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Saturday, 20th April 2024 |
| Reporting for credit derivatives is deterring investors |
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By: Vincent Reilly, Vincent Reilly
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| The move to fair value accounting and the associated potential for earnings volatility has deterred some investors from credit derivatives. Vincent Reilly explains the vagaries of credit derivatives, and the impact mark to market reporting has had on them. |
The modern credit derivative market is about 25 years old - ISDA first mentions them in 1992 and they have grown rapidly since - from a standing start in the early 1990s, the outstanding volume of credit derivatives is now over $17 trillion.
The rationale for this growth has been that credit derivatives make the capital markets more efficient. They allow lenders, such as banks, to follow their comparative advantage in originating credit, whilst allowing investors access to a range of assets that they would not otherwise have access to.
As far as banks are concerned, credit risk management tools, such as credit derivatives, allow banks to move away from an 'originate-and hold' approach to an 'underwrite/ distribute/invest approach'. This should mean that banks price credit more accurately and should result in banks holding more diversified and more efficient portfolios. Investors benefit by being able to acquire exposure to, and therefore potential reward from, assets that they might otherwise find expensive or difficult to acquire.
However, investors in credit derivative type products reporting under the IFRS regime are struggling to cope with the increased volatility arising from fair valuing credit derivatives as stipulated by IFRS.
Prior to the accounting standards on financial instruments, including derivative instruments, a credit default swap would have been subject to financial guarantee accounting.
If you take, for example, the basic credit default product which is a privately negotiated bilateral contract between two parties.
It is a contract that provides one party the insurance against the risk of default by a specified company known as a 'reference entity'. The buyer of the protection pays a fixed premium, the CDS spread, to the seller of the protection for a period of time and obtains the right to be compensated when there is a 'credit event'. If no credit event occurs, the buyer will continue to pay the premium until maturity. However, if the credit event occurs, the seller owes a payment to the buyer of the protection.
A financial guarantee contract is defined in IAS39 as a contract that requires the protection seller to make payments to reimburse the protection buyer for a loss it incurs because the specified debtor fails to make payment when due in accordance with the original or modified terms of the debt instrument.
For an investor selling protection, under IAS37: Provisions, Contingent Liabilities and Contingent Assets, the guarantee represents a potential liability and provision is recognised when it is probable that an outflow of cash will be required and the amount can be measured reliably. For the most part, contracts that would be covered by IAS37 would most likely be disclosing a contingent liability where the test for a probable outflow of cash has not been met. This accounting meant that credit derivatives did not add significant volatility to earnings and the impact on earnings was limited to the creation of provisions, if and when, they were required under the contract.
This financial guarantee accounting described above is in stark contrast to the rules under IFRS. The initial starting point from an accounting perspective is IAS 39 which states that all derivatives, including some embedded derivatives, are measured at fair value through profit or loss.
The scope paragraphs of IAS 39 also include certain specific requirements in respect of pure financial guarantee contracts which fall within the scope of IAS 39, but are allowed to be accounted for in a manner similar to IAS37. Those financial guarantee contracts that do not meet this definition, which is set out above, will then fall within the definition of a derivative and be treated accordingly.
The key points to note are:
• Contracts that require a payment in other circumstances i.e. there is no default by a specified debtor e.g. a payout is due and it arises on the occurrence of a credit event such as a restructuring and not a default, or a change in credit rating; or
• Contracts where the holder did not suffer a loss on default; then
• Such contracts are to be treated as derivatives and from a financial reporting perspective, should be marked to market.
In a world of a standard ISDA terms it is clearly the case that many credit derivative contracts will not qualify as guarantee contracts but will be treated as derivatives.
It is only in exceptional circumstances that credit default swaps will be excluded from the scope of IAS39 and will fall to be treated under IAS 37. To be excluded, a credit default swap would need to be indistinguishable, in substance, from a pure financial guarantee contract.
The pricing of credit derivatives should aim to provide a 'fair value'. There are a number of different pricing models and approaches used to model the price of a CDS. Typically, the fair value pricing typically attributes a value to the two cash flows - the fixed leg and the contingent leg. The fixed leg consists of a series of fixed payments made by the protection buyer; the contingent leg requires the protection seller to make only one payment if the reference credit defaults.
The fair value of the CDS (to the protection seller) = PV [fixed leg] - PV [contingent leg]
The models also require the following key inputs:
• The default probability of the reference credit (i.e. the credit curve)
• The notional swap value
• The recovery rate in case of default
• The risk free discount (i.e. yield curve)
In practice, the level of sensitivity to the credit curve is highly leveraged. Small changes to the credit curve can result in large changes to the 'fair value' of the underlying CDS resulting in substantial mark to market changes reported in profit or loss. This compares to changes in the recovery rate which has a significantly lower impact on the CDS price.
Recently, the Financial Services Authority (FSA) in the UK has responded to well publicised instances of traders and asset managers who failed to value appropriately positions or portfolios involving credit derivatives. The FSA noted that this has caused the institutions in question significant losses, and in one case, has led to the liquidation of a hedge fund.
According to Thomas Huertas of the FSA, valuing credit derivatives is critical to managing market risk. This is a difficult task, particularly for especially complex instruments such as nth-to-default derivatives on a basket of credit exposures, or for bespoke products that may exactly suit the special needs of a particular investor but have no broader appeal (and therefore have only limited liquidity).
To value complex, illiquid instruments, firms generally mark to model rather than mark to market. This results in what is generally called model risk.
The FSA announced three streams of work to highlight what constitutes good practice in this area and of relevance to the structured finance area is the second stream. The second stream is looking at how investment banks value complex, illiquid instruments that they hold in their trading books. What is the source of pricing for such instruments, and how independent is this source from the trader? Are the inputs to the model reasonable? Does the model give plausible and/or verifiable results? What assumptions are made about liquidity? Is the price, the price that the bank could achieve if it sold on the day, or is it the price that the bank could realise if were given several days or weeks to trade itself out of the position?
Some 'would-be' investors have been deterred from investing in these complex credit instruments because of the move to fair value accounting and the potential for earnings volatility. Those investors brave enough to stay on, have to endure the daily 'roller-coaster' of mark-to-market adjustments and learn to live with the vagaries of highly complex and sensitive CDS pricing models. |
Vincent Reilly is a partner at KPMG Financial Services.
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