As anyone who has looked at the nightly news or any newspaper knows, the financial markets are reeling from a crisis in defaults on sub-prime mortgages. Indeed, losses to lenders to date have totaled almost $400 billion, and estimates suggest some 3 million additional borrowers will default this year in the absence of some type of public or private effort to ease mortgage debt burdens. But even more bad news looms on the horizon. According to signals coming from a relatively new market that trades instruments called “credit derivatives,” the prospects for defaults on business credits (commercial loans and bonds) have increased sharply in the last few months. But just what are credit derivatives, and how do they work?
A credit derivative is a financial contract in which a buyer makes an upfront payment to a seller in return for a future payoff that depends on whether a particular borrower (or set of borrowers) defaults on a specific debt contract at some point in the future. The most common type of credit derivative is called a “credit default swap” (CDS). Sellers of these contracts, typically banks and insurance companies, are providing insurance against the risk of default in return for an upfront premium. Banks are the largest buyers of credit protection, followed by hedge funds and insurance companies.
In the event of default, the owner of a CDS receives the difference between the face value of the contract and the market value of the defaulted debt. But if the borrower in question never defaults, the payoff to the CDS insurance buyer is zero (just as you never collect on your car insurance contract unless you have an accident.) What constitutes a default is carefully described in the contract. Credit default swaps come in various sizes ($5 and $10 million are the most common amounts) and various maturities, ranging from a few months to up to 10 years.
If the buyer of a CDS also owns the debt against which the insurance is written (called the “underlying instrument”), then the CDS payment offsets some or all of the loss on the bond or loan. In such a case, the CDS buyer is “hedging” against a credit-risk loss on a debt it already owns. CDS buyers that do not own the underlying instrument are “speculating” (more colloquially “betting”) that a particular borrower is going to default. Banks are not permitted to engage in such speculation, but hedge funds can, and do, speculate.
Not surprisingly, the price of a CDS depends on the perceived probability that a borrower will default. For example, a CDS on a BBB-rated bond will be substantially more expensive than one on an AAA-rated bond. And since default prospects on all credits (save for Treasury debt) vary over time with the state of the economy, the price on any single CDS on the same borrower will change on a daily basis. For example, the price of the credit protection against default by General Electric on its bonds is about 10 times higher today than it was twelve months ago. The price of insurance against default by Citigroup is almost 20 times higher than a year ago. Since defaults go up substantially in economic recessions, the recent sharp increase in the price of credit insurance protection is consistent with the increasingly likely prospect that the U.S. economy is currently in recession.
The credit derivatives market was virtually non-existent a decade ago, but the total value of all credit derivative contracts globally is roughly $5 trillion today. These contracts trade in a secondary market and thus are at least somewhat liquid. Liquidity is a particularly valued characteristic for speculators in this market. If you purchase $10 million worth of insurance for $10,000 today and the price rises to $50,000 one year from now (which would mean the expected probability of default must have gone higher), you could sell your contract at a tidy $40,000 profit, yielding a return of 300 percent. Since the return on the underlying bond or loan is probably in the range of 5-8 percent, the temptation for a hedge fund to speculate by purchasing a CDS can be a large one.
Just as there are indices that reflect average equity values on various stock markets, there are also indices for various credit derivates, called CDX indices. The Markit (no, it’s not misspelled) CDX North America Investment-Grade Index, for example, shows the cost of insuring against default by 125 U.S. and Canadian investment-grade companies, including AT&T Inc., Wal-Mart Stores Inc. and McDonald's. Just since January 1, 2008, the average cost of insuring these high-credit quality firms over the next five years has almost doubled and now stands at a record high level of $152,000 per $10 million of insurance. Unless the credit derivatives market has substantially misjudged the outlook for defaults, the financial system is in for a period of substantial travail over the next six to 12 months as corporate borrowers join mortgage debtors in sending their lenders that dreaded message: “Sorry, I can’t pay.”
Dr. Donald Mullineaux is a professor of finance at the University of Kentucky’s Gatton College of Business and Economics.