China Calls on Credit Default Swaps to Spread the Pain

Unleashing 'financial weapons of mass destruction' could bring unintended consequences
September 25, 2016 Updated: September 26, 2016

News Analysis

China has a debt problem, and it’s desperate enough to employ drastic—and dangerous—means to counter it.

Chinese regulators on Sept. 23 approved trading of complex financial derivatives called credit default swaps (CDSs) that provide investors insurance against defaults. The move signals that Beijing may finally allow more delinquencies and even bankruptcies of state-owned enterprises.

But such swaps are a dangerous double-edged sword. The CDS market expanded in the United States before the global financial crisis. Their widespread use in speculation, lack of transparency and regulation, and complexity exacerbated the effects of the crisis and contributed directly to the collapse and bailout of insurer AIG in 2008.

The People’s Bank of China (PBC) outlined rules of engagement for the use of CDSs after weeks of consulting with banks and brokerage firms across China. The regulator had considered approving the swaps in 2010, but as bond defaults were relatively unheard of before 2014, the market had little appetite in trading CDSs.

Default swaps have been in existence in the West since their creation by J.P. Morgan in the mid-1990s. A CDS allows a party to buy or sell insurance that will cover payments if a company fails to repay interest or principal. Similar to an insurance contract, the party buying the swap pays premiums, while the party selling the swap receives the premiums. In the event of a default or other credit event, the seller must compensate the buyer by an amount specified in the CDS contract, usually the difference between the price at time of contract and the ending price.

Beijing has never been comfortable in allowing companies, especially state-owned enterprises (SOEs), to default on their bonds. This isn’t to protect investors per se; any company defaulting on its debt is effectively barred from raising new debts, thus preventing access to crucial working capital, as many SOEs are effectively insolvent otherwise.

Local and regional governments—which rely on SOEs to provide jobs, tax revenues, and local economic growth figures—often step in to help struggling firms repay bonds. But since last year, local governments’ ability to help has been diminished due to slowing economic growth and weakening real estate prices.

More Defaults Ahead

So how does China plan to use CDSs to help its debt problem? First, swaps lessen the pressure for Chinese authorities to act as an initial backstop on bond defaults.

Secondly, the allowance of CDSs gives banks and brokerages a way to hedge their portfolio of loans and nonperforming loans. “To have CDSs is a very good thing because, so far, there are no meaningful hedging tools in the domestic market. The market has high demand for such instruments,” Liu Dongliang, an analyst at China Merchants Bank, told Bloomberg on Sept. 22.

(The Epoch Times)

Analysts also believe the decision is a sign that the Chinese communist regime may allow more bond defaults. That’s the raison d’être. After all, if authorities don’t believe the rate of bond defaults would increase, there wouldn’t be a need to introduce such insurance contracts.

And there’s increasing evidence to support that conclusion. Nine months after Guangxi Nonferrous Metals Group defaulted on its bonds, the provincial court on Sept. 12 allowed the metals company to go bankrupt and liquidate. It was a momentous decision—the company became the first Chinese SOE allowed to liquidate after defaulting on bonds.

So far, there are no meaningful hedging tools in the domestic market.
— Liu Dongliang, China Merchants Bank

More companies similar to Guangxi Nonferrous Metals—lower-tier companies in remote regions and supported by local governments—are expected to default. “It is very important to recognize that not all SOEs are equal in their likelihood of receiving support,” said Ivan Chung, Moody’s associate managing director, in a press release.

“If you look forward three to five years, it seems more and more probable that local government entities will need to increasingly stand on their own, and the likelihood of substantial government support will gradually recede for those not providing a public goods or service linked to national priorities as their sole or predominant purpose,” Chung said.

Passing the Credit Hot Potato

The Chinese financial sector has reason to applaud a liquid CDS market. But there is a big question left unanswered: Who will write the swaps and, in turn, assume risk of default?

Will they be the banks, the state-directed asset management companies, or perhaps the insurance companies that have an unenviable mandate to protect the pensions of millions of Chinese workers? Beijing talks a lot about “sharing” the risk of default—is it simply looking to shift the risk of default from various levels of government to the banking and the insurance sectors?

There is a host of other challenges to work through. What will the legal framework around swaps look like for China? The International Swaps and Derivatives Association has simplified most of the language and terms around “plain vanilla” CDS contracts in Western markets. Western investors in China would likely demand more clarification on enforcement and settlement of swaps.

Pricing volatility could be another land mine for CDS investors and regulators. The spread, or price the protection buyer must pay over the notional value of the referenced bond, will be extremely hard to determine for Chinese swaps. The likelihood of local or regional governments to step in and prevent defaults is unpredictable, and such possibilities could result in wild price swings. 

Creation of a New Problem?

Credit default swaps also introduce undesirable consequences, which led Warren Buffett to describe such instruments as “financial weapons of mass destruction.” Many of these effects exacerbated the 2007–2008 global financial crisis.

Swaps can easily be used by speculators to bet on defaults, due to the relatively small outlay necessary to make a wager. A party who does not own a particular bond can bet on its default by entering into a naked CDS, as long as there’s a taker on the other side of the contract. A naked-CDS contract is akin to taking out life insurance on one’s ailing neighbor. It’s not only hazardous from an ethical standpoint but also inflicts further damage on an already tenuous SOE bond market.

China must think about how to regulate its CDS market. If left unchecked, naked swaps would compound shocks to the financial markets in the event of mass default. A naked-CDS holder need not own the referenced bond. So if a bond defaults, the losses are not just limited to the holders of the bond itself (capped at the total issuance amount), but potentially thousands of other banks, insurance companies, and investors who may have written swaps on that same bond.

CDSs can also distort the market and hide true concentrations of risk from regulators. Leading up to the financial crisis, AIG’s Financial Products unit underwrote default swaps on more than $440 billion worth of asset-backed securities. When such securities defaulted en masse, the insurance giant was suddenly saddled with liabilities it could not pay, ultimately bringing about its collapse and $180 billion in government bailouts.

On top of managing credit risk, investors also must monitor counterparty risk to determine whether the seller of the CDS (counterparty) is able to pay up in the event of a default. In AIG’s case, it was not, and thousands of investors who previously thought their risks were completely hedged suffered a rude awakening when the insurer collapsed.

Swaps can indeed spread around the risk of default, but they add another layer of complexity for investors and a mountain of problems for regulators.

As Beijing readies a new way to deal with its debt crisis, it may have inadvertently sowed the seeds of a future crisis.