"Credit Swaps ‘Big Bang’ Loosens Bank Grip as Pimco, Primus Gain
By Shannon D. Harrington
April 8 (Bloomberg) -- JPMorgan Chase & Co., Goldman Sachs Group Inc. and the eight other banks that have dominated the credit-default swaps market for a decade are now ceding some power to their clients as regulators push for transparency.
Pacific Investment Management Co., Elliott Management Corp. and three other investment firms will join 10 dealers this week on a committee that will make binding decisions for the first time on how contracts are settled. Such decisions have influenced payouts and, at times, had the potential to almost double the amount investors made or lost.
The committee may help boost confidence in the $28 trillion market, where banks, hedge funds, insurance companies and investors speculate on the creditworthiness of borrowers or hedge against losses on debt. Market decisions, while not binding, were made previously during conference calls between dealers, with no clear rules in place to ensure all sides were being considered.
“It’s largely in the past been seen as a closed-door process,” said Brian Yelvington, an analyst at debt research firm CreditSights Inc. in New York. With the committee, “the transparency and the fact that you should get some consistency gives people a lot more confidence than they’ve had,” he said.
The committee is part of a broader effort being pushed by regulators including the Federal Reserve Bank of New York to curb the risk of systemic losses from the privately negotiated market, where outstanding contracts ballooned to as much as $62 trillion at the end of 2007.
Cataclysmic Shift
The overhaul, dubbed the “Big Bang” because it’s considered a cataclysmic shift for the market, aims to bring a fresh set of standards to existing and new trades.
The 2,023 entities that had signed up as of late yesterday in New York, as measured by the International Swaps and Derivatives Association, will agree to abide by the committee’s decisions and auctions that determine the value of underlying securities. The auctions effectively set the size of the payout when borrowers default.
Both the auction and the credit-swaps committee are necessary for another effort pushed by regulators: moving the derivatives through clearinghouses designed to absorb the failure of a dealer collapse.
Without a panel to make binding decisions, clearinghouses would be at risk of having a firm on one side of a trade disputing a so-called credit event while the other side demands payment. After more than a week of debating, dealers last month overruled some objections and declared a credit event for contracts guaranteeing the debt of a unit of Montreal-based AbitibiBowater Inc., North America’s biggest newsprint maker.
Fed Support
Credit-default swaps pay the buyer face value if a borrower defaults in exchange for the underlying securities or the cash equivalent.
The Fed began pushing for clearinghouses last year after the near-collapse of Bear Stearns Cos. in March 2008 and the failure of Lehman Brothers Holdings Inc. in September triggered concern that banks were too interconnected.
Dealers probably lost “hundreds of millions” of dollars because of failed trades with Lehman, Moody’s Investors Service said last year. Lehman’s collapse also triggered a panic that other firms could fail, prompting the U.S. to provide capital to the nine biggest banks and guarantee new debt for three years.
80 Percent Majority
Rules of the new committee will require an 80 percent majority among the 15 members before a credit event can be declared. Credit events allow a firm that bought protection against default to demand payment from its counterparty. Matters failing to get an 80 percent agreement would be sent to a panel of arbitrators.
The International Swaps and Derivatives Association, or ISDA, will serve as secretary of the committee and will be required to publish each matter brought before the committee on its Web site, including information on the firm that brought it and how each member of the committee voted.
Market participants “know that even if they aren’t in the room themselves, they’ll at least understand how the decisions were made and can have more confidence that the decision is correct,” said Jason Quinn, co-head of high-grade and high- yield flow trading at Barclays Capital in New York. Barclays is one of the 10 dealers on the committee.
Along with Newport Beach, California-based Pacific Investment, known as Pimco, which manages the world’s biggest bond fund, and Elliott Management in New York, the swaps committee will include representatives from Rabobank International, Legal & General Investment Management Ltd. and Primus Asset Management Inc.
Stronger Process
“The inclusion of buy-side firms makes the process stronger,” Thomas Jasper, chief executive officer of Bermuda- based Primus Guaranty Ltd., said in a statement. The firm, which manages about $22 billion in credit-default swaps, is the parent of Primus Asset Management.
Spokespeople for the other firms didn’t return calls for comment, declined to comment or couldn’t immediately be reached.
Investment firms have “long been an intrinsic part” of “decision-making processes,” ISDA Chief Executive Officer Robert Pickel said in a statement. “This community constitutes over a third of our membership.’
The other dealers with votes on the committee for U.S. and European markets are Deutsche Bank AG, Morgan Stanley, Bank of America Corp., UBS AG, Citigroup Inc., Credit Suisse AG and Royal Bank of Scotland Group Plc.
Justin Perras, a spokesman for JPMorgan, and Michael DuVally, a spokesman for Goldman Sachs, declined to comment.
Dispute Settlement
Disputes are now largely settled outside the courts, said Robert Claassen, chairman of the derivatives and structured products group at New York-based law firm Paul Hastings.
“There have definitely been some disagreements, they just haven’t ended in litigation, so you don’t hear about it,” Claassen said. “People settle.”
After the government seizure of Washington-based Fannie Mae and Freddie Mac of McLean, Virginia, triggered settlement of credit swaps linked to the mortgage-finance companies last year, a group of investors fought to have included in the settlement so-called principal-only bonds, some of which traded at almost half the value of most of the companies’ debt.
Because investors have the option to deliver the cheapest eligible securities, allowing the bonds to be covered by the derivatives would have led to a larger payout than the 0.1 cent to 8.5 cents on the dollar that dealers set at an auction used by more than 650 entities.
“Within the new framework, a committee member has to make a decision regardless of his firm’s involvement in the decision,” Yelvington said. “This should encourage everyone to be looking for fairness and consistency so that everybody knows how the game is played.”
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