Credit Default Swap (CDS) & Securitization

Since October 2011, CDS has been available in India, but only for corporate bonds. Commercial banks, primary dealers, NBFCs, insurance companies, and mutual funds are all eligible.

A credit derivative transaction is one in which two parties enter into an agreement in which one party (the “protection buyer”) pays the other party (the “protection seller”) periodic payments for the duration of the agreement. Unless a credit event involving a pre-determined reference asset occurs, the protection seller makes no payment. If this happens, the Protection Seller is obligated to make a settlement, which can be cash or physical (India follows physical settlement).

CDS is a credit derivative

It means that CDS is a credit derivative that can be used to transfer credit risk from a risk-averse investor (called a protection buyer) to a risk-taking investor (called a protection seller).

It functions similarly to an insurance policy. In an insurance policy, the insurance company pays the insured party the amount of the loss. Similarly, the CDS buyer—a bank or institution that has invested in a corporate bond issue—wants to minimize the losses it might incur if the bond issuer defaults. Credit default swaps allow one party to ‘purchase’ protection from another for losses incurred as a result of a reference instrument’s default (a bond issue in India).

The ‘buyer’ of protection pays a premium to the seller, and the seller agrees to compensate the buyer for losses incurred as a result of any of the specified ‘credit events.’ As a result, CDS allows the buyer to transfer the credit risk associated with financial assets to the seller without actually transferring ownership of the assets. 

Let us use an example to better understand it. Assume Punjab National Bank (PNB) purchases a TISCO bond worth Rs. 150 crore. If PNB wants to protect itself against the risk of TISCO defaulting, it can buy a credit default swap from a financial institution like Templeton. In exchange for default protection, PNB will pay Templeton fixed periodic payments (just like the premium of an insurance policy).

CDS can be used for different purposes

CDS can be used for different purposes in a financial system, viz.,

• Protection sellers can use it to participate in credit markets without actually owning assets, while protection buyers can use it to hedge their credit exposure.
• The protection buyer can transfer credit risk on an entity without transferring the underlying instrument, reap regular benefits in the form of lower capital charges, reduce specific credit portfolio concentrations, and go short on credit risk.
• The protection seller will be able to diversify his portfolio, gain exposure to a specific credit, gain access to an asset that he might not otherwise have, and boost his portfolio’s yield.
• Banks can use it to transfer risk to other risk-takers, create capital for more lending.
• Distribute risk widely throughout the system and prevent concentrations of risk.

Concerns about CDS

Some analysts are extremely concerned about CDS. In 1993, Nobel Laureate economist George Akerlof predicted that CDS would cause the next financial crisis. Warren Buffet, the legendary investor, referred to them as “weapons of mass destruction” in 2003. Former US Federal Reserve Chairman Alan Greenspan, who made large CDS bets, said after the subprime crisis that CDS was “dangerous.” ‘The monster that ate Wall Street,’ according to Newsweek, a leading US weekly. Many Indian experts believe that CDS will not stabilise the economy but may actually destabilize it.

CDS contracts are risky because they can be used to cause havoc. It all comes down to insurable interest, which is never present because it is used for speculation. It’s bad to have a derivative that’s essentially an insurance contract with no insurable interest. But are the speculators’ interests insurable? They don’t have any, unfortunately. The’sub prime’ crisis in the United States was the result of such CDS contracts—one defaulting and another claiming ‘protection,’ eventually resulting in the insuring company’s defaulter—overnight, the largest US insurance giant, AIG, went bankrupt. Many US banks were similarly affected.

The most damaging aspect of CDS is that the credit risk of one country or region is easily and silently exported to another. As a result, if there are defaulters, there is a serious risk of a ‘contagion effect,’ as happened during the US’sub prime’ crisis.

Securitization

This is the process of creating marketable securities’ that are backed by a pool of existing assets like auto or home loans. After an asset is converted into a marketable security, it is sold to an investor, who receives interest and principal payments from the loan’s cash flow. NBFCs and microfinance companies, for example, convert their loans into marketable securities and sell them to investors. This allows them to extract liquid cash from assets that would otherwise remain on their balance sheets. Securitized assets lose value when the value of the underlying asset falls, as it did during the US’sub-prime crisis, when home loans against which securitized assets were sold to insurance companies and banks fell in value, resulting in a crisis. The RBI has taken some precautionary measures in order to avoid such crises. It has required companies to hold securities for a set period of time:

1. NBFCs must keep assets for six months, with a minimum retention requirement of 5-10% to ensure that they have a continuing stake in the performance of securitized assets.
2. Micro Finance Institutions (MFIs) need to hold them for three months.

It has been in the news since the RBI allowed it in India – whether the securitizations trusts’ will have to pay tax on it. Meanwhile, the government clarified the situation in 2015. If the income distributed by the trust is received by a tax-exempt person, there should be no additional income tax. Mutual funds are expected to return to the securitization market as a result of this.