Bankruptcy Futures: Hedging against Credit Card Default

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This article discusses the new bankruptcy futures contract to be launched by the Chicago Mercantile Exchange and examines the mechanics and contract specifications of this innovation, illustrating its hedging potential in the process.

Sometime during the latter half of 1999 or early 2000, the Chicago Mercantile Exchange intends to launch an innovative new futures contract that will offer consumer-lending institutions, particularly credit-card issuers, a hedge against the bankruptcies filed by their borrowers. Bankruptcy futures - contracts to buy or sell a cash-valued index based upon the current number of actual bankruptcies - will enable consumer lenders to transfer default risk to other lenders and/or speculators holding opposite expectations. Significantly, this new contract also constitutes a proxy variable for banks' confidence in the value and liquidity of their own loan portfolios, just as other proxy variables now measure consumer and investor confidence.

Consumer Borrowing

U.S. consumer debt currently totals $1.5 trillion and is growing faster than any other type of credit. Much of this increase is attributable to the strong U.S. economy of recent years, during which times consumers historically spend more, and simultaneously finance a large portion of such spending with installment credit.

Credit-card debt is becoming particularly burdensome. The average credit-card balance is approximately $2,500, with typical households having at least three different bank cards. The average card holder also uses six additional cards at service stations, department stores, specialty stores, and other vendors issuing their own credit cards.

Commensurate with such increases in consumer debt is an ever-growing rise in consumer bankruptcies, which, in turn, represent an ever-increasing proportion of total bankruptcies. In 1998, 96.9% of all bankruptcy filings were personal - not business - bankruptcies. (In terms of dollar volume, however, businesses continue to comprise the overwhelming majority of bankruptcies.) From 1990 to year-end 1998, filings for personal bankruptcies almost doubled (up 94.7%), while filings for business bankruptcies declined 31.6%.

This trend has, understandably, caused growing losses for and increasing pressure upon consumer lenders of all types, including credit-card issuers. During the period 1994-98, credit-card issuers saw their default rate of non-performing loans increase from 4% (as a percent of the dollar volume of all loans) to nearly 8%.

Unlike business loans, consumer loans are largely unhedgeable. Business loans can be hedged via traditional hedging techniques such as maturity matching, variable-rate lending, and various interest-rate derivatives. However, such techniques are largely non-existent (particularly the lack of derivatives) and/or not effective for consumer-lending risks, especially credit-card debt. Ironically, business lending, whose bankruptcies constitute only 3% of all bankruptcy filings, has the best hedging possibilities, while consumer lending, whose bankruptcies comprise 97% of all bankruptcies, has the least. (Once again, these percentages refer to the absolute number of bankruptcy filings, not the dollar volume.)

Finally, bankruptcies are largely unpredictable. Since business bankruptcies can't be predicted with any significant degree of accuracy, personal bankruptcies (with far more uncertainties) are even less predictable. This greater uncertainty is corroborated by an almost complete absence, in financial literature, of personal-bankruptcy models with any reasonable degree of predictive accuracy.

One reason that personal bankruptcies are so unpredictable is that the level of consumer debt is notoriously volatile. This volatility, when coupled with such factors as huge (and also unpredictable) layoffs, continually changing bankruptcy laws (at both the federal and state levels), as well as other unpredictable economic variables, makes the prediction of personal bankruptcies exceedingly difficult, if not impossible. …