Short change

Brad Pitt: star of The Big Short

“You just bet against the American economy and if you win hardworking people will suffer,” says Brad Pitt’s character Ben Rickert in the 2015 film The Big Short. In a line designed for laymen, he is explaining what a credit default swap (CDS) does. Rickert was based on a real-life banker called Ben Hockett, who founded Cornwall Capital and, along with a group of other hedge fund managers, made billions betting against sub-prime mortgages in the run up to the 2008 global financial crisis.

At the end of September, the Chinese central bank unveiled a new form of CDS to give domestic credit markets a better tool to hedge against risk at a time of rising bond defaults. Unsurprisingly, the announcement has prompted some apocalyptic headlines in the national media, which remains highly conscious of the destructive role the instruments played in the West’s financial meltdown.

Jilin-based Nangou Morning Post even references The Big Short and notes how some brokers have been issuing explanatory reports based on investors’ poor understanding of the swaps. “The biggest killer has been approved,” it quotes one as saying. China Daily added that some took the view the CDS could be used to pop China’s property bubble (by going short the bonds of property developers).

CDS instruments are the bond market equivalent of short-selling equities since they can be traded on the basis of an issuer’s bonds falling further. In their pure form, they provide an insurance contract for bond or loan holders hedging against default. In their naked form, however, a CDS holder does not need to own the underlying credit in question and this can have a particularly adverse effect on bonds if a large short position develops, creating a plunge in price as confidence drops.

As we wrote in WiC79, the Chinese regulators came up with their own form of CDS structure with “Chinese characteristics” in 2010. These derivatives were called Credit Risk Mitigation Warrants and Credit Risk Mitigation Agreements but never got off the ground.

The Global Association of Risk Professionals (GARP) estimates only 60 CRM instruments were ever written with notional value of Rmb5 billion ($750 million) compared to the Rmb100 trillion-plus size of China’s credit markets. Some believe they didn’t take off since Chinese institutions didn’t think they needed the hedging tool because the government always stepped in whenever a company was set to default.

This view may have changed following 45 defaults totalling Rmb26.81 billion so far this year. But Haiyun Zhang, co-director of GARP’s Beijing chapter, believes this is a misreading of the situation as most Chinese credit is loan-based and banks have to manage their own NPLs.

Zhang thinks CRMs were unpopular because of their Chinese characteristics – only allowing a CDS to be referenced against a single loan or bond rather than multiple ones. This has now been changed, bringing China into line with international standards.

But a number of unknowns remain. As many commentators point out, the full legal framework, plus settlement and trading procedures have yet to be ironed out. What, for example, constitutes a default event in a country where defaults are not hard and fast, with market participants often waiting months for a white knight to appear?

And how will market participants price a CDS given the inadequacy of risk pricing in the underlying market (i.e. the small spread differential that still exists between China’s best and worst credits, although it is getting wider by the month)? One asset manager tells the International Financing Review he doubts the underlying markets are liquid enough to support the swaps with trading in individual bonds often thin.

That is possibly just as well. As China’s leveraged stock market crash of 2015 showed, Chinese investors have a propensity to act en masse and the tsunami of money behind them can wreak havoc when it is funnelled down the same channel. But Liu Dongliang of China Merchants Bank tells Bloomberg the new amendments are, nevertheless, a welcome step forward. He also concludes the market is entering a new stage of maturity; one where the government “will be under less pressure to bail out many of the troubled companies”.

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