The Next Wave Why You Should Care About Credit Default Swaps
During the last wave of restructuring, professionals learned to deal with constant changes in creditor constituency membership as debt trading became much more prevalent. In the next wave of restructuring, debt trading is going to have even more of an impact. Through the use of credit default swap (CDS), a substantial amount of corporate indebtedness has already been sold—and there is virtually no way of knowing to whom.
A CDS, in its simplest form, is a contract whereby the holder of an indebtedness buys protection of its investment by paying a third party in exchange for the third party's agreement to purchase the indebtedness from the original holder at par value. Upon the occurrence of a "credit event" (default in payment, etc.), the third party (the seller) is required to purchase the defaulted debt within a given time. These swaps are virtually always documented on forms promulgated by the International Swaps and Derivatives Association (ISDA). The forms themselves allow for varying definitions of what constitutes a "credit event," the length of time the swap is open and what is covered by the swap. The swaps are regularly placed through banks and investment banks like other credit derivatives, such as interest rate swaps.
Although executed on a form approved by ISDA, each of these documents can have many options. Some swaps require physical delivery of the underlying instrument in order for the CDS buyer to be paid. Others use a cash-settlement feature that allows the seller of the CDS to pay a cash amount on the settlement date that is equivalent to the difference between par value and the debt's then-current trading price.
Certain CDSs are written for a specific tranche of debt at a specific company. Other CDSs will cover "any" debt of the company, including bank debt, bond debt or even convertible bonds. As the concept of CDSs has matured, new uses are made of them. You can now buy a "basket" of CDSs, which includes five or six different companies' debt. These baskets can be set to pay on the "first to default," or second or third; it is all dependent upon what type of risk the buyer is trying to protect against. Another use of CDSs is called a "synthetic securitization," in which a special-purpose entity (SPE) is set up that contains CDSs on all or a portion of the loans held by the buyer. The default risk is transferred to the SPE and the investors who purchase the interests in the SPE; the loans meanwhile are being carried on the books of the buyer, who, again, has no risk.
Scope of the Market
Why should a restructuring professional be concerned? According to The New York Times, there are $8 trillion of CDSs out there.1 To put that in context, WorldCom, the largest bankruptcy in the United States, had pre-petition indebtedness of approximately $35 billion.
Cash collateral, DIP financing and pre-negotiated §363 sales are just a few of the situations where we have previously negotiated a resolution in advance that now will be impacted by these issues.
The CDS market, which basically did not exist 10 years ago, has become a thriving part of everyday life in the financial world for a simple reason: the varying appetite for risk in today's financial markets. While it is true that buying a CDS will reduce the rate of return because the buyer pays the cost of the CDS from its return (interest collected), it is also true that the buyer effectively has no capital at risk—and is still collecting a (albeit smaller) return, with no investment risk. Therefore, if the original holder has any concern, he can buy one or often more (as the CDS market has limited appetite for concentration) CDSs to cover all or part of his debt. The pricing and terms vary on a company-by-company basis and are very much driven by events. The steadily increasing cost of CDSs to cover General Motors's (GM) indebtedness is an example. There are anecdotal comments about CDSs maturing when GM's debt was downgraded in May 2005, but the financial derivative market is not a public market, and the extent of CDSs maturing as a result of that downgrade is not really known.
To put it in a perhaps more familiar context, the buyer of the swap is shorting the debt (assumes a default is possible), while the seller of the swap is going long in the debt (assumes it will perform as agreed). If you are beginning to see a correlation to the bond or equities market, you are quite correct. Debt trading has become so much like the securities business that inevitably people began to apply the same strategies to nonpublicly traded debt. These swaps are not restricted to nonpublic debt, however. Their use is also possible on publicly traded debt, but because of the existence of a market to trade public debt and the ability to pursue a short/long strategy in the market, it is an unlikely vehicle to be used for that purpose.
As with any derivative, once past the original holder of the debt it is very difficult to determine who the final holder of the indebtedness will be after the occurrence of a credit event. An original seller of a CDS might find someone who is willing to sell them this protection at a lower price than the original seller charged, so a new CDS is signed with the original seller taking the spread as pure profit. Or, if the original seller feels the chance of a default is now greater than he thought, he can buy a CDS, limiting his loss. On and on it goes, through many different investors. This is one of the reasons that the $8 trillion figure is probably overstated. While that figure may reflect the face amount of CDSs in the market, there is no real way to tell how many are on an actual debt (the first seller) and how many are hedges.
So when you sit down at the table to explain your financial predicament and looming default to your bankers, you have no way of knowing which of those bankers really is your banker, and which is getting ready to call their counter-party to their CDS and tell them to get out the checkbook. How do you negotiate with a group of creditors you cannot identify? How can you strike a "deal" when the chairs will be filled with many different people after your "credit event?" And in the case of a basket swap, the banker sitting there might not even know whether that credit event is the triggering event in the basket!
The answer to that is not immediately obvious. If the debt is being agented, the agent will be there, but his constituency will probably have changed. A more difficult issue arises in negotiating pre-default agreements. If you need a certain percentage of the debt to vote to waive, for instance, a default that also constitutes a "credit event" under CDSs covering a portion of your debt, the fracturing of your bank group is inevitable, with no way to predict the outcome. A debt-holder that is completely covered by CDSs could be highly motivated to see you default. Not many debt-holders are going to agree to a prepacked, or pre-negotiated, plan if your filing is going to trigger a CDS payment. And when your filing of a bankruptcy is the triggering event, you won't even know who your creditors are going to be until the settlement of the CDSs (typically five business days later). You might want to consider the implications of that scenario in a dark, quiet room to minimize the exacerbation of your migraine. Cash collateral, DIP financing and pre-negotiated §363 sales are just a few of the situations where we have previously negotiated a resolution in advance that now will be impacted by these issues. The worst headache will be reserved for debtor's counsel in large cases. You have cleared your conflicts process and filed your Rule 2014 affidavit, and five days later the participants change. While you may have been disinterested on the day the case was filed, what if one of your firm's largest clients shows up as a creditor as the result of a CDS being triggered?
There are several long-term, practical effects to these structures. The borrower will not know exactly who its real creditors are until after a default or other "credit event," making negotiation and planning difficult. Since most of the institutions that have purchased CDSs to cover pieces of the debt in smaller bundles as the holder's faith in the credit declined, the maturation of these CDSs could lead to one holder morphing into five or 10 other holders. Most of the sellers of CDSs are financial investors who buy and sell positions, and whose interest in spending the time and energy in collecting a loan is limited. A great deal will come down to the strength of the secondary market for distressed debt and whether it has the appetite or resources to absorb the debt that the CDS sellers have had to buy. Clearly, the price discounts that will be imposed in the secondary market are going to dwarf the less than 3-4 percent margins on which most CDSs are written. Or maybe the CDS sellers are right, and there just won't be any default. A more likely scenario is that the distressed debt funds will cherry-pick the field, leaving a large group of fractured claimants holding pieces of various notes.
What about representation on a secured creditors' committee? Section 1102(a)(1) seems to provide for this possibility with the language "additional committees of creditors...as the U.S. Trustee deems appropriate." In a financial structure with second, or more junior, lien debt that is actively traded, you could already have hundreds of holders. The existence of any swaps will magnify that number. Each holder will be a secured creditor, entitled to the protections granted to secured creditors under the Bankruptcy Code. While there have been large cases, such as airlines, with a large number of secured creditors, those creditors generally had liens on different collateral. Trying to negotiate an agreement with a group that large, whose liens are all on the same collateral, will be time-consuming, if not impossible.
The CDSs join several other new financial products that bankruptcy professionals are going to have to deal with in the next wave of restructurings. While we all anticipate adjusting our practice to the latest changes in the Code, what the financial world has created within the rubric of "structured finance" will likely be much more challenging.