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.
"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.