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Second Quarter 2010
Coming Legislation Seeks Middle Ground on Credit Swaps, Derivatives RegsCredit-default swaps have been in the news again recently, with recent reports casting them in a somewhat different light than just a few short years agoReports in the wake of the 2008 credit crisis may have led the public to suspect that swaps were some exotic financial instrument used by hedge funds to swoop in and turn a profit, but in reality, swaps are a means by which traditional asset managers, banks and corporate treasurers protect themselves in a fluctuating market. In late March, when the yield on Greece's 10-year benchmark bond rose to its highest level in more than a decade, Greek stocks fell, and the cost to insure Greek government bonds against default rose again. The activity only heighted concerns about its national debt — which stands at more than 110 percent of the country’s annual output — and reminded many of late 2008. Then, just as the credit crisis began to take hold, the Securities and Exchange Commission issued an order barring short-selling, fearing that some investors would exploit the weakness of U.S. financial firms for profit. But credit-default swaps and trading of derivatives is nothing new. Large multinationals have traditionally used derivatives to hedge currency exposure, or limit the risks of oil or gas price fluctuations. And over-the-counter derivatives play a major role in the risk management practices of American companies. According to a 2009 study by the Association for Financial Professionals, nearly 70 percent of companies surveyed use interest-rate swaps and nearly another 80 percent used foreign-exchange swaps. And while credit exposure from derivatives activities declined by 18 percent in the fourth quarter of 2009 — and by half during the full 2009 year — according to the Office of the Comptroller of the Currency, the notional value of derivatives held by U.S. commercial banks increased $8.5 trillion in the fourth quarter, to $212.8 trillion. The net current credit exposure for the same period decreased to just under $400 billion, half of its late 2008 peak of $800 billion, but undoubtedly still a major market and one that continues to be dominated by a small group of large financial institutions. Five large commercial banks represent 97 percent of the total banking industry notional amounts and 88 percent of industry net current credit exposure. Derivative contracts for both swaps and credit derivatives have gained acceptance as financial products remain popular among the commercial banking giants, even after the 2008 credit crisis, though the amount of banks’ credit exposures have declined (with prodding from the federal government): Derivative Contracts by Product ($ Billions)1
Credit Equivalent Exposures ($ Millions)2
Those banks and other businesses will be paying attention as the U.S. Senate returns to session from its spring recess, looking to take up a financial reform bill. The issue of granting regulatory exemptions for corporate swap users is likely to be one of lawmakers’ biggest debates. This March, the Senate Banking Committee approved a bill that could expose companies that use derivatives to new regulations. Groups including the U.S. Chamber of Commerce, the Business Roundtable and the National Association of Manufacturers have already begun preparing for a fight, forming the Coalition for Derivatives End-Users. Those more than 200 “end user” organizations, identifying themselves as companies that have traditionally bought derivatives as a way to hedge against investment risks, want to be excluded from any coming legislation. The coalition has said that it is not just companies in the Fortune 1000, but even small non-profits and universities, which are worried about the cost of posting cash collateral to a clearinghouse and tying up valuable liquid capital as proposed by the Senate Banking Committee. The coalition also objects to proposals that would impose higher margin costs on swaps that are too customized to be cleared — the type of swap they say is essential for risk management. Some officials, including Commodity Futures Trading Commission Chairman Gary Gensler, have argued loudly against any exemptions and suggested there may be a better way to address the worries of companies around the cost. How firm a stance lawmakers take remains to be seen. Last year, derivatives end users lobbied successfully to be excluded from new House requirements that they post margin, trade swaps on regulated platforms and route those swaps through clearinghouses, which guarantee trades. Commentary However, the concern of many lawmakers is that investors holding a company’s debt as well as related credit default swaps might hinder restructuring outside of bankruptcy -- with the ultimate end result being that troubled companies are pushed into bankruptcy. The refrain has been picked up by some lawmakers, who are open to banning credit default swaps, or restricting the voting rights of creditors who own them. Firms that hold swaps should keep such concerns in mind when drafting credit agreements in the near-term. Though there was undoubtedly a problem with the extent of credit default swaps in the case of AIG, suggesting that all derivatives harm the financial system goes too far. As this edition of Alternative Investment Watch went to press, the Senate began debating a reform bill largely drafted by Senate Banking Committee Chairman Chris Dodd. Dodd’s bill was merged into a package already approved by the Senate Agriculture Committee that would require OTC markets to adopt aspects of regulated markets, such as mandatory clearing through derivatives clearing organizations and trading on exchanges or exchange-like facilities. The package has a narrow exemption for many of those commercial "end users" noted above, though it remains to be seen whether that exemption will remain in place. And a controversial part of the package would also require a bank that qualifies as a "swap dealer" or a "major swap participant" to either divest its swap desk, or forego access to federal credit assistance. Whatever form financial legislation in the United States takes, it does seem likely that more disclosure for creditors hedged with credit default swaps will be required before restructuring or bankruptcy conversations start. Sal (Kislay) Shah is a managing director in the New York office of McGladrey He can be reached at 212.372.1201, or via e-mail, at kislay.shah@mcgladrey.com. 1In billions of dollars, notional amount of total. Data Source: Call Reports from the Office of the Comptroller of the Currency, “Quarterly Report on Bank Trading and Derivatives Activities – Fourth Quarter 2009,” March 19, 2010. 2Data Source: Call Reports from the Office of the Comptroller of the Currency, “Quarterly Report on Bank Trading and Derivatives Activities – Fourth Quarter 2009,” March 19, 2010, and “Quarterly Report on Bank Trading and Derivatives Activities – Fourth Quarter 2008,” March 27, 2009. 3 Acquired by Wells Fargo in a Dec. 31, 2008, merger precipitated by that year’s credit crisis. 4 |
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Alternative Investment Watch
The newsletter of developments in finance for alternative investment providers