Credit default swaps: what happens in a credit event?

Although a credit default swap (CDS) is basically an insurance policy against a bond issuer’s default, many investors use these securities to assess specific credit events. The major bankruptcy in the fall of 2008 caught some investors in these contracts by surprise; after all, there has not been a major CDS incident since Delphi in November 2005.

The events of the fall of 2008 were a test of the system for resolving credit default swaps. This article will take the bankruptcy of Lehman Brothers (LEHMQ) as an example to discuss what happens to CDS holders when the company encounters a credit event.

Single-name credit default swap

To understand the credit event auction default process, it is helpful to have a general understanding of single-name credit default swaps (CDS). A single-name CDS is a derivative instrument whose underlying instrument is the reference obligation or bond of a specific issuer or reference entity.

There are two aspects to a credit default swap transaction: a protected buyer and a protected seller. If the bond issuer defaults, the protected buyer will not lose the principal. Therefore, the structure of the credit default swap is that if a credit event occurs in the reference entity, the protected buyer will receive payment from the protected seller. (For more information, see: Credit default swaps.)

CDS expiration time or period

Maturity—the remaining time for a debt security to mature—is important in credit default swaps because it coordinates the remaining period of the contract with the maturity time of the underlying asset. A reasonably structured credit default swap must match the period between the contract and the asset. If the maturity and the maturity date of the asset do not match, integration is unlikely. In addition, coordination between cash flows (and subsequent yield calculations) is only possible when maturity and asset maturity are correlated.

In the inter-dealer market, the standard term for credit default swaps is five years. This is also referred to as a predetermined deadline, because the credit event causes the protected seller to pay, which means that the swap will end. When the term expires, the default swap payment will also expire.

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Credit event trigger

In the CDS world, credit events are the triggers that lead to the termination and settlement of the contract for the protection of the buyer. The credit event is negotiated at the beginning of the transaction and is part of the contract. Most single-name CDS transactions are triggered by the following credit events: bankruptcy of the reference entity, failure to pay, acceleration of obligations, rejections, and suspensions.

Physical and cash settlement

When a credit event occurs, the settlement of the CDS contract can be in kind or in cash. In the past, credit events were settled through physical settlement. This means that the buyer of protection actually paid a deposit to the seller of protection at face value. If the CDS contract holder actually holds the underlying bond, this will work well.

As CDS become more and more popular, they are used less and less as hedging tools and more as a way to bet certain credits. In fact, the number of CDS contracts exceeds the cash bonds on which they are based. If all CDS protection buyers choose to settle bonds in kind, it will be an operational nightmare. Need to consider a more effective way to resolve the CDS contract.

To this end, cash settlement is introduced to more effectively settle single-name CDS contracts when credit events occur. Cash settlement better reflects the intentions of most participants in the single-name CDS market, as the tool has changed from a hedging tool to a speculative or credit opinion tool.

Evolution of the CDS settlement process

As CDS evolves into a credit trading tool, the default settlement process also needs to evolve. The write volume of CDS contracts is much larger than the volume of physical bonds. In this environment, cash settlement is better than physical settlement.

In order to make cash settlement more transparent, credit event auctions have been developed. Credit event auctions set prices for all market participants who choose cash settlement.

The auction of credit events under the International Swap and Derivatives Association (ISDA) global agreement was launched in 2005. When protecting buyers and sellers submitting an agreement to comply with a specific bankrupt entity, they formally agree to settle their credit derivatives contract auction process in the following way. To participate, they must submit a compliance letter to ISDA via email. This happens in every credit event.

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Credit default auction

Protected buyers and sellers participating in the auction of credit events can choose between cash settlement and actual settlement. Physical settlement in the auction process means that you settle your net buying or selling position, not every contract. This is better than the previous method because it reduces the volume of bond transactions required to settle all contracts.

The auction process has two consecutive parts. The first stage involves the physical settlement request and the dealer market process for setting the internal market midpoint (IMM). The dealer places an order for the debt of the company where the credit incident occurred. The price range received is used to calculate the IMM (for the exact calculation method used, please visit: http://www.creditex.com/).

In addition to setting the IMM, the dealer market is also used to determine the size and direction of open positions (net buying or net selling). Publish the IMM for review and use in the second stage of the auction.

After the IMM is released, together with the size and direction of the open interest, participants can decide whether to submit a limit order for bidding. The submitted limit order is then matched with the open position order. This is the second stage of the process.

Lehman Brothers Auction

The collapse of Lehman Brothers in September 2008 provided a real test for the procedures and systems for clearing credit derivatives. The auction was held on October 10, 2008, and the price of the Lehman Brothers bond was 8.625 cents per U.S. dollar. It is estimated that between US$6 billion and US$8 billion changed hands during the cash settlement of the CDS auction. The recovery rates of Fannie Mae and Freddie Mac (FRE) were 91.51 and 94.00, respectively. (For more information, please read: How Fannie and Freddie were saved.)

Because the US government supports the debt of these companies, the recovery rate of mortgage financing companies that are placed under supervision is much higher.

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8. What does the price of 625 cents mean? This means that the protection seller of Lehman CDS must pay 91.375 cents to the protection buyer in order to settle and terminate the contract through the Lehman agreement auction procedure.

In other words, if you hold Lehman Brothers bonds and purchase protection through the CDS contract, you will receive 91.375 cents in USD. This will offset the loss of your cash bond holdings. You would have expected them to receive face value or 100 when they expire, but you will only receive their recovered value after the bankruptcy proceedings are over. Instead, because you purchased protection using the CDS contract, you received 91.375. (For more information, please read: Case Study: The collapse of Lehman Brothers.)

CDS “Big Bang”

Further improvement and standardization of the CDS contract will continue. The various changes being implemented are collectively referred to as the “Big Bang”.

In 2009, the new CDS contract began to be traded at a fixed coupon rate of 100 or 500 basis points, and the advance payment varies according to 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 sign each agreement separately, which increased management costs. If investors want to settle their contract outside of the auction process (using a pre-approved list of deliverable obligations), they must now opt out of the agreement.

Bottom line

All changes to the CDS contract should make single-name credit default swaps more popular and easier to trade. This represents the evolution and maturity of any financial product. (For more information, see: Credit Default Swaps: Introduction.)

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