Excerpts from a roundtable discussion sponsored by Chase Securities Inc., held on November 16 in New York City.

MODERATORS

Joyce Frost, formerly with the global credit derivatives group, Chase Securities Inc. Joe Kolman, editor, Derivatives Strategy

PARTICIPANTS

Richard Kennaugh, managing director and co-head of credit derivatives trading, Chase Securities Inc. Hetty Harlan, managing director and head of credit capital markets for portfolio management, Bank of America Mark Holmlund, executive vice president in the institutional products division, Pacific Life Insurance Co., and executive vice president and COO of Pacific Financial Products Inc. Zed Francis, managing director and head of portfolio management, Bank of America Elizabeth Gile, managing director of credit markets in North America, J.P. Morgan Anthony Urick, credit manager, Securities Valuation Office, National Association of Insurance Commissioners Philip Prince, managing director, Chase Securities Inc. Bob Pickel, CEO and executive director, International Swaps and Derivatives Association Richard Williams, head of credit derivatives, Abbey National Financial Products Christopher Walvoord, director of hedge fund investments, The Northern Trust Co.

Joyce Frost: Historically, there have been mismatches between hedgers and investors in the credit derivative markets. The differences include acceptable reference names and the size and tenor of the transactions. But more importantly, they now include the structure and documentation of contracts.

"If one institution starts invoking the moral-hazard issue by throwing companies into bankruptcy just to get paid out on a credit derivative, borrowers will smarten up pretty quickly.” — Joyce Frost, Chase Securities Inc.

Many investors want to buy credit risk in derivative form as a proxy for a bond or loan, while hedgers need to offset risks like loan or swap counterparty exposures. The challenge we face in creating a long-term, deep and liquid market is accommodating the needs of the varied users of credit derivatives. What steps is the market taking to accommodate these needs? Is the current debate on the inclusion of restructuring as a credit event unsettling the credit derivatives industry?

Richard Kennaugh: We've gotten this far by using what many people would judge to be imperfect documentation. When the 1999 definitions came out—on the very day of their release—there were people who favored the removal of the restructuring credit event definition. They continued to use the documentation, however, because the rest of the market used it. We had pretty good market consensus. We had a form of contract that was acceptable to all users of the credit derivative product.

That consensus, for various reasons, has recently stalled. I don't think this is a disaster; instead, it's healthy that the credit derivatives market has had to address this issue. From a dealer's point of view, I'd prefer not to use it, but we're in the business of accommodating our customers' needs, so we will do that. If we were solely a seller of protection, we would prefer not to have it, but buyers of protection would prefer to have it—therein lies the challenge.

Mark Holmlund: We've always viewed restructuring as problematic—it lends itself to mischief. At one point, we actually liked the old definition better than the new one. Perhaps the new "new” definition will be better, but possibly not. It's our preference to eliminate restructuring as a credit event. We could sit here and debate it for 24 hours a day, and there probably wouldn't be resolution. But I think the market will resolve it over time.

Standardization is a good thing, of course, and we adopt it in many of our contracts, but not all. We took on the restructuring language on the theory that it provided more liquidity, but we view all the terms of the contract as negotiable. An example of that is repudiation, which is certainly far less controversial. We've done a number of transactions with European names and, in dealing with European counterparties, they've insisted on that standard. We insisted right back, and we've never done a transaction with repudiation. So I agree with Richard that the restructuring issue is not a huge negative for the market. It's more of a two-steps-forward, one-step-back situation. To the extent that default contracts start trading with a big delivery option and become less like the cash instrument, though, I think that's a negative.

Zed Francis: I've been responsible for portfolio management at Bank of America for about 15 months, so we're relatively new at looking at credit derivatives for portfolio use. On the hot-button topic of restructuring, we're realistic. We understand that restructuring creates uncertainty and basis risk. But we want to get regulatory capital relief as well as economic risk protection. Based on the discussions earlier today, the regulators will have a difficult time allowing regulatory capital relief to banks if the restructuring provision is eliminated.

If you go down the road with no restructuring, you create a paradox. Simply stated, more bankruptcies will occur. That's because if you're long $100 million in the loan, and you've hedged $50 million, you're going to force a bankruptcy if the protection you purchased has no built-in restructuring concept. Otherwise, you won't be able to recoup the economic value of the purchased hedge. That damages the overall system. When you go through a bankruptcy, rather than a restructuring, it's not just the value of the swap that's affected. The bond market and the equity market are affected. Anybody holding instruments of that borrower could be harmed.

The other point in this discussion involves the consent of borrowers. If the derivatives market evolves away from the restructuring provision, and banks are perceived as having more of an incentive to cause a bankruptcy in order to get paid, does that cause problems in delivering the underlying loan? Borrowers won't allow their loans to be assigned. I think the general belief is that there is value in the restructuring provision—but how to value that, and how a dealer or an end-user hedges that risk, is a complicated issue.

Generally, banks are going to be the holders of loans that would have the restructuring capabilities. So if the deliverable for a settlement under a restructuring event is limited to the restructured loan, with some reasonable tenor limitations, and not the proverbial 30-year bond, real value has been given to the writers of default protection. They would settle on a superior instrument in terms of loan recovery and maturity by receiving a loan under a restructuring event. In return, they will have given up some value and assumed some basis risk by accepting a restructuring contract provision. Do those perfectly offset one another? I can't say quantitatively, but I believe it's a reasonable economic value for both parties.

Elizabeth Gile: I agree with what's been said. By way of background, we at J.P. Morgan are active users of credit derivatives to hedge our credit exposures. We have roughly $30 billion in notional contracts in North America alone, of which $10 billion are single-name default swaps. Having the restructuring language in the spotlight is good for the whole market, because it encourages investors and hedgers to better understand the risks they own. And I don't think it was as clear up until now—or at least not as obvious as it now is to all of us.

"Clearly, a contract without a restructuring definition could limit the appetite of bank portfolio managers to hedge loans.” — Elizabeth Gile, J.P. Morgan

Clearly, a contract without a restructuring definition could limit the appetite of bank portfolio managers to hedge loans. This is because loans are usually carried under accrual accounting, so banks think of these contracts as hedges—not in terms of the mark-to-market value of their portfolio, but as insurance contracts to cover themselves in times of severe credit distress or default. However, it is worth noting that a spate of companies that have recently filed for bankruptcy did not go through a restructuring, and so a credit derivative contract without restructuring would have provided effective "insurance” for both mark-to-market and accrual assets.

At J.P. Morgan, we use credit derivatives to hedge not only the default risk in our accrual loan book, but also the market-value fluctuation of some of our credit assets that are marked to market. And there, credit derivatives without restructuring have worked well. It would be terrific if we could have one market standard for the credit derivatives market with respect to restructuring, but what I'm most in favor of overall as a hedger is a liquid market.

Anthony Urick: The issue is that the lack of restructuring language could result in the forcing of an early bankruptcy if an issuer gets into financial difficulty. If there's no restructuring language in contracts, there could be a massive asset transfer from the lender and common equity community to the lawyers, accountants, advisers, restaurants and airlines—as all the deals that get into trouble go immediately into bankruptcy. Bankruptcy is probably the most expensive way to settle any issue in this market. I've been on both sides, in both workouts and bankruptcies, and bankruptcy is probably 10 times more expensive. If you want to see assets disappear rapidly, just go into Chapter 11—a significant portion of the assets go to the advisers.

Joe Kolman: This seems to introduce a different kind of counterparty credit risk, almost a moral hazard. If I went to a dealer and didn't realize who was on the other side, I would be in the situation of having that person controlling whether something gets restructured or not. How do you control the moral hazard on that side?

Frost: In some respects, the moral-hazard issue will be self-correcting. If the market, or at least one institution, uses credit derivatives to hedge its loans without restructuring, and starts invoking that moral hazard by throwing companies into bankruptcy and not cooperating with the lending group just to get paid out on a credit derivative, borrowers will smarten up pretty quickly. It can only happen once or twice to an institution before it gets shut out of what is still a clubby market, both from the investor side, to whom they sell the loans, and from the borrower side, to whom they lend.

Kennaugh: There are actually two moral hazards in this issue. One is that perfidious banks may go around capriciously exercising their credit derivative transactions where in fact no tangible event exists…

Frost: For some people this is a new business opportunity. (Laughter)

Kennaugh: …There is also the hazard that one buys protection from a counterparty and the counterparty objects to the contract because of the restructuring event and refuses to honor it. Fortunately, this doesn't happen often. But there is one well-documented case about failure to pay—in which one party refused to acknowledge the contract—and the case ended up in the British high court.

Philip Prince: The first question to ask is, "Will banks, in the course of pursuing their own enlightened self-interest, do what from a bondholder's perspective is the smart thing in terms of restructuring?” That raises the notion that the restructuring process creates value for everybody by avoiding a transfer of wealth to lawyers and accountants. The bankers, bondholders and people who write protection are all on the same page in that regard. That is why bondholders routinely accept that risk by permitting bond issuers also to borrow from banks that typically enjoy tighter covenants than the bondholders—which, in effect, gives those banks the ability to make the decision to restructure a loan or put a company into bankruptcy without any bondholder input. Consequently, the moral-hazard issues of including restructuring as a credit event and owning unsecured bonds issued by a company with bank lenders is not very different.

Francis: I think the moral-hazard issue actually gets a little thornier in bilaterals. In a large syndicated deal in which, say, 50 banks are involved, I would argue that you don't have to worry much about the moral-hazard question. I am sympathetic to the question, "If it's a bilateral contract, how can I have confidence?” I'm not sure how to resolve that, but that's different from a broadly syndicated transaction where you have true transparency.

"If you go down the road with no restructuring, you create a paradox. Simply stated, more bankruptcies will occur. That damages the overall system.” — Zed Francis, Bank of America

Kennaugh: The problem is in quantifying things. Good old Keynsian market forces could work the whole thing out. Hedgers that require restructuring may find that they don't require it quite so ardently when protection with restructuring is quite expensive, compared with protection without—and therefore they may simply put a price on where they're prepared to accept that basis risk.

Similarly, if a protection seller can get a good bid for protection with restructuring, it may choose to accept the additional hazard that ensues, and the market could work itself out in real trade. We as market-makers could have a specialist sitting on the desk whose job it is to trade the basis risk, and we could have the quants model it up. We're just not there yet.

Francis: On trading desks, if you're trying to model that basis risk to know whether you would get a bank loan with a maturity similar to the original tenor of the contract—vs. a 30-year bond—there's real value there. But how would you value the benefit of the tenor limitation of a deliverable bank loan with one finger, while you value the implicit cost of including the restructuring option with the other finger?

Kennaugh: That leads us back into the argument that some people compromise when the restructuring event is tightened up and when there is some restriction on the deliverable obligations in the form of maturity. Honesty checks might be the way forward.

Gile: How do we get there?

Bob Pickel: I think it's a combination of a couple of things. One is how the market develops over the next few months. If these alternatives are explored, a consensus in the marketplace could develop. At ISDA, we're looking at pulling together people from different perspectives to look at whether there's a basis for compromise. We've typically followed the market in documentation processes—we've tried to reflect the way the market comes out on an issue. But I don't know whether we have the luxury of waiting this time.

Kennaugh: Right now we might have a slightly artificial picture of the effect this issue has had on the market. On the one hand, many people are spending more time arguing about the restructuring issue than they are on trading. On the other hand, there are many dealers who own protection on their books with restructuring—simple, outright short risk positions, which they're prepared to offer to the market with the event and charge the arbitrary 5 basis points. Once this has been worked out and you're ready to choose whether to take on a new position selling protection with restructuring or without it, that's when you have to start thinking hard about the basis risk you're assuming and how you're going to price it. And that's probably some way off.

"The first question to ask is, ‘Will banks, in the course of pursuing their own enlightened self-interest, do what from a bondholder's perspective is the smart thing in terms of restructuring?'” — Philip Prince, Chase Securities Inc.

Also, I think many people in the market are now motivated to sort this out. There is a lot of background work being done, with people taking a step back—really looking at identifying the real needs vs. the desires, so that they can peel the issue back to its essential elements. If we get to that stage and there's still a mismatch between the needs of investors and the needs of hedgers—and it's impossible to come up with a compromise—I think we will have a real problem on our hands. Unless, of course, pricing is the solution, and everyone is prepared to live with the basis risk.

Richard Williams: The biggest difficulty at the moment is that with so many people in the market, it's difficult to focus the conversation of a large meeting of market participants in any one direction. I've had lots of bilateral conversations recently, and they were all fairly similar—substantially heading in a compromise direction—but as yet there's no synthesis of this into a new agreed-upon form.

Urick: This has already been done in the bond market. For years the public bond market was a highly liquid, no-covenant restructure market, and the private bond market for years was a low-liquidity, high-degree-of-covenant restructure market. The two existed side by side, and there was a price differential. The market has done it before.

Pickel: You can't minimize these bilateral discussions. One suggestion has been to try to put together a paper that lays out the alternatives thrown out in the marketplace, and to talk about the pros and cons. We will do that. Moreover, dealer institutions have recently put their flag in the ground as to what their view is. I'm not sure we have such clear and definitive statements from other groups like portfolio managers and investors, but I want to encourage people to get together to clearly identify their needs and views.

Hetty Harlan: I wish we could convince people that restructuring isn't a problem. Restructuring is your FRIEND. It is about preserving value. You don't want a default; you don't want bankruptcy. Those are value destroyers.

Christopher Walvoord: If restructuring is a good thing, then that's not a risk you need to hedge, so we don't need to include it in these contracts.

Harlan: If it's not there, then I'm going to have to push for default, because my job is to hedge credit losses and, in your scenario, the only time I can recover the lost loan value is when a default triggers payment under the credit default swap contract.

Let's face it, restructuring is better for everyone. The company's problems can be worked out over time, the company may recover, and then you recover your loan—whereas if I hand you something in a default situation, you will probably realize a heavy and permanent loss.

Walvoord: So we all agree that the problem with the current documentation is not that we have a restructuring definition and preserve some value, but that the option exists to deliver something other than the restructured loan?

Harlan: Yes. The moral hazard issue needs to be dealt with. If we can deal with the deliverable obligation, I think we can get to a good place and have a robust, growing market.

Walvoord: If that happens, we would certainly consider including restructuring. It's a matter of defining this distress—defining exactly what the risk is that you're transferring to the investor.