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Column : CDS versus credit ratings

Last fortnight, the Reserve Bank of India issued guidelines on the introduction of Credit Default Swaps for Corporate Bonds. The guidelines would become effective from October 24, 2011, as part of RBI?s effort to developing bond market infrastructure.

Last fortnight, the Reserve Bank of India (RBI) issued guidelines on the introduction of Credit Default Swaps (CDS) for Corporate Bonds. The guidelines would become effective from October 24, 2011, as part of RBI?s effort to developing bond market infrastructure.

A credit-default swap is a virtual insurance agreement between two parties. The reason CDS is considered ?virtual insurance? instead of actual insurance is to avoid the onerous regulations the government puts on official insurance products. In a CDS, one party which has, but does not want, credit risk transfers it to another party that can better manage that risk. It is important to bear in mind that risk transfer is a zero-sum game. If one entity transfers risk to another entity, that does not create any new additional risk in the system, much the same way as money transfer does not create additional wealth.

An example of a typical CDS agreement would involve one firm, let?s call it ?CDSbuyer? with R100 crore invested in the bonds of a company called ?RiskeyLtd?. The risk for the bond investor is that RiskeyLtd may default. Another company, say, ?CDSseller? offers to sell CDSbuyer insurance protection against RiskeyLtd?s default. Perhaps CDSbuyer would agree to pay 0.5% a year to insure its R100 crore investment in RiskeyLtd bonds. All that the CDSbuyer is doing is transferring his risk to CDSseller. The terms of the agreement would spell the circumstances under which CDSseller would have to pay CDSbuyer and how much, but typically, payment is triggered by formal bankruptcy or failure to pay bond interest. In such a case, CDSseller would buy the bonds from CDSbuyer at par or pay CDSbuyer the difference between the bonds? current market value and their par value. In gist, the CDSbuyer is transferring his risk to CDSseller. The origin of the credit risk is in the bonds issued by RiskeyLtd and not in the CDS.

CDS let companies relocate risk. What?s more, they work to keep the credit markets honest and expose negligence on the part of credit rating firms. For instance, CDS markets forewarned about sovereign defaults much ahead of the rating agencies. Until December 2009, credit rating of Greece was A-, three notches above the BBB- rating of India. However, CDS markets were correctly reflecting the credit risk of Greece. The Greece Sovereign CDS was trading way above 300 basis points, which then corresponded to a rating lower than BB-. Like in any information, there is an element of noise too. But a shrewd investor or regulator would normally be able to filter out the noise and extract useful information.

Likewise, there are many instances of a company being rated credit-worthy by rating agencies while the CDS trades at a high yield, indicating future credit troubles?the most infamous example being Blockbuster Inc, the movie rental giant which filed for bankruptcy in September last year.

Enron was another case in point. Typically, markets can better assess a company?s financial health than credit rating firms. Not having a CDS market, as some conservatives argue, may merely shield unsound companies from having the reality of their situation exposed to the average investor.

In a recent paper, Oliver Hart of Harvard University and Luigi Zingales of the University of Chicago argue that CDS is a valuable asset class as it can forewarn about crisis events much in advance. One of the problematic aspects in dealing with financial crisis is to prima facie know that there is a crunch situation. If diagnosis is done early enough, there is a greater likelihood of limiting the damage due to crisis. Hart and Zingales argue that CDS can assist regulators forewarn about possible credit landmines much ahead of time and hence help with the diagnosis. CDS were wrongly accused of being part of the problem in the recent financial crisis. It is only fair that they are now seen as part of the solution.

The initiative by RBI to introduce CDS would allow insurance companies, housing finance companies, provident funds, listed corporates and foreign institutional investors to hedge their exposures on listed corporate bonds with commercial banks, who have better ability to manage credit risk. There are some other supplementary benefits of CDS too. For instance, RBI has made an exception for rated but unlisted bonds of infrastructure companies. This could give a fillip to debt financing in infrastructure sectors as the bond investors now have the option to buy protection from commercial banks on long dated infrastructure bonds. Introducing CDS is a praiseworthy move by RBI because the easier option would have been to do nothing. We ought to give ?credit? to the central bank where due, for not shirking on the mandate to develop the debt market microstructure.

The author, formerly with JPMorgan Chase, is CEO, Quantum Phinance

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First published on: 10-06-2011 at 01:52 IST
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