Nowhere else in finance are conflicting interests as fundamental as when banks buy or sell credit default swaps, derivative instruments that serve as insurance against a borrower's default. When the borrower involved fails to make timely payments of interest and principal, the buyer of the protection can exchange the debt it holds for cash from the seller of the swap. But when commercial banks are involved in the deals, the party on the other side has to worry that the lenders can profit from the use of information they have privately gleaned from borrowers in the course of assessing their creditworthiness.
Federal Reserve Board chairman Alan Greenspan has had nothing but praise for the proliferation of credit default swaps and other derivatives. That worries observers such as Chris Dialynas, a managing director of PIMCO, the nation's largest bond-investment firm. "There's no surveillance mechanism," Dialynas warns. "It's very, very difficult to know who's doing what."
Even so — or perhaps precisely for that reason — the market for credit default swaps has been booming. At the end of 2003, the notional value of these instruments had risen to $3.6 trillion, up sixfold in less than three years, according to the International Swaps and Derivatives Association. Yet that could very well represent a high-water mark, thanks to the latest twist in the long-running bankruptcy proceedings of Enron Corp. Indeed, some participants and observers fear that the outcome of this Chapter 11 case could cast a pall over the entire market for credit insurance.
Now at issue is whether buyers of some $2.4 billion in notes tied to Enron's creditworthiness and underwritten by Citigroup will get paid, and if so, how much they will receive and from whom. (Credit-linked notes are a form of default insurance that, unlike a swap, can be sold to multiple investors.) The investors, which include such powerful investment groups as Angelo Gordon & Co., Appaloosa Investment LP, and Elliot International LP, are appealing a July 15 decision by the bankruptcy court for the Southern District of New York to subordinate their claims to those of senior creditors.
Citigroup underwrote these notes in a deal known as Yosemite to reduce its own exposure to Enron. According to the Wall Street Journal, the bank's exposure by 1999 totaled almost $1.7 billion, or four times the bank's internal limit on exposure to the energy-trading company. While the securities these investors purchased were senior unsecured notes, Enron argued in court — and the judge agreed — that they did not deserve senior status. Why? Because Citigroup not only knew about the accounting fraud that brought down the energy company in late 2001, but also helped mislead investors, ultimately paying $101 million in a settlement with the Securities and Exchange Commission.
Enron's recovery plan, approved by the court on July 15, would give senior creditors about 20 cents on the dollar if the proposed sale of Enron's Portland General electrical-generation facility and CrossCountry Energy pipelines is successful. But all bets are off if the owners of the Enron notes convince the New York State Supreme Court to overturn the bankruptcy judge's decision to subordinate their claims. In that event, the investors could demand to have their claims included in the recovery plan, sending Enron's effort to emerge from Chapter 11 back to square one.
But a court decision in favor of Citigroup would cast "a real cloud on the horizon" for the credit insurance market, says Walter Pollard, a partner in the Boston law firm Goodwin Procter LLP who has negotiated credit default swap transactions on behalf of hedge funds. It is one thing for a bank to trade on inside information, says Pollard. In fact, he asserts that the market already takes that possibility into account when pricing credit derivatives. But Pollard contends that a ruling in favor of an underwriter involved in "truly toxic things" such as the fraudulent transactions at the heart of Enron's failure could give rise to "a concern that that will undermine the market" for all kinds of credit insurance. Adds Michael Gerity, an analyst for Fitch Ratings, a credit-rating firm: "It would be a pretty negative precedent."
On the other hand, a ruling in favor of the Enron investors could have troubling implications for CFOs and corporate treasurers elsewhere. Fans of swaps argue that they encourage bank lending, an assertion that isn't reflected in loan data. But if they're right, then a serious setback for the market cannot help but make banks less willing to extend credit, particularly to companies in financial straits. (For more, see the October 2004 CFO magazine article "Default Swap Faults.")