US CREDIT-US banks face higher capital needs on CDS change

By Karen Brettell

NEW YORK, Jan 9 (Reuters) - U.S. banks may need to increase
the amount of capital they hold after changes are introduced to
credit default swap contracts, which the banks use to hedge
against defaults on corporate bonds and loans.

Credit default swaps are used to insure against a borrower
defaulting on their debt or can be used to bet on a company's
credit quality.

A protection buyer can be paid out the insurance when a
borrower files for bankruptcy, fails to make an interest or
principal payment on their debt or, in some cases, when a
company restructures its debt.

Changes expected to roll out as early as next month,
however, will remove the restructuring trigger for standard
contracts in North America. Buyers of protection may still
request restructuring triggers in tailored trades, although it
would cost more.

The changes will standardize contracts on single company
debt with those on indexes, which do not include restructuring.
Standardized contracts are part of an industry push to set up a
central clearing system for the $47 trillion CDS market.

The changes will also remove confusion over how to settle
contracts paid out on a restructuring, which could be
significantly more complicated to close out than those sparked
by bankruptcy or failure to pay.

For banks, however, the move may prove expensive. It will
reduce by 40 percent the capital relief awarded by using use
CDS to hedge bond and loan holdings, said Bank of America
analyst Glen Taksler.

"The downside to removing restructuring is that banks get
full capital relief from buying CDS with restructuring, but
only 60 percent capital relief without restructuring," Taksler
said.

A protection buyer wanting to include a restructuring
trigger in a CDS contract would pay a higher premium of 2 to 10
percent than if they bought a contract without restructuring,
based on market valuations, Taksler said.

Banks may react to the change by selling bonds and loans,
which could pressure their valuations.

"In the absence of regulatory capital relief, it is
possible that banks that buy bonds, or lend loans, and buy
protection may find their capital requirements increase
significantly," Taksler said.

"Given current capital constraints, this may force the
unwinding of some existing cash positions," he said. "The
result would be wider bond spreads and lower loan prices."

Market participants are in discussions with regulators with
the hope of removing or reducing the penalty for excluding
restructuring as a trigger in contracts, said a person familiar
with the discussions who declined to be identified.

STANDARDIZATION

"Right now, if you try to net index and single name trades,
you're left with restructuring risk because one contract has
restructuring and the other doesn't," said Sivan Mahadevan,
head of credit derivative and structured credit research at
Morgan Stanley in New York.

Credit derivative dealers have large portfolios of trades,
in which they both buy and sell protection on corporate and
other debt.

As defaults increase, banks have been simplifying these
portfolios by reducing their offsetting positions, a process
known as netting.

"Given how important the indices are and how much trades
there, netting between the indices and the single names would
be so much easier," said Mahadevan.

Restructuring is also complicated as it makes the
incentives different for the protection buyer and the
protection seller, said Karel Engelen, head of technology
solutions at derivatives trade association, the International
Swaps and Derivatives Association.

This is because the debt backing the contracts is different
depending on whether the protection buyer or the protection
sellers calls payments on the contracts.

If a protection buyer seeks to be paid out after a
restructuring they are only able to settle the swaps with debt
that has a similar maturity as the swap. If a protection seller
triggers payments, debt of any maturity can be used.

"If the incentives to trigger on the buy and sell side are
not identical, then it becomes a lot more difficult for a
central counterparty to manage those two trades," Engelen
said.