1 Introduction
The credit default swap (CDS) market is often regarded as one of the most influential financial market innovations to occur in the past 20 years.⁴ Despite its size,⁵ importance, and development, very little public information is available about how financial institutions use CDSs as investments or credit risk hedges. To better understand how derivatives are used requires, at a minimum, knowledge of the specific derivative transactions the institution undertakes as well as the institution's securities and loan portfolio. Extant research on how banks use derivatives has been conducted at the aggregate level because matching specific derivative transactions data to underlying credit exposure has been unattainable.⁶

This note uses a unique dataset that matches banks' securities and loan portfolios to bank credit derivative transactions to characterize the basic features of how the largest banks in the U.S. use the single name CDS market in their investment portfolios. Specifically, we combine data collected through the Comprehensive Capital Analysis and Review (CCAR) and the Capital Assessments and Stress Testing Report (FR Y-14Q Report) with transactions in corporate single-name CDS market from the Depository Trust & Clearing Corporation (DTCC).

We first provide descriptive reference entity characteristics for firms with and without traded CDS on their debt issuances (CDS and non-CDS firms, respectively). Consistent with current research, CDS firms tend to be larger and are generally higher-quality than non-CDS firms. Turning to banks' use of CDS, we find that CDS positions are quite large compared to the direct credit exposure of the CDS reference entities. We also find that banks tend to sell more credit protection than they buy for the firms in their loan and securities portfolios, which is the opposite of what one would expect if the only reason to use CDS were to hedge credit risk. Lastly, we document a distinction between how banks use the CDS market based on whether the bank issues loans to a firm, owns bonds issued by a firm, or has a combination of a firm's loans and bonds in its portfolio. Specifically, banks are net sellers of credit protection across priority-risk categories for their loan exposure. For their bond exposures, banks are net buyers of credit protection against secured bond holdings and net sellers of protection against unsecured bond holdings, which also runs counter to a hedging motive.

2 Data Description
We use two main data sets for our analysis. We obtain the loan and bond holding data for 31 of the largest U.S. bank holding companies (BHCs) from FR Y-14Q report. The report is collected on a quarterly basis and contains asset class and capital component data for the BHCs with total consolidated assets of $50 billion or more.⁷ For the purpose of our analysis, we use the Wholesale Risk (Corporate Loan Data) and the Securities Schedules from Q3:2011 to Q4:2015.⁸

The Corporate Loan Data Schedule (Schedule H) collects loan level details on corporate loans and leases that are held for investment or for sale by the BHCs at each quarter-end. The population of loans is reported at the credit facility level.⁹ If borrowers have multiple facilities from the same bank, each facility is reported separately. The data contain obligor and loan specific characteristics, including bank level assessments of obligor financial health. Our loan sample is limited to commercial and industrial loans with a committed balance greater than or equal to $1 million, issued to non-financial domestic firms.

The Securities Schedule (Schedule B) collects portfolio position data for individual securities that are available-for-sale or held-to-maturity. The BHC positions of each security are reported as amortized cost, market value, current face value, and original face value. We select only corporate bonds issued by domestic non-financial corporations.¹⁰

Panel (a) in Figure 1 shows the time series of the total amount of loans (committed and utilized) issued by all the BHCs during our sample period. We notice that both the amount of credit extended by the banks and the amount of credit utilized by debtors are growing at similar rates. The large jump in both variables in the second quarter of 2012 is the result of additional banks being included in the CCAR supervisory exercise. As shown in panel (b) of Figure 1, the market value of the banks' corporate bond portfolios is steady from 2011 through the first half of 2012, averages around $75 billion, and then begins to decline and level off at around $30 billion by the end of 2015.¹¹

We obtain weekly outstanding CDS transactions written on U.S. firms from DTCC Trade Information Warehouse (TIW).¹² From the overall data reported through TIW, we can only observe transactions for which at least one counterparty, or the reference entity, is a FRB-regulated entity, or a FRB-regulated entity acts as the clearing agent. Each record includes information about the name of the reference entity, trade date, effective date, contract maturity date, the names of the counterparties participating in the transaction, including their type (dealer vs. non-dealer entity), the notional amount,¹³ the market sector to which the reference entity belongs, and other information specific to the contract. For each lender-reference entity pair, this database allows us to compute the notional amount of CDS protection bought and sold over time.

First, we combine the weekly outstanding CDS transactions executed by each of the BHC affiliates' and subsidiaries' accounts. Next, we compute the notional amount of CDSs bought and sold by each counterparty for all reference entities.¹⁴ We define the notional value of the net position that each counterparty holds on a reference entity as the difference between the amount of protection bought and sold.

In Figure 2, we plot the total notional value of the net CDS positions, the value of utilized loans, and the market value of outstanding bonds held by CCAR banks at the reference entity level. Because we compare CDS use to credit exposure, we reverse the sign of the total net positions so that a positive number represents the net amount of protection sold. The first thing to note is that the size of total net protection sold is generally larger than the size of direct credit exposure. Second, the utilized loan amount grows similarly to the overall utilized loan amounts in Figure 1. Third, the notional value of net protection sold on single name CDS contracts largely tracks the trajectory of the utilized loan amounts until the beginning of 2015. The growth in the notional value of net protection sold suggests that the banks were selling more protection against their obligors as the obligors were utilizing more of their loans. These data are in line with the results of Campbell and Gallin (2015). The authors document that banks and dealers are typically net sellers of single name credit protection, while hedge-funds and mutual-funds are net buyers of credit protection.

Lastly, the market value of bonds issued by CDS firms declines similarly to the market value of the overall bond issuances held by large U.S. banks shown in Figure 1. The decline in bond portfolio values and the rising utilized loan exposure indicates there may be some substitution between how the banks construct their portfolios across the loan and bond markets.

We use DTCC data to split the sample according to whether or not debtors in the FR Y-14Q data have CDS contracts (CDS Firms) or not (non-CDS Firms). Specifically, we define "CDS Firm" as a firm that has a CDS contract traded on its debt at least once in the four weeks prior to the reporting quarter. Our final sample includes 670 unique U.S. corporations with CDS contracts traded by at least one of the CCAR banks during the period from September 2011 to December 2015.

Panel A in Table 1 presents summary statistics for firms that have at least one outstanding loan issued and/or their bond issuances are held by at least one of the CCAR banks. The values are computed from Q3:2011-Q4:2015. Our data confirm the well-documented finding that CDS contracts tend to exist for larger and well established firms. On average, firms with CDS contracts have more assets, more cash and outstanding liabilities, and are more profitable than firms without CDS. Panels B and C present the loan and bond characteristics, respectively, for both CDS and non-CDS firms. In any given quarter, BHC's committed a total of $1.58 trillion in loans to non-CDS firms and $268 billion in loans to CDS firms. However, the average committed amount to non-CDS firms was only $24 million compared $629 million for CDS firms. Additionally, CDS firms have an average utilized exposure seven times larger than non-CDS firms. CDS firms borrow, on average, from six lenders and the non-CDS firms typically borrow from a single lender. Turning to bond positions, in any given quarter, BHCs hold a total book value of $32 billion in bonds issued by non-CDS firms compared to $15 billion in bonds issued by CDS firms. The average book value of the bond issuance held by BHC's is $39 million for a CDS firm compared to $30 million for a non-CDS firm.

We also distinguish the amount of loans that CDS and non-CDS firms obtain from the banks based on their rating. For this purpose we use the internal ratings that each BHC assigns to its obligors in the Schedule H of the FR Y-14 report. To allow comparison of the ratings across reporting institutions, the internal rating is converted to a standardized rating scale going from AAA (very low risk of default) to D (in default).¹⁵ Finally, if in a given quarter there is more than one rating assigned to one creditor, we take the lowest rating assigned by the reporting BHCs. As shown in Table 2, most of the loans to non-CDS firms are issued to firms with internal rating equivalent to BB (35% of the committed exposure and 44% of the utilized exposure), followed by firms with internal rating equivalent to BBB and A. For CDS firms, the loans are mostly issued to firms with internal rating equivalent to BBB (39% of the committed exposure and 46% of the utilized exposure) followed by A and AA or higher.

In Table 3 we repeat the same analysis on the bond positions. For issuer rating, when available, we use the same internal rating banks assign to their obligors in the loan schedule, otherwise we use Standard & Poor's (S&P) long-term issuer ratings from Compustat.¹⁶ For CDS-firms, most of the CDS positions are associated with firms with internal rating equivalent BBB (43% for both market and book values), followed by firms with internal rating equivalent to A or higher (37% for both market and book values). For non-CDS firms, CCAR banks hold bonds mostly issued by firms with internal rating equivalent to BBB (approximately 35% for both market and book values), followed by A and higher (60% for both market and book values).¹⁷ The ratings distribution for CDS firms is slightly more concentrated at the higher end of the rating scale than for non-CDS firms. The higher rated concentration is irrespective of the type of the credit exposure-loans or bonds-the banks have, and is consistent with the notion that the CDS market tends to exist for, relatively, less risky firms.

In Table 4 we pair the CDS positions (protection bought and protection sold) to the type of credit exposures the banks have. Specifically, we consider three types of credit exposures. In the first two panels we show the CDS positions for firms that have only bonds held by CCAR banks or have only loans (measured by utilized amount) Table 3: Bond Amount by Rating (in millions) issued by CCAR banks. The last panel shows the CDS positions for the firms that have both loans issued and bonds held by CCAR banks.

There are a number of surprising observations to note. First, when banks have only loan exposure to an obligor, the banks tend to be net sellers rather than net buyers of credit protection, and the average size of net protection sold is substantially larger than the average size of net protection bought. This data is inconsistent with the assumption that banks use the CDS market largely to hedge their credit exposure (Minton et al. 2009). Second, the difference between the net value of protection bought and protection sold is much smaller when banks only hold a firm's bonds. Third, banks tend to be net buyers of protection when they own both loans and bonds of the same debtor, which is consistent with a hedging motive. Finally, banks tend to hold much larger loan exposures when they also own an obligor's bonds, but hold much smaller bond exposures when they also issue loans to the same obligors. The differences between loan and bond holdings may suggest loans act as a substitute for bonds in banks' portfolios, but not vice versa.

Table 5 shows the quarterly average total amount of loans issued to CDS and non-CDS firms, by lien position. Seventy percent of the loans issued to CDS firms are senior-unsecured loans, while only 20% of the loans issued to non-CDS firms are senior-unsecured. The propensity to issue unsecured loans is consistent with the notion that banks hedge unsecured credit risk through the CDS market. However, the last two columns in the table show that the banks have much larger net sell positions than net buy positions on their unsecured loan exposures, which is inconsistent with a hedging motive.

To perform an analysis for bond holdings by seniority and collateral, we supplement the FR Y-14 securities data with data from the Fixed Investment Securities Database (FISD). We are able to match only 7,538 out of 11,313 of the bond issues in the FR Y-14 Securities Schedule. Table 6 reports, by seniority, CCAR bank bond holdings issued by CDS and non-CDS firms. The vast majority of the bond issuances held by the banks are senior-unsecured, for both CDS and non-CDS firms. The percentage of unsecured bond holdings issued by CDS firms is larger than the percentage of unsecured bond holdings issued by non-CDS firms (93% and 83% respectively), though the difference is much less pronounced than the difference in the loan issuance data. The similarity in bond holdings issued by CDS and non-CDS firms suggests that seniority and collateral in bond markets is much less significant than the lien position in the loan market in determining how banks use CDS.

3 Conclusion
In conclusion, CDS firms tend to be larger and rated slightly higher than non-CDS firms. For the subset of firms for whom banks buy and sell CDS, the type of credit exposure - loan issuance or bond holding - seems to differentially affect banks' CDS positions. Mainly, larger loan exposures are correlated with larger net sell positions, and bond exposures do not tend to tilt CDS positions in either direction. Banks tend to be net buyers of protection only when they have both loan and bond exposure to an obligor. Additionally, lien and seniority considerations do not indicate that banks are hedging their credit exposure against lower priority debt claims. On the contrary, banks appear to be selling credit protection more frequently for the lien positions one would expect them to be buying credit protection against if hedging credit risk were their only motive. In sum, our data suggest that banks may be largely taking additional credit risk through the single name CDS market rather than using the market largely to hedge existing credit risk. The focus of our current and on-going research seeks to formally explain this novel finding.

References

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3. Sean Campbell and Joshua Gallin. Risk transfer across economic sectors using credit default swaps. FEDS Notes 2014-09-03, Board of Governors of the Federal Reserve System (U.S.). 2014.

4. Andras Danis. Do empty creditors matter? Evidence from distressed exchange offers. Manuscript, Georgia Tech, 2015.

5. Beranadette Minton, René M. Stulz, and Rohan Williamson. How much do banks use credit derivatives to hedge loans? Journal of Financial Service Research, 35:1-31, 2009.

6 .Alessio Saretto and Heather Tookes. Corporate leverage, debt maturity, and credit default swaps: The role of credit supply. Review of Financial Studies, 26:1190-247, 2013.

7. Marti Subrahmanyam, Dragon Y. Tang, and Sarah Q. Wang. Does the tail wag the dog? the effect of credit default swaps on credit risk. Review of Financial Studies, 27:2927-60, 2014.

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Please cite as:
Caglio, Cecilia, Matt Darst, and Eric Parolin (2016). "A Look Under the Hood: How Banks Use Credit Default Swaps," FEDS Notes. Washington: Board of Governors of the Federal Reserve System, December 22, 2016, https://doi.org/10.17016/2380-7172.1865.