LENDING

Bankruptcy Futures: Hedging Against Card

by Russ Ray his article discusses the new to be launched by the Mercantile Exchange and examines the mechanics and contract specifications of this innovation, illus- trating its hedging potential in the process.

ometime during the latter half of 1999 or early Credit-card is becoming particularly burden- 2000, the Chicago Mercantile Exchange intends some. The average credit-card balance is approximately to launch an innovative new futures contract that $2,500, with typical households having at least three dif- will offer consumer-lending institutions, particularly ferent cards. The average card holder also uses six credit-card issuers, a against the additional cards at service stations, department stores, filed by their borrowers. Bankruptcy futures—contracts specialty stores, and other vendors issuing their own cred- to buy or sell a -valued index based upon the cur- it cards. rent number of actual bankruptcies—will enable con- Commensurate with such increases in consumer sumer lenders to transfer default to other lenders debt is an ever-growing rise in consumer bankruptcies, and/or speculators holding opposite expectations. which, in turn, represent an ever-increasing proportion Significantly, this new contract also constitutes a proxy of total bankruptcies. In 1998, 96.9% of all bankruptcy variable for ' confidence in the and liquidity filings were personal—not business—bankruptcies. (In of their own portfolios, just as other proxy vari- terms of dollar , however, businesses continue to ables now measure consumer and confidence. comprise the overwhelming majority of bankruptcies.) From 1990 to year-end 1998, filings for personal bank- Consumer Borrowing ruptcies almost doubled (up 94.7%), while filings for U.S. currently totals $1.5 trillion business bankruptcies declined 31.6%. and is growing faster than any other type of credit. This trend has, understandably, caused growing Much of this increase is attributable to the strong U.S. losses for and increasing pressure upon of recent years, during which times lenders of all types, including credit-card issuers. Dur- historically spend more, and simultaneously finance a ing the period 1994-98, credit-card issuers saw their large portion of such spending with installment credit. default rate of non-performing increase from 4%

© 1999 by RMA. Ray is Professor of Finance at University of Louisville, Louisville, Kentucky.

28 The Journal of Lending & Management June 1999 Bankruptcy Futures

(as a percent of the dollar volume of all loans) to nearly vided by Hogan Information Services (a First Data 8%. Company and a leading provider of bankruptcy infor- Unlike business loans, consumer loans are largely mation), the CME has constructed the Quarterly unhedgeable. Business loans can be hedged via tradi- Bankruptcy Index (QBI) which is based on the number, tional hedging techniques such as maturity matching, in thousands, of new bankruptcy filings in U.S. bank- variable-rate lending, and various -rate deriva- ruptcy courts each quarter. tives. However, such techniques are largely non-existent The dollar of the index is $1,000 times the (particularly the lack of derivatives) and/ or not effec- QBI, with “ticks” (changes) in increments of .025 (equiv- tive for consumer-lending , especially credit-card alent to 25 bankruptcies). Hence, a QBI of 300 would debt. Ironically, business lending, whose bankruptcies translate into a $300,000 QBI index, with a minimum constitute only 3% of all bankruptcy filings, has the price change of $25. A separate QBI index will be con- best hedging possibilities, while consumer lending, structed for each quarter of the year, with contract whose bankruptcies comprise 97% of all bankruptcies, months of March, June, September, and December. Each has the least. (Once again, these percentages refer to the contract expires in the month immediately following the absolute number of bankruptcy filings, not the dollar respective quarter (for example, the March QBI expires volume.) in April 1999). A summary of the contract specifications Finally, bankruptcies are largely unpredictable. appears in Table 1. Since business bankruptcies can’t be predicted with any significant degree of accuracy, personal bankruptcies Hedging Against Consumer Defaults (with far more uncertainties) are even less predictable. In order to see how a consumer lender could use This greater uncertainty is corroborated by an almost bankruptcy futures to hedge against unexpected default complete absence, in financial literature, of personal- losses, consider the hypothetical case of the FNB Bank bankruptcy models with any reasonable degree of pre- which has $1 billion of credit-card loans outstanding, dictive accuracy. with an 8% (annual) default rate. Given the rising trend One reason that personal bankruptcies are so unpre- of personal bankruptcies, the bank would like to hedge dictable is that the level of consumer debt is notoriously against unexpected default rates in excess of 8%. volatile. This , when coupled with such factors The bank has tracked its credit-card bankruptcies as huge (and also unpredictable) layoffs, continually against the national filings of all bankruptcies, and has changing bankruptcy (at both the federal and state found that it tends to realize 20 credit-card bankruptcies levels), as well as other unpredictable economic vari- for every 1,000 national filings. (The bank found an ables, makes the prediction of personal bankruptcies approximately linear relationship between its credit- exceedingly difficult, if not impossible. card charge-offs and national bankruptcies; curvilinear Clearly, the U.S. economy (and, by extension, relationships can also be easily modeled via regression industrialized economies throughout the world) needs some means with which to hedge against the rising tide Table 1 of consumer bankruptcies. And clearly, the stage is set Bankruptcy Futures Contract Specifications for the first-ever tool to effectively allow such hedging. Exchange Chicago Mercantile Exchange (CME) The CME-QBI Futures Contract Index Quarterly Bankruptcy Index (QBI) Similar to futures contracts for the S&P 500 Index, the Nasdaq 100 Index, and , the bankruptcy Price $1,000 times the CME-QBI ($1.00 per bankruptcy filing) futures contract developed by the Chicago Mercantile Exchange (CME) is based upon a cash-settled index. Ticks Increments of .025 (.025 = 25 filings = $25 in With cash-settled indices, profits/losses are paid in cash variation) at settlement time, that is, there is no physical delivery of anything. (For a more comprehensive description and Contract Months March, June, September, December explanation of cash-settled indices, see the Contract Month following QBI month Bibliography item for Harris, 1990.) Utilizing data pro- (e.g., the March QBI expires in April)

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analysis, moving averages, or other standard statistical sent a $50,000 gain per contract, for a total of $2.5 mil tools.) The average loss the bank incurs for each bank- (= 50 X $50,000) for all 50 contracts. rupt card is $2,500. Hence, the bank expects a loss of Thus, in this hypothetical example, the futures gain $50,000 (=20 X $2,500) for each 1,000 national filings. of $2.5 mil exactly offsets the unexpected loss of $2.5 (See Table 2 for a summary description of the bank’s mil. In actuality, the net gain or loss would be some credit-card portfolio.) small finite number (say, in this example, several thou- With bankruptcies currently running at 400,000 fil- sand dollars) since hedges can rarely be tailored exactly ings per quarter, the bank expects a recurring quarterly to cover every dollar of unexpected losses. default loss of $20 mil (= 400 X $50,000). If, however, Notice that the bank, in hedging its credit-card quarterly filings unexpectedly increase, then the bank portfolio, is immune to Murphy’s in the sense that will incur unexpected default losses. it has locked in a certain default rate regardless of what To hedge against such unexpected losses, the bank the actual default rate subsequently turns out to be. In could buy futures contracts based on the QBI whose the example above, if the actual default rate had been value is currently 400 (reflecting the recurring 400,000 7% (instead of 9%), the bank would have had losses in filings per quarter). Since the bank incurs $50,000 in the futures market (instead of gains) and gains in the losses for each 1,000 national filings, and since 1,000 (instead of losses). But, as happened above, national filings constitute one point of the QBI, then the the gains and losses would have offset each other, so bank can expect to lose $50,000 for each one-point that, again, there are no unexpected losses. increase in the index. Thus, in order to hedge, the bank The question remains as to who would sell the needs 50 futures contracts (= $50,000 4 $1,000) to pro- bankruptcy futures contracts to the bank. Two certain tect itself against each one-point increase in the index parties would be: (that is, its hedge ratio is 50:1). 1. Speculators (the sine qua non of all futures mar- This transaction is depicted in Table 3. Suppose kets). that quarterly filings closed out at 450,000 for the cur- 2. Other banks which have already hedged with bank- rent quarter, causing the bank $22.5 mil in losses (= ruptcy futures but which now wish to “unwind” $50,000 X 450) instead of the $20 mil (= $50,000 X 400) in losses which it had expected. Concurrently, the value of the QBI rose from 400 to 450 to reflect this Table 3 increase in bankruptcy filings. FNB Bank Hedging Results At the close of the quarter, the bank, to recapture its unexpected loss of $2.5 mil (= $22.5 mil - $20 mil), Now: QBI index = 400 would sell off its 50 futures contracts at the now-higher Later: QBI index = 450 price of 450. Since each point change in the index rep- Now: Bank expects 2nd quarter losses of $20 million resents $1,000, the 50-point increase in the index repre- Later: Bank realizes 2nd quarter losses of $22.5 million Now: Bank buys 50 QBI contracts @ 400 Later: Bank sells 50 QBI contracts @ 450 Table 2 Credit Card Portfolio: FNB Bank Unexpected Spot Market Loss: $2.5 mil (= $22.5 million actual— • $1 billion of credit-card loans outstanding $20 million expected) • 8% current (annual) default rate Corresponding Futures • $2,500 average loss per bankrupt card Market Gain: $2.5 mil [= (450-400) x • 20 bankrupt FNB cards per 1,000 national filings (50 contracts) x ($1,000)] • $50,000 expected loss (=20 X $2,500 for every Net Gain (Loss): $0 1,000 national filings) Result: FNB Bank used bankruptcy futures to • Bank wants to hedge against unexpected default hedge its credit-card portfolio against rates above 8% unexpected default losses.

30 The Journal of Lending & Credit Risk Management June 1999 Bankruptcy Futures

their futures for various reasons, such as ic indicators are important measures of the health of believing that personal bankruptcies will begin to any economy. decline. Finally, banks should note that the hedging potential Ray can be contacted by telephone at 502-852-4832 or of this new contract is not limited to credit-card debt. by e-mail at [email protected]. Any consumer debt (for example, personal-signature loans) and any business debt (for example, poorly collat- Sources eralized loans) can be hedged with bankruptcy futures as “ABI Press Releases.” Various dates. American Bankruptcy Institute as a significant historical correlation exists between (www.abiworld.org) the particular type of debt and national bankruptcy fil- Canner, G., et al. “Household Sector Borrowing and the Burden of ings. Banks would be well advised to examine the his- Debt.” Bulletin vol. 81, no. 4 (April, 1995), pp. 324- torical relationship between their various loans and 338. national bankruptcies, less they overlook an excellent “CME Announces First Exchange -Traded Consumer Credit Products.” hedging opportunity. Chicago Mercantile Exchange. Press release of April 2, 1998. (www.cme.com) Summary Harris, L. “The of Cash Index Alternatives.” Journal of Futures Markets 10 (April, 1990), pp. 179-194. Bankruptcy futures are a sorely needed innovation, allowing consumer lenders—particularly credit-card Hull, J. Options, Futures, and Other Derivatives, 3rd ed. Prentice Hall, 1997. lenders—to hedge against the rising tide of personal bankruptcies. Banks, as well as many other consumer Kenmickell, A., et al. “Family in the U.S.: Recent Evidence from the Survey of Consumer Finances.” Federal Reserve Bulletin, vol. lenders (see Table 4), will be able to utilize this new 83, no. 1 (January, 1997), pp. 1-24. contract to protect themselves from unexpected default Mitsch, R. “The Road Ahead in Bankruptcy: Results of the National losses. Moreover, such hedging abilities will allow Bankruptcy Review Commission Report.” Credit World, vol. 86 banks to plan more accurately, and also maintain tighter (Jan/Feb, 1998), pp. 7-9. Morris, R. “Predicting Failure: A Failure in Prediction?” Accountancy, vol. 20 (December, 1997), pp. 104-105. Table 4 Mossman, et al. “An Empirical Comparison of Bankruptcy Models.” Potential Users of Bankruptcy Futures Financial Review, vol. 33, no. 2 (May, 1998), pp. 35-53. • Banks • Foreign lenders Stoll, H., and Whaley, R. Futures and Options: Theory and Applications. South-Western Publishing Company, 1993. • Credit-card companies • companies Womack, A. “The High Cost of .” Bank Marketing, • Department stores • Thrifts vol. 30, no. 3 (March, 1998), pp. 10-12. • Finance companies • Speculators control over their operations. Finally, for the first time ever, planners, policy makers, and others will now be able to gauge banks’ confidence in their own loan port- folios, just as other proxy variables now measure investor and . Such macroeconom- Happy 85th Anniversary, RMA! Your Association, founded in June 1914 for the exchange of credit information among commercial lenders, today works with the industry to develop new risk management techniques, innovative products, and education and training programs. Our continuing mission is to be your most valuable resource.

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