Monday, January 27, 2014

Credit Hedging Agency vs. Credit Default Swaps
This article appeared in The Edge, Malaysia on Nov 25, 2013

Some time back in September 2013, this newspaper published a convincing case of a Credit Hedging Agency model as an alternative to Credit Default Swaps to hedge credit risk in the Malaysian credit market. This initiative would allow investors to hedge the default risk in lower rated corporate bonds and hence promote the credit market segment. In this article, I examine the Credit Hedging Agency model and discuss its suitability as an alternative to the well-established credit default swap product.

Credit Hedging Agency: The potential business model

The establishment of Danajamin, a Financial Guarantee Insurer was to promote the issuing of lower
rated bonds, typically by small & medium enterprises (SME). The insurer guarantees payments to investors in the event of default of the bond issuer. The guarantee enhances the credit rating of the bonds to typically an investment grade type, and attracts investors to subscribe for the bonds.
However the above scheme does not tackle the issue of the general lack of appetite in lower rated bonds in the Malaysian credit market. Now with a Credit Hedging Agency in place, investors who otherwise would be wary of the default risk in lower rated bonds could potentially pay a premium to the Agency as a protection against default risk. Should there be a default, the investor delivers the
bond to the Agency and receives par value of the bond plus any accrued coupons.
From a business model perspective, I anticipate the agency’s prime income to be the premium charged for various corporate bonds’ default risks. The income will weigh against the contingent liability of the losses suffered from any defaulted bonds. So, very likely, a reasonable capital-to-loss ratio will be established to cover this contingent liability.
The Credit Hedging Agency is said to be also involved in market marking of the bonds. As the bonds are sold from one party to another, the default risk protection may be transferred to the new party, via the Agency. Or the protection disappears should the new buyer decide not to hedge the credit risk.

Credit Hedging Agency: Potential Challenges

The Credit Hedging Agency can materialise in many forms. It can emerge as a single entity or it may consist of member banks. Nevertheless, there will be some interesting challenges ahead.
Pricing of the premium, which is essentially the price of the default risk of the bonds, will be a major task. In established markets, the price for a unique risk in an instrument is derived from the supply and demand for the risk in the market. For example, in equity markets, there is a liquid plain-vanilla options market where option prices are generated via supply and demand by investors. The volatility parameter is actually derived from the prices of the plain-vanilla options to price other illiquid instruments. Similarly, in the credit market, with a liquid credit default swap (CDS) market in place; default probabilities are derived from the prices of the CDS. It has been established in research studies that the CDS market gives out the most reliable default probabilities compared to the bonds market, due to its better liquidity.
Without a market that trades the default risk in Malaysia, the Agency will have to theoretically derive the credit risk pricing. This measure may well expose the Agency to various open questions like the acceptability of the model used, any judgemental perimeters applied and the robustness of the pricing model. The main issue here is that the risk is priced remotely and it is not very likely to be aligned with the market.
Another potential issue is defining the credit event. Would it include failure to pay coupons and restructuring events, or is it purely confined to bankruptcy events? Multiple events of defaults may further complicate the theoretical pricing of the default premium.
And Credit Default Swaps (CDS)?
Credit default swaps, which are over-the-counter instruments of the 1990s and early 2000s, were indeed unregulated instruments, an outcome of a few regulations in the U.S. such as the Gramm-Leach-Biley Act, 1999 that exempted regulation for certain OTC instruments like the CDS. The lack of transparency on the CDS further propelled the significant amount of leverage taken by major financial institutions that contributed to a web of inter-connectedness, which induced massive systemic risk into the financial system.
However after the 2008 crisis, the CDS is being re-invented as an exchange traded product for those with common names and maturities that can be easily standardized. For the more illiquid names and structures, central clearing houses and swap execution facilities are being put in place, albeit with a number of teething issues to be tackled with.

The proposed Credit Hedging Agency initiative is a noble move that hopes to attract investors to trade in lower rated bonds. It is not a tradable product like the CDS, but rather a hedging service with a fee. The survivability of the business model will very much depend on its default premium and volume of business.
Meanwhile, we should also pay attention to the enormous effort being put in globally to make the CDS a safer and transparent product.
As a final point, perhaps we need to probe deeper to find out what exactly is the cause of such lack of appetite in subscribing and trading for lower rated bonds, in comparison to other countries. Lower rated bonds attract investors with a different risk profile, compared to higher rated bonds. These investors are willing to accept the higher coupon and take higher risk as they have higher mandate to take more risk. They could be hedge funds and even private equities, but to a large extent, this market consists of bond traders who typically buy and sell bonds for profit, like shares. They often form part of an investment bank activity and make proprietary profits for the bank. Do we have enough of these bond traders in Malaysia? In spite of everything, it is always traders that make a market, not long-term investors.