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FAIR USE ONLY
How Credit-Default Swaps
Are Used to Predict Trouble
By HENNY SENDER
Staff Reporter of THE WALL STREET JOURNAL
This burgeoning but little-known market for credit-default swaps
(essentially, insurance that lenders and big bondholders, among
others, can buy to protect against a borrower defaulting on bonds)
has proven to be an effective early indicator for disasters-in-
waiting. To many who follow this market, it is better than a
company's stock and bond prices. The price of this insurance often
goes up sharply in the several months before a corporate debacle,
as it did in the case of both Enron Corp. and WorldCom Inc.
Now, for those who see this market as an indicator, credit-default
swaps are signaling troubles ahead for several telecommunications
companies, most notably Sprint Corp. In recent weeks, the cost of
buying protection against a default by Sprint has soared. Other
firms -- AT&T Corp., AT&T Wireless Services Inc. and Qwest
Communications International Inc., which is facing investigations
about its accounting -- also show up on the radar screen.
Recently, they have been joined by media companies such as AOL Time
Warner Inc. that also have been hard-hit by investors' rising alarm
about heavy debt loads, along with a variety of companies such as
energy business AES Corp. To be sure, it is dangerous to read too
much into the credit-protection prices when the overall markets are
as spooked as they are today.
In short, this is a market where banks, bondholders and other
corporate creditors act not too differently from homeowners wanting
to protect themselves financially from a worst-case scenario, such as
a fire burning down the house. In this case, the big guys are seeking
insurance not for their homes but for the bonds and loans they hold.
The market's name is a bit of a misnomer: it's more about insuring
against exposures to defaults than actually swapping them.
Say, for example, an investor is holding Sprint bonds valued at $10
million and is nervous about the solvency of that company in the wake
of meltdowns in the general industry. As recently as January, this
investor could obtain protection against a default by Sprint for one
year for about $150,000. The price of protection started rising in
February. By April, the price had risen to $400,000, and by June, it
was much harder to obtain and had risen in cost to $900,000.
"Over the past few weeks, pessimism has gotten tighter and affected
other companies," says a spokesman for Sprint. "But nothing has
changed at Sprint. We continue to improve our financial flexibility."
Because there is no exchange, most individual investors can't easily
access information about credit-default swap prices, except by asking
their brokers to check with the credit-derivatives desk at their
brokerage firm. For big investors this is more-easily done, and
growing numbers are paying attention to the market because it "has
enormous value as a lead indicator," says Allen Yarish, head of
credit derivatives at Royal Bank of Canada in Toronto. "Ignore it at
your peril." Adds Jeremy Barnum, head of North American credit-
derivatives trading at J.P. Morgan Chase & Co: "This market is better
at reflecting the totality of opinion on any credit than more
traditional markets."
Whatever Sprint's fate, the pricing in the credit-default swap market
proved to be very prescient in the case of both WorldCom and Enron.
In the days before the telecommunications giant revealed a $3.8
billion accounting irregularity, its shares traded at a couple of
dollars each and its $26 billion in bonds traded anywhere from 44
cents to 77 cents on the dollar. But even months before the June 25
disclosure of what could be the largest corporate financial fraud,
the credit-default swap market was signaling distress, as players
were focused on WorldCom's enormous debt burden, nervous about its
ability to make good on bonds that would begin maturing in January
2003. The demand for credit-default protection had soared with almost
nobody willing to take the other side at levels that made economic
sense.
"The bet with WorldCom was when it would default, not if," says Boaz
Weinstein, global head of investment-grade credit-trading risk at
Deutsche Bank. While WorldCom hasn't since defaulted even as it moves
closer to a possible bankruptcy-court filing, its shares have joined
the penny-stock club and the bonds now fetch about 16 cents on the
dollar.
The same for Enron. Even before the energy company lost its
investment-grade status last fall, just before its free fall into
bankruptcy-court protection amid myriad accounting issues, the demand
from lenders and creditors for protection against a possible Enron
default was so great that the price was far higher than it should
have been given its then-high credit rating.
>From a small group of banks, notably J.P. Morgan Chase and Deutsche
Bank, players in the credit-default market now include a wide range
of securities firms, investment funds, insurers and reinsurers. The
big banks tend to both buy and sell the protection, even as they also
hedge their own exposure to corporate clients. Others, such as hedge
funds, often take one-way bets, usually by selling the protection.
Estimates of the market's size are imprecise. But according to people
in the market, there is about $900 billion in the equivalent of
insurance premiums outstanding -- not bad for a market that is less
than seven-years old.
If there is one message the market has been signaling recently, it is
massive aversion to debt, especially when held by companies whose
assets may not be all that tangible. After WorldCom's disclosure of
the accounting debacle, buying protection on just about every company
in the telecommunications world and related spheres, such as media,
soared. But patterns were there. For example, while all telecom
companies were hard hit, the cost of protection against defaults by
AT&T, AT&T Wireless and Sprint has risen far more than for SBC
Communications Inc. or Verizon Communications Inc. That reflects the
market's view that the sources of revenue at the former group are
less stable than at the latter two companies.
For Sprint, the price of credit-default protection seems unusually
steep given that the company is still rated investment-grade, albeit
just barely. In early June, Moody's Investors Service downgraded the
company's $22 billion of debt to one level above junk. Moody's cited
concern about the cash drain of wireless operations at its Sprint PCS
Group, inadequate cash balances and the fact that it "will not
generate material free cash flow as a percentage of total debt until
2004," even as it expects Sprint to complete a new revolving facility
and renew its accounts-receivable securitization program.
"If a company has negative cash flow and lacks liquidity, it may not
be able to control its own fate," says Steven Zamsky, a credit
analyst with Morgan Stanley. Adds David Barden of Banc of America
Securities: "The phone company generates cash flow, but PCS is a net
borrower, and in this market that is not a great thing." The Sprint
spokesman says comparisons with WorldCom are "faulty."
AES, meanwhile, didn't raise red flags with its $5.5 billion in
parent-company debt and $18.7 billion in debt on individual projects
back when it had $30 billion in stock-market capitalization. But
today, its market capitalization is only about $2 billion, and that
makes it a "red light" company, said Mr. Zamsky, meaning that credit-
default protection is now far too expensive to buy.
"We are being painted with the same brush as energy-trading
companies," says an AES spokesman. "But our business is totally
different. We have long-term contracts. We are not energy traders."
Then there is the case of AOL Time Warner. Protection against an AOL
Time Warner default became dramatically more expensive in recent
days, but some dealers say the lurch in price was partly because
banks extending the company $10 billion in new credit lines were
buying protection, creating a sudden surge in demand. In the past,
banks used to sell down their lending exposure in the secondary loan
market; now, they often prefer to hedge exposure to big borrowers in
the credit-default swap market. The AOL protection price has receded
a bit of late.
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