Although credit default swaps (CDS) are essentially insurance policies against the default of a bond issuer, many investors have used these securities to rule on a particular credit event. The major bankruptcies of fall 2008 caught some investors in these contracts by surprise; after all, no major CDS event had occurred since Delphi in November 2005.
The events of fall 2008 put credit default swap settlement systems to the test. This article will explore what happens to CDS holders when a company experiences a credit event, with the Lehman Brothers (LEHMQ) bankruptcy as an example.
Single name credit default swaps
To understand the credit event auction failure process, it is helpful to have a general understanding of single name credit default swaps (CDS). A single-name CDS is a derivative in which the underlying instrument is a reference obligation or an obligation of a particular issuer or reference entity.
Credit default swaps have two sides: a protection buyer and a protection seller. The protection buyer insures himself against loss of capital in the event of default by the issuer of the bond. Therefore, credit default swaps are structured so that if the reference entity experiences a credit event, the protection buyer receives payment from the protection seller. (For more information, see: Credit Default Swaps.)
CDS Time to Maturity or Tenor
Duration, that is, the time remaining to maturity of a debt security, is important in a credit default swap because it coordinates the remaining term of the contract with the maturity of the asset. underlying. A properly structured credit default swap must match the maturity between the contract and the asset. If there is a mismatch between the term and maturity of the asset, then integration is unlikely. In addition, coordination between cash flows (and the subsequent calculation of yield) is only possible when the duration and maturity of the assets are linked.
In the inter-professional market, the standard term for credit default swaps is five years. This is also referred to as the expected term because the credit event results in a payment by the protected seller, which means the swap will be terminated. When the term expires, the payments on the default swap do the same.
Credit event triggers
In the world of CDS, a credit event is a trigger that causes the protection buyer to terminate and settle the contract. Credit events are agreed upon at the conclusion of the transaction and form part of the contract. The majority of single-name CDSs are traded with the following credit events as triggers: bankruptcy of the reference entity, default in payment, acceleration of the obligation, repudiation and moratorium.
Physical settlement against cash settlement
When a credit event occurs, settlement of the CDS contract can be either physical or cash. In the past, credit events were settled by physical settlement. This means that the protection buyers have effectively given the protection seller a bond for the peer. This worked well if the CDS contract holder actually owned the underlying bond.
As CDSs gained in popularity, they were used less as a hedging tool than as a way to bet on certain credits. In fact, the amount of CDS contracts issued exceeds the number of cash bonds on which they are based. It would be an operational nightmare if all buyers of CDS protection chose to physically settle the obligations. A more efficient way to settle CDS contracts should be considered.
To this end, cash settlement has been introduced to more efficiently settle single-name CDS contracts when credit events occur. Cash settlement better reflects the intention of the majority of participants in the single-name CDS market, as the instrument has shifted from a hedging tool to a speculative, or credit scoring tool.
CDS Settlement Process Evolves
As CDS became a tool for credit trading, the default settlement process also had to evolve. The volume of CDS contracts subscribed is much greater than the number of physical bonds. In this environment, cash settlement is superior to physical settlement.
In order to make cash settlement even more transparent, the Credit Event Auction has been developed. Credit event auctions set a price for all market participants who choose cash settlement.
The International Swaps and Derivatives Association (ISDA) Global Protocol Credit Events Auction was launched in 2005. When buyers and sellers of protection submit to the protocol of a particular bankrupt entity , they formally agree to settle their credit derivative contracts through the auction process. To participate, they must submit an ISDA membership letter by email. This happens for every credit event.
Credit default auctions
Both buyers and sellers of protection participating in the credit event auction have a choice between cash settlement and what is effectively physical settlement. Physical settlement in the auction process means that you settle on your net buy or sell of the position, not on each contract. This method is superior to the previous method because it reduces the volume of bond transactions required to settle all contracts.
There are two consecutive parts to the auction process. The first step involves physical claims and the broker market process where the Internal Market Midpoint (IMM) is defined. The dealers place orders for the debt of the company that has suffered a credit event. The price range received is used to calculate the IMM (for the exact calculation used, visit: http://www.creditex.com/).
In addition to the definition of IMM, the dealer market is used to determine the size and direction of open interest (net buy or net sell). The IMM is published for viewing and used in the second stage of the auction.
Once the IMM is published, along with the size and direction of the open interest, participants can decide whether they want to submit limit orders for the auction. Limit orders submitted are then matched to open interest orders. This is the second step in the process.
The Lehman Brothers auction
The bankruptcy of Lehman Brothers in September 2008 provided a real test of the procedures and systems developed to settle credit derivatives. The auction, which took place on October 10, 2008, set a price of 8.625 cents on the dollar for Lehman Brothers’ debt. It has been estimated that between $ 6 billion and $ 8 billion changed hands during the cash settlement of the CDS auction. The recoveries for Fannie Mae and Freddie Mac (FRE) were 91.51 and 94.00 respectively. (To learn more, read: How Fannie Mae and Freddie Mac were saved.)
Collections were much higher for mortgage finance companies placed under trusteeship because the US government guaranteed the debt of these companies.
What does the price of 8.625 cents mean? This means that sellers of protection on Lehman CDS would have to pay 91.375 cents on the dollar to buyers of protection to settle and terminate contracts through the Lehman Protocol auction process.
In other words, if you had held Lehman Brothers bonds and bought protection through a CDS contract, you would have received 91.375 cents on the dollar. This would offset your losses on the cash bonds you held. You would expect to receive face value, or 100, at maturity, but you would not have received their salvage value until after the bankruptcy process was completed. Instead, since you bought protection with a CDS contract, you received 91.375. (To learn more, read: Case Study: The Collapse of Lehman Brothers.)
The “Big Bang” CDS
Further improvements and standardization of CDS contracts continue to be made. Together, the various changes implemented have been called the âBig Bangâ.
In 2009, new CDS contracts began trading with a fixed coupon of 100 or 500 basis points, with the initial payment differing depending on the perceived credit risk of the underlying bond issuer.
Another improvement is to make the auction process a standard part of the new CDS contract. Previously, the auction process was voluntary and investors had to register individually for each protocol, which increased administration costs. Investors must now opt out of the protocol if they wish to settle their contracts outside of the auction process (using a pre-approved list of deliverable bonds).
The bottom line
Any changes to CDS contracts are expected to make single name credit default swaps more popular and easier to trade. This is representative of the evolution and maturity of any financial product. (For more information, see: Credit Default Swaps: An Introduction.)