Unintended Consequences of New Reporting on Credit Default Swaps?

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Gretchen Morgenson of the New York Times has a story on proposed new reporting rules for credit default swaps that in passing raises the question that if implemented on the envisioned schedule (becomes effective in fiscal year financial statements after November 15, 2008, so the impact could be soon in coming), it may lead banks to try to pretty up their balance sheets.

Now I will concede that a lot of the byplay in the article is annoying, starting with the breathless first sentence:

Everybody knows that the market for credit default swaps is one of the hottest investment arenas around. At the end of last year, according to the Bank for International Settlements, the fair value of credit default swaps outstanding totaled $2 trillion, up from “just” $133 billion three years earlier.

Funny, the article is all about how opaque the CDS market is, yet she fails to connect the dots that the BIS “fair value” figure is therefore a guesstimate. More on that:

The entire amount of insurance that has been written, also called the notional amount, is $62 trillion. The fair value of C.D.S.’s is a more meaningful figure, though, as it represents a more precise assessment of potential losses and gains. The fair value of these derivatives has had a growth rate far steeper than that of the notional amount in recent years.

Ahem. The $62 trillion number (as of its reporting date; no doubt the total now is higher) is more accurate; the fair value figure is more significant but less accurate. “Precise” and OTC markets do not go together. And calling the change in economic exposure a “growth rate” is a tad misleading. It indicates that the riskiness of the CDs has increased (as in higher risk credits have higher spreads). Is this because more CDS are being written proportionately on riskier companies, or because CDS spreads are widening on many existing credits due to the weakening of the economic environment? While what Morgenson has written is technically accurate, it should either be explained or the observation omitted (it isn’t germane to the thrust of the piece).

While this isn’t the only lapse, the article is nevertheless useful. From what I can tell (Google News search and blog search), this story hasn’t gotten much (any?) coverage, so Morgenson is seemingly out early with it. Here’s the guts of the piece:

To help investors get a grip on the financial implications for companies that have sold credit default swaps, the F.A.S.B. has suggested a list of new disclosures to be effective in financial statements for fiscal years that end after Nov. 15, 2008. That very specific deadline may ensnare some of the nation’s biggest brokerage firms with fiscal years ending in November — Lehman Brothers, Morgan Stanley and Goldman Sachs….

The F.A.S.B. proposal would cover sellers of C.D.S.’s, the entities that act as insurers. They would have to disclose such details as the nature and term of the credit derivative, the reason it was entered into and the current status of its payment and performance risk.

In addition, the seller would provide the amount of future payments it might be required to make, the fair value of the derivative and whether there are provisions that would allow the seller to recover money or assets from third parties to pay for the insurance coverage it has written.

However, if you go to the FASB website, things get curiouser. The proposal was issued at the end of May; the comment period closed on June 30. Morgenson only quotes one expert (“Jack Ciesielski, an accounting guru and the publisher of The Analyst’s Accounting Observer, an accounting advisory service for investment professionals”) which unwittingly creates the impression that he pitched the story to her and she relied on him overmuch.

And there is more sloppy drafting. The use of the term “credit derivative” above tracks the language in the proposal, but the proposal provides a definition:

…the term credit derivative includes groups of similar credit derivatives

In fact, the use of “credit derivative” sent me running to the FASB site, because without the definition, it reads as if financial firms are required to make instrument-by-instrument disclosure, which is clearly not happening. Again, oddly, that section largely tracks the FASB language but omits the fact that CDS writers would also disclose the amount of collateral held.

Now the “accounting guru” does make an important observation:

As the requirements of the new disclosure sink in among companies in the next few months, Mr. Ciesielski said he expects increased volatility to emerge in the C.D.S. market. Fearful of how investors will react to the extent of their swap holdings, companies may move to unwind them or offset them when they can.

“This is something that will change behavior,” Mr. Ciesielski said. “If you don’t want to look so bad, you’re going to have to be busy in the next few months to work these down, wriggle out of them or offset them.”

The lack of apparent interest in this rule change is surprising, particularly if firms wind up shuffling exposures before the first time they become subject to the disclosures. Normally, interbank liquidity starts drying up in December; last year, it started early, in November. Let’s hope this otherwise useful proposal doesn’t increase year-end stresses.

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  1. Steve

    — Disclosure is good, accounting for them as insurance contracts would be even better.

    — It’s past time for Congress to revisit CFMA, which removed OTC derivatives from the purview of the CFTC (and SEC).

  2. Richard Kline

    Glory be!: a Sunshine proposal for CDSs. O’ course visibility will hit issuers right in their fee spot—but perhaps that’s half the goal. Won’t solve the problems with CDSs by itself, but still a babystep on the road to New Prosperity, what?

  3. Anonymous

    How about regulating them like insurance- that would be best. At least get rid of the gambling aspect- make it illegal to write a CDS unless the CDS buyer has a direct financial interest in the underlying asset.

  4. Anonymous


    There have been widespread claims that credit derivatives like credit default swaps (CDS) have lowered the cost of debt financing to firms by creating new hedging opportunities and information for investors. However, these instruments also give banks an opaque means through which to sever links to their borrowers, reducing lender incentives to screen and monitor. In this paper, we evaluate the impact that the onset of CDS trading has on the spreads that underlying firms pay at issue in order to raise funding in the corporate bond and syndicated loan markets. Employing matched-sample methods, we fail to find any evidence that the onset of CDS trading affects the cost of debt financing for the average borrower. However, we do uncover economically significant adverse effects on risky and informationally-opaque firms. It appears that the onset of CDS trading reduces the usefulness of the lead bank’s retained share in resolving any asymmetric information problems that exist between a lead bank and non-lead participants in a loan syndicate.

  5. Lune

    They would have to disclose such details as the nature and term of the credit derivative, the reason it was entered into and the current status of its payment and performance risk.

    I’m not so sure that all this disclosure is really going to be beneficial. The problem with CDS is that right now, there is no market for these things. And as Yves has indicated, even the BIS’s best attempts to value the market in the aggregate are guesstimates. As the saying goes, garbage in, garbage out. While I’m glad the FASB is requiring this information, I don’t know if firms really have this type of information. Thus, they’ll merely provide guesstimates of their own (which unsurprisingly will be favorable to their own balance sheets). Heck, most firms can’t even give a proper accounting of their mortgate-backed securities, and those are supposed to have iron-clad paper trails from the day the homeowner signs on the dotted line through all the slicings and dicings they undergo on Wall St.

    The real reform in this area isn’t to force more disclosure (not that I’m against that), but to push all these transactions onto a regulated exchange, with standardized terms, and designated market makers.

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