happen to trade at a high price, a distinct possibility given the reduction in outstanding debt that may be achieved by the exchange, then bondholders who had hedged with CDS could end up getting CDS payments covering only a small fraction of their actual losses. Our proposed redesign of the CDS contract would avoid this outcome through a settlement procedure that approximates actual bondholder losses. This would allow better sovereign default risk management. Further, CDS prices would more accurately reveal the risk of a sovereign default. Under our proposal, a notional CDS position of 100 can be settled by the delivery of whatever package of instruments a sovereign gives in exchange for legacy bonds with a face value of 100. To illustrate, suppose a European sovereign restructures its debt by forcibly exchanging each 100 principal of legacy bonds for 50 principal of new bonds. In this case, our proposal would allow a notional CDS position of 100 to be settled by the delivery of new bonds with a principal of 50. The current CDS contract fails to match protection payments to bondholder losses, sometimes perversely, with adverse consequences for hedging performance and price discovery. When triggered, the current CDS contract pays buyers of protection based on the price of the sovereign s outstanding bonds. In order to illustrate the problem this may create, suppose that a Eurozone sovereign has exchanged essentially all of its old bonds for a smaller quantity of new bonds worth 80 per 100 of principal. Such an exchange might be implemented under a collective action clause, as with the recent restructuring of Greek sovereign debt. In this event, a buyer of CDS protection would probably receive about 20 for each 100 of bond principal covered by the CDS contract. But suppose the sovereign has 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 per 100 of original bond principal. This restructuring implies an actual loss of 92 per 100 of original bond principal, far greater than the CDS protection payment of 20. This CDS design flaw is especially perverse. The more severe is the exchange ratio of new bonds per old bond, the lower is the sovereign s remaining debt burden, so the higher will be the price of the new bonds, all else equal. Thus, as the sovereign increases the aggressiveness of its restructuring, the affected bond investors lose more but the CDS pays less! 2

3 Redesigning Credit Derivatives to Better Cover Sovereign Default Risk Our proposal is simple. The redesigned CDS contract would allow settlement based on the market value of whatever the sovereign gives a bondholder in exchange for each old bond. This market value would be determined in a settlement auction. So, if the sovereign gave 10 in new bonds for each 100 in principal of old bonds, then the CDS contract would settle based on the delivery of 10 of new bonds per 100 notional of CDS. If the new bonds are valued at 80 per 100 principal, then the CDS deliverable is worth 8 per 100 notional. Thus, a CDS buyer of protection would receive = 92 per 100 notional CDS position, which is the actual loss to the bond investor. In practice, a sovereign may give a package of several financial instruments in exchange for each old bond. With our proposal, the redesigned CDS contract would allow settlement based on the market value of the entire exchange package. For example, in the recent restructuring of Greek sovereign debt, in exchange for every 100 principal of old Greek sovereign bonds, bond investors received a package of three instruments, consisting of 31.5 in principal of new Greek sovereign bonds, 31.5 in GDP-linked securities (paying an amount that will depend on the gross domestic product of Greece in future years), and 15 in PSI payment notes, which are obligations of the European Financial Stability Facility (EFSF). Under our proposal, the exchange package would be included as one item on the list of assets that are deliverable in a settlement of the CDS contract. If this package had been delivered and auctioned at, say, 20, then CDS protection buyers would have received 80 per 100 notional CDS position, matching the actual loss on 100 principal of the old bonds. The current CDS contract design, however, led to a protection payment that completely ignored the quantity of new bonds given in exchange for each old bond, and ignored the remainder of the exchange package, the PSI payment notes (EFSF bonds), and the GDP-linked securities. (See Appendix B.) The ISDA Determinations Committee that was empaneled for the Greek sovereign default was indeed asked to include the actual proceeds of the Greek exchange on the list of deliverables. The Committee declined, 2 apparently limited by the language of the current CDS contract. 3 We believe the contract should be adjusted so 2 A footnote to the list of deliverable obligations provided as part of the ISDA Determinations Committee (DC) Decision of March 13, 2012 states that It was proposed to the DC Secretary that the exchange proceeds of the Greek exchange offer should be included on the Supplemental List as proposed Deliverable Obligations. The DC Secretary has not done so because the DC has already considered this proposal and determined that the exchange proceeds should not be included as Deliverable Obligations (except to the extent that the Bonds listed in Numbers 1-20 (inclusive) constitute Deliverable Obligations in their own right). See 3 ISDA further commented on this issue on March 29, 2012, stating that,...yet among those obligations were certificates issued by the European Financial Stability Facility, not the Greek government, so the package was not considered in the auction. The fact that the package was not included in the auction was picked up in the blogosphere as evidence that CDS are somehow fundamentally flawed. We beg to differ with that broad characterization. We believe that it is important to adhere to the terms of contracts as written and agreed between parties as to do otherwise would adversely impact the market. Also, we knew there would be good deliverables for the auction.... We are also committed to considering changes going 3

4 Redesigning Credit Derivatives to Better Cover Losses at Sovereign Debt Restructurings as to include the actual exchange package as an item on the list of assets that are deliverable in settlement of the CDS contract. Failing that, the value of CDS protection will depend on the vagaries of the restructuring decision of a sovereign, and the current design of CDS could unpredictably lead to a protection payment that is far greater or far less than the actual loss to a bond investor. By luck alone, the March 2012 Greek CDS settlement payment was not so far from actual bondholder losses. Going forward, CDS hedgers have no reason to expect such good luck. It may be argued that our proposal has the disadvantage that a participant on the other side of the CDS market may receive a package containing various instruments, and may therefore need to do some extra work to dispose of this package. Those who participate in the settlement process by accepting deliverables are dealers and other sophisticated market participants. They are better situated to handle the package of instruments provided by the sovereign than most other bond investors. Thus, our proposal offers the advantage of not only providing a better hedge against actual sovereign default losses, but also a mechanism by which the bond market can more efficiently digest the exchange package of potentially complex instruments that may be created in a sovereign debt restructuring. There are currently concerns over the potential default of some larger Eurozone nations. The CDS market cannot be effective for managing this risk to bond investors and for price discovery if protection payments are not reliably correlated with actual bondholder losses. Our proposal addresses this problem in a straightforward and practical way. Appendix A: The Cheapest-to-Deliver Option Our proposal does not eliminate the potential for imperfect CDS hedging quality due to the cheapest-to-deliver option that arises when a restructuring leads to different losses for different types of bondholders. In this case, no matter what the contract design, a single CDS protection payment cannot match the losses on all types of bonds simultaneously. With some sovereign defaults, such as the Brady restructuring of Mexico s sovereign debt described later in Appendix C, a particular type of debt instrument is exchangeable for any item from a menu of alternative instruments, or packages of instruments, offered by the sovereign, at the option of the bondholder. In forward, not just for new contracts, but where there is market consensus for a change, for existing contracts as well. See In an interview for Risk.net published on April 27, 2012, Robert Pickel, Chief Executive of ISDA, acknowledges changes may need to be made to the sovereign CDS documentation, particularly with regard to the deliverable obligations following a restructuring credit event. Mr. Pickel stated: These would be important changes, and experience suggests we should be looking at this, but it would be a fairly targeted change. It is primarily the sovereign CDS area where this would be an issue, and it is primarily restructuring credit events. See 4

5 Redesigning Credit Derivatives to Better Cover Sovereign Default Risk this case, the ISDA Determinations Committee would need to exclude from the menu of CDS deliverables any package offered by the sovereign that is not accepted by at least a moderate amount of creditors. Otherwise, the cheapest-to-deliver option would lead to a distorted CDS settlement value that does not approximate actual creditor losses. Consider the following illustrative example. A credit default swap on a particular Eurozone sovereign covers three different types of bonds, A, B, and C. At some point, the sovereign restructures its debt. Each 100 in principal of Bond A is exchanged for Package A, consisting of new bonds and other instruments. Holders of Bond B were given the option of accepting either Package B1 or Package B2, both of which include bonds and other financial instruments backed by specified state-owned assets. Bond C was left untouched by the restructuring, and trades at a price of 45 per 100 notional. Most owners of Bond B accepted Package B1. Only a negligible amount of Bond B was exchanged for Package B2, which was judged to be worth significantly less than Package B1. The ISDA Determinations Committee is empaneled and reaches the conclusion that the CDS is triggered by the forced restructuring. The Committee states that, under the terms of the CDS contract, the list of alternative deliverables consists of: Package A, Package B1, and Bond C. Package B2 was excluded by the Committee because it had been rejected by essentially all bondholders. Some buyers of protection settled their CDS contracts before the settlement auction by delivering units of Package B1, for which they received 100 each. Some buyers of protection delivered Package A, receiving 100 per unit delivered. There were no deliveries of Bond C, which was judged to be much more valuable. A settlement auction for deliverable units was then held, in which sellers supply units of Package A, units of Package B1, or some principal amount of Bond C, in any combination totaling 1 unit per 100 notional CDS position. Winning sellers in the auction delivered a total of 4 billion units of Package A and 6 billion units of Package B to the highest bidders. The auction cleared at a price of 21 per unit, paid by buyers to sellers. CDS protection holders who had not provided deliverables in advance of the auction then received a cash settlement of = 79 per 100 notional CDS position. Appendix B: The Greek Restructuring of March 2012 On March 9, 2012, Greece (the Hellenic Republic) activated the Collective Action Clause (CAC) that it had retroactively inserted into its bonds. As a result, the ISDA Determinations Committee declared a triggering credit event. The CDS settlement auction was held on the 19th of March, by which time most of the old bonds held by private investors had been exchanged under the CAC for a package consisting of new bonds of the Hellenic Republic, obligations of the European Financial Stability Facility, and GDP-linked securities, as described above. This exchange reduced the outstanding amount of Greek sovereign debt by approximately 100 billion. It became apparent that there might be an insufficient remaining amount of old bonds to allow a robust CDS 5

6 Redesigning Credit Derivatives to Better Cover Losses at Sovereign Debt Restructurings settlement, and that the new Greek bonds could become the cheapest-to-deliver. Luckily for CDS protection buyers, the new Greek bonds traded at prices not so far from the prices at which the old bonds had traded just before the restructuring was announced. The CDS settlement auction matched the supply and demand for deliverable bonds at 21.5 per 100 face value. Appendix C. The Brady Restructuring of Mexican Debt In , Mexico became the first country to institute a debt reduction package under the Brady framework. 4 Negotiations between Mexico and a steering committee representing 500 worldwide creditor banks gave individual creditor banks a menu of exchange options: 1. Banks could convert each $100 principal of their loans to Mexico to $65 face value in 30-year Debt Reduction Bonds (DRBs) with a floating interest rate of LIBOR plus (13/16)%. These DRBs would be secured by U.S. Treasury bonds. 2. Alternatively, or in combination, banks could convert their loans to Mexico to 30-year Debt Service Reduction Bonds (DSRBs) with the same principal and a below-market fixed interest rate of 6.25%. These loans would also be secured by U.S. Treasury bonds. 3. As a final option, a bank could provide new loans to Mexico over a fouryear period in exchange for up to 25% of the bank s outstanding loan exposure, net of any loans exchanged under Options 1 and 2. These new loans would be at a floating rate of (13/16)% over LIBOR, but had no U.S. Treasury bond backing. Of about $50 billion in loans to Mexico covered by the restructuring, 49% were converted into DRBs under Option 1, 41% were converted into DSRBs under Option 2, and 10% of the loans were converted to new loans under Option 3. Suppose that CDS covering bank loans to Mexico had existed, and had been based on our proposed contract design. The banks took up all three options in significant amounts. Thus, against a notional CDS position of $100, the ISDA Determinations Committee might have allowed the delivery of $65 in principal of USTsecured DRBs, $100 in principal of UST-secured DSRBs, or $100 in principal of the new floating-rate loans with no US Treasury backing that were granted under Option 3, or any combination of these. In any case, the criteria for deliverability would have been specified in advance in the CDS contracts. 4 See H. Unal, A. Demirgüç-Kunt, and K. Leung, 1993, The Brady Plan, Mexican Debt-Reduction Agreement, and Bank Stock Returns in United States and Japan, Journal of Money, Credit and Banking, 25(3), pp