Ratings users beware: using information from the credit default swap market to validate credit assessments.
The Dodd-Frank Wall Street Reform and Consumer Protection Act introduced a number of useful reforms to the ratings industry, such as tighter oversight and several specific provisions to mitigate conflicts of interest. These issues have been the subject of reform efforts in the past, notably in the wake of the Sarbanes-Oxley Act of 2002 (see, for example, the SEC's "Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities Markets," January 2003). Recognizing the limitations of the ratings system, regulators and other market observers have urged reducing the market's reliance on credit ratings. Concerns about overreliance on ratings are not new. For example, in 2000, the Bank for International Settlements addressed alternative credit measures in its working paper, "Credit Ratings and Complementary Sources of Credit Quality Information." Clearly, the difficulty and sensitivity of credit assessment call for the development of effective and transparent means of validating the credit grades provided by the agencies. But where can professionals turn for alternative, independent risk measures?
The authors believe that the credit default swap (CDS) market, a huge but still somewhat obscure sector, offers a valuable and much-needed alternative tool for measuring credit risk and risk trends. Despite the esoteric-sounding name, a credit default swap is simply an insurance policy against bond default. In exchange for a fee, the owner of a CDS receives the full principal amount in the event that the issuer of the insured bond goes into default. Like any insurance policy, the price of a CDS varies directly with the risk of the insured bond. While credit ratings reflect the complex and often conflicting objectives of credit ratings agencies, the credit default swap market operates quite differently. In CDS transactions, buyers and sellers have to put their money where their month is: Prices paid and received represent market participants' best, up-to-the-minute estimates of the financial risk of issuer default. In principle, then, CDS prices can claim to provide an objective, market-based, and up-to-date alternative to credit ratings. But finding the information and using it effectively can require considerable effort.
What Do Ratings Really Mean?
The most striking thing to emerge from the CDS market is the wide divergence in risk among issuers having identical credit ratings. Such differences do exist, however, and are too large to ignore for professionals responsible for implementing and validating consistent credit standards.
As indicated in Exhibit 1, Exhibit 2, and Exhibit 3, debt issuers with the same credit ratings have dramatic differences in underlying credit risk, as measured by the CDS market, with these differences strongly associated with market sector.
EXHIBIT 1 Credit Default Swap Prices for A-rated Debt, by Industry Sector, 9/27/10 Industry Credit Default Swap Price Banks and Brokers 193 Other Financial 144 Basic Industries 73 Consumer 65 Note: Table made from bar graph. EXHIBIT 2 Credit Default Swap Prices for AA-rated Debt, by Industry Sector, 9/27/10 Industry Credit Default Swap Price Banks and Brokers 102 Other Financial 126 Basic Industries 79 Consumer 55 Note: Table made from bar graph. EXHIBIT 3 Credit Default Swap Prices for BBB-rated Debt, by Industry Sector, 9/27/10 Industry Credit Default Swap Price Banks and Brokers 274 Other Financial 261 Basic Industries 189 Consumer 156 Note: Table made from bar graph.
For example, single-A-rated banking-related obligations are more than twice as risky as single-A-rated industrial or consumer sector bonds. This discrepancy flies in the face of common sense, which says that one single-A-rated security should have at least similar default risk as others with the same rating. Additionally, the averages shown in Exhibit 1 obscure significant variation within industry sectors. For example, among A-rated basic industries firms, CDS pricing ranged from $34 to $90. Exhibit 4 indicates that the disparities by industry sector are relatively new, beginning with the onset of the financial crisis in 2007.
What is surprising to us, and relevant to anyone interpreting ratings today, is that such disparities on the part of the credit ratings agencies continue even now, despite the considerable public uproar over ratings quality. While ratings agencies such as Moody's now make distinctions between the meaning of an A-rated structured debt product and an A-rated corporate bond in their official guides, they provide no such distinction or warning about sector differences among corporate obligations. Market-based evidence from CDS pricing suggests that these distinctions are both significant and persistent.
The fundamental message for accountants and other financial professionals is that ratings can fail to reflect major disparities in risk. An ancillary message is that investment policies or practices that rely primarily on ratings can mask significant inconsistencies in actual risk exposure.
At the same time, the CDS market has attracted its own share of negative press. For example, financier George Soros has criticized the destabilizing effects of speculation on weakening firms, and suggested that the purchase of CDS contracts be limited to owners of the underlying bonds. While speculative forces can affect CDS prices, this potential exists for any market and does not by itself negate the prices' informational content. Like any measure, CDS prices should not be used as the sole criterion for credit assessment and, like any market input, should be interpreted with care (see the Sidebar). In the authors' view, however, the size and maturity of the CDS market have reached a level where its signals cannot be ignored.
Where to Find Prices
The CDS market is large and well established. For example, among a group of 29 major banks recently surveyed by Fitch Ratings, annual trading volume in CDSs exceeded $10 trillion. Yet the market is still largely invisible outside the relatively small circle of direct participants. Extensive price information does exist, but is generally available only through expensive institutional data services such as Bloomberg, or through portals offered by broker-dealers to large customers in exchange for their trading business. For the ordinary accountant, access to this information is difficult, but not impossible--if one knows what to ask for. Larger accounting firms typically now have in-house valuation capabilities with their own market data subscriptions. A client company is also a potential source of information, because any business with a substantial investment portfolio is likely to have access to one or more major data services.
Users of CDS prices should also gain some familiarity with the sources and limitations of pricing information (see; Sidebar). The Dodd-Frank Act calls for the Commodity Futures Trading Commission and the SEC to promulgate rules for real-time public data reporting of swap transactions, including price and volume. The development and implementation of these reforms are likely to take some time; however, the resulting improvements in price availability and transparency should greatly expand the use of CDSs and other derivative prices in auditing and financial analysis. While data access remains a challenge for now, the insights to be gained are well worth the effort.
Lessons for Financial Professionals
The data presented earlier suggests that credit ratings and credit ratings agencies continue to have problems, even after recent increased scrutiny of the industry. What is the lesson for investors, accountants, and auditors?
At a macro level, financial professionals should advocate for ongoing efforts to increase the transparency of the derivatives markets and financial markets in general. As indicated in Exhibits 1 and 2, the market for credit default insurance clearly suggests that ratings system failures are continuing. While the Dodd-Frank Act promises substantial reforms, the timing, scope, and ultimate effectiveness of its provisions hinge on many as-yet-undetermined implementation issues. The act itself is merely the beginning--rather than the culmination--of the efforts needed to achieve its objectives.
At a micro level, investors, accountants, and auditors should seek out CDS information and gain familiarity with the market as a way to validate ratings and assure that actual risk levels do not exceed those indicated. By relying on credit ratings to set investment policy, companies may be investing in some securities that arc riskier than the company is willing to tolerate. Conversely, inconsistent ratings may lead firms to forgo investing in some securities that are within their intended risk limits. CDS prices can alert investors, accountants, and auditors to inconsistent or out-of-date credit ratings, providing information about credit trends that are not reflected in the relatively infrequent event of a rating downgrade or upgrade.
New users should educate themselves about the credit default swap market. CDS prices are far from a foolproof indicator. Prices can be affected by a number of technical factors in addition to credit risk, and indicative quotes are available (at this time) only through limited, institutional-investor-only information services. Users should understand the basics of the market, such as how prices are generated and how prices may be affected by limited liquidity or temporary market conditions.
A Useful Tool
Despite the recent increased scrutiny of credit ratings and credit ratings agencies, the authors' analysis shows that discrepancies in credit ratings continue. The passage of the Dodd-Frank Act is one step toward imposing discipline on credit ratings agencies. Notwithstanding ongoing efforts at reform, the ratings system will never be perfect. Indeed, credit assessment is too critical and too complex to hinge on any one measure alone. The CDS market holds considerable promise as a clear and independent alternative to ratings, as well as a means of providing market discipline for the credit ratings agencies themselves. With extensive price history dating back to at least 2004, and with annual notional trading volume currently exceeding $10 trillion, the market has attained a level of size and maturity sufficient to make it a robust and meaningful tool.
Useful information on CDS pricing is available right now, but few know where to look for it or have sufficient familiarity with the market to use the information with confidence. With broader awareness of the market, and hoped-for improvements in pricing availability, credit default swap pricing should count among the basic set of credit assessment and validation tools available to the financial profession.
RELATED ARTICLE: WHERE DOES THE PRICING INFORMATION COME FROM--AND CAN IT BE RELIED UPON?
The CDS market for major corporate names is large and quite mature, with many banks and investment firms acting as market makers (e.g., running proprietary trading desks that both buy and sell contracts). These trading desks provide daily pricing information on CDS names they cover to data aggregators, who compile the information for sale. This is usually a reciprocal relationship, whereby the trading desks receive the surveyed information back from the aggregator in exchange for supplying their prices. Other pricing firms, such as CMA DataVision (which currently supplies Bloomberg its CDS quotes) use surveys of major buy-side firms.
How reliable is this price data? Most market participants would say that it is generally quite good for investment grade (BBB and higher) issuers included in the major data services. However, some caution is in order. The prices are averages of indicative quotes provided by dealers and buy-side firms; thus, they do not necessarily represent actual transactions or active bids or offers. Therefore, the prices that the public sees depend entirely on the dealers that provide them. If a name is thinly traded or not of particular interest to a participating dealer, pricing quality may suffer.
Active trading usually provides one of the best barometers of price reliability; however, dissemination of detailed trade volume information will have to await implementation of the clearing and reporting provisions of the Dodd-Frank Act. Several tradable indexes now exist for different categories of credit default swaps (for example, Markit Group's CDX index). CDS prices for issuers included in these indexes (numbering several hundred issuers over a variety of different indexes) are particularly well-traded, enhancing price quality. CDS prices for below-investment-grade issuers (BB and below) may lack the liquidity of higher rated issuers and, therefore, should be interpreted with caution. Infrequent trading in these names means pricing may be out-of-date; low trading volume also increases the potential for price manipulation. Professionals should be aware that such cautions apply to virtually any market price, whether it be derivatives, debentures, mortgages, or equities. The CDS market seems particularly challenging because of its newness and relative obscurity. However, the educated consumer of CDS prices can find rewards in the form of a direct market measure of loss exposure from default--the essence of credit risk.
James M. Cataldo, PhD, and Alex C. Yen, PhD, CPA, are assistant professors of accounting at the Sawyer Business School, Suffolk University, Boston, Mass. The authors are grateful for the helpful comments of Paul Pustorino and Tracey Riley, and for the research assistance of Donglin Li and Li Xu.
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|Title Annotation:||markets & investments; Credit default swaps; Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010|
|Author:||Cataldo, James M.; Yen, Alex C.|
|Publication:||The CPA Journal|
|Date:||Jan 1, 2011|
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