....and before you can say "Counterparty risk"....
quote.bloomberg.com
Credit Derivatives Boom as Bonds Dip: Rates of Return (Update3)
By David Wigan and Tom Kohn
London, Nov. 2 (Bloomberg) -- Sales of credit derivatives may increase by 50
percent this year, as investors try to protect themselves from corporate bond
downgrades and the risk companies will struggle to pay their debts as
economic growth slows.
The global credit derivative market will expand to $893 billion in 2000, compared
with $586 billion last year, according to the British Bankers Association.
``For holders of (corporate) loans and bonds they could be a real life saver in
this environment,'' said Sanjeev Gupta, head of credit derivatives trading at
Credit Suisse First Boston. He says the BBA numbers are conservative and
estimates the market is actually between $1 trillion and $1.2 trillion.
Credit derivatives operate like insurance policies, paying out on a specified
event such as the failure of a company to make interest payments on a bond,
bankruptcy of a company or higher yields. They can also be traded like normal
bonds, and their value is based on the value of the underlying corporate bond.
Corporate bonds have become riskier in the past few months as a string of profit
warnings and evidence of slowing growth made investors wary of lending.
Ratings company Moody's Investors Service predicts default rates on corporate
bonds may reach about 8.4 percent by September 2001, the highest level since
the 10- percent plus rates during the 1991 recession.
Companies ranging from Ericsson AB, the world's largest maker of cellular
phone networks, to Xerox Corp., the No. 1 copier maker, have downgraded their
profit forecasts this year.
Pay to Play
The average yield gap, or spread, between higher-rated corporate bonds and
benchmark Treasuries has grown more than half a percentage point to about 2
percentage points this year, according to a Merrill Lynch & Co. bond index,
reflecting the higher yields investors are demanding to take on corporate debt.
``Customers are finally switching on,'' said Robert Burns, head of U.K. credit
derivative sales at RBC Dominion Securities. ``They need credit derivatives to
hedge risk.''
The mechanics are simple. A derivative security is sold to an investor, who
makes periodic payments for insurance against a default. The default can be any
event agreed between the investor and the issuer of the derivative, usually a
bank.
In a typical scenario, investors pay bankers an annual fee for the right, in the
event of a default, to sell them the bond at face value. The price depends on the
bank's own credit rating.
Investors can then sell the bond back at that price if the issuing company
defaults, or sometimes if credit downgrades mean the price of its bonds slump.
Holders of protection also benefit when ratings companies downgrade bonds. A
downgrade pushes up the value of the insurance, which can then be sold at a
profit.
Risk Protection
``The market took off about four years ago as a way for banks to protect against
companies defaulting on their debt repayments,'' said Patrick Wright, a credit
derivative specialist at Barclays Capital, the investment banking arm of Barclays
Plc. ``They have developed so you can now protect a variety of credit risks, as
well as use them to bet on whether a company's credit is going to perform.''
The only situation in which a derivative holder loses is where he buys a derivative
and nothing bad happens to the company.
``A widening of spreads makes credit derivatives more interesting because they
typically reflect an underlying economic environment in which investors are more
concerned about company's prospects,'' Wright said.
Junk Bonds
Spreads on U.S. junk bonds, the lowest-rated debt, have grown even more,
widening almost 3 percentage points this year to top 7 percentage points,
according to Merrill figures. Credit downgrades on the bonds have exceeded
upgrades, marking the biggest decline in junk-bond credit since 1989, according
to Moody's.
This will be the fastest growing part of the market for credit derivatives, since
``that's where people are actually looking for protection,'' said CSFB's Gupta.
Xerox has seen the value of its bonds decline in recent weeks amid disappointing
results and credit downgrades. The company's investment-grade-rated notes due
August 2004 plunged about 30 percent since September to about 68 cents on
the dollar. Spreads have widened almost 12 percentage points on the debt,
leaving yields at levels more akin to distressed debt.
Burns at RBC Dominion said he's helping customers who own the debt of
companies like Xerox as well as telecommunication companies with triple-B
ratings. He's targeting treasurers of European banks and insurers, as well as
U.K. companies.
Revenue Gains
``We're delighted with the growth in the market,'' said Paul Ellis, chief executive
of CEO of Creditrade, an Internet credit trading exchange, which made $2.3
billion of trades last month. ``We've achieved twice or three times the revenue we
anticipated at the start of the year.''
Phone companies are borrowing billions of dollars and euros to pay for European
licenses giving them the right to beam high- speed data into mobile phones.
Standard & Poor's Corp. reckons the total cost will reach about 300 billion euros
($258 billion).
France Telecom last week sold 1.4 billion euros of five-year euro-denominated
notes yielding 138 basis points more than French government debt. When it sold
similar bonds in 1998, France's largest phone company had to pay investors a
premium of just 22 basis points. France Telecom's long-term credit rating was
cut by two notches to ``A1'' from ``Aa2'' by Moody's last month. The S&P rating
is one step lower than the Moody's grade.
Banks Big Buyers
Sixty-five percent of institutions in a BBA survey said failure to pay the
fixed-interest payments on a bond was the most- used event for documentation
purposes, with bankruptcy the next most frequently used.
The biggest buyers of credit protection are banks and securities firms,
accounting for 81 percent of the market at the end of 1999. Companies account
for 6 percent, while insurance companies buy 7 percent of credit protection.
Other buyers include pension, hedge and mutual funds and government
agencies.
Banks are also the biggest sellers of credit derivatives, with 47 percent of the
market. Still, their share has fallen from 54 percent in 1997, while insurance
companies' share has risen from 10 percent in 1997 to 23 percent at the end of
1999.
``There's a trend of increasing non-bank credit protection in the markets,'' said
Simon Wills, a director at the British Bankers' Association. ``The message this
year is that the market is growing strongly. Particularly from insurers.''
Ok, let's say I bought a billion dollars worth of Xerox (or better yet, WCOM) bonds, and decided to add a derivative chaser from say, Citigroup (I only chose them 'cause their well-known, but all the other counterparties in this scheme aren't nearly well enough capitalized to be able to do what they claim they can. Picture Credittrade in the same situation, LOL). Citigroup has been degrading its asset base steadily since the Traveler's merger in '98 (in part due to pooling, see link).
billparish.com
So then WCOM defaults (or better yet, declares Chapter 11). All of a sudden, all of the baghold...ERRR, DERIVATIVE holders are gonna be made whole? By who, and with what? (Unfortunately, I suspect the answer is either "nobody" or worse, "The Federal Treasury", but we will see...
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