Reuters: Bankruptcy News: Bail-in fuels CDS reform

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Bail-in fuels CDS reform Jun 15th 2012, 14:07 Fri Jun 15, 2012 10:07am EDT (This story originally appeared on IFRe.com, a Thomson Reuters publication) By Christopher Whittall LONDON, June 15 (IFR) - Plans to allow regulators to write down - or bail-in - senior bank debt have re-enforced the urgency of overhauling the legal documentation for all credit default swaps if the instrument is to remain a valid hedging product going forward. On June 6, the European Commission released the final text on bail-in as part of a package of legislation aimed at bolstering bank recovery and resolution frameworks. Lawyers had previously said bail-in debt could render CDS impotent when the Commission tabled the proposals to boost the capital base of failing institutions last year. Derivatives lawyers continue to debate how the proposals could affect CDS referencing bank senior debt. Some had previously argued bail-in provisions in bond documentation could prevent restructuring credit events from being triggered at all. Edmund Parker, co-head of the derivatives and structured products group at Mayer Brown, believes otherwise, pointing out that a senior debt haircut would tick the box required for triggering a credit event, but notes there are still serious ramifications for CDS. "If the claims of senior creditors are written down and debt converted to equity, then I would say it would trigger CDS as you would have a reduction (or postponement) in the amount of interest or principal payable to bondholders," he said. "The problem comes if they have written down all of the bank's debt and turned it into equity. You wouldn't have any obligation to value in the CDS auction." Usually, dealers in a CDS auction will bid on a series of bonds of the issuer in question to determine payouts for holders of CDS. This is to ensure protection buyers are adequately compensated for losses on equivalent bond positions. The problem with bail-in measures is that there might not be any bonds left to value in the auction, which would effectively make the CDS protection worthless. "If all the debt is exchanged for equity then CDS holders might not get a pay out at all," added Parker. Similar situations have arisen in the corporate world with debt restructuring, although the industry has so far managed to muddle through with off-the-cuff solutions up until now. The debacle around the Greek restructuring served as a sharp wake-up call for market participants, though, leading ISDA to acknowledge there is a flaw in the standard CDS contract that needs to be fixed. In Greece, "old" government bonds were exchanged for a package of "new" bonds, some EFSF paper and Greek GDP warrants. The problem was that only the "new" bonds were deliverable into the CDS auction rather than the entire package, raising the prospect of protection holders not being adequately remunerated for losses on Greek bond positions. There was a happy ending for Greek CDS: despite 100bn being shaved off the country's debt, the "new" bonds miraculously traded at the same level of the "old" bonds and CDS payouts were in line with market expectations. But this outcome was down to pure luck, traders say, and ISDA has been urged to overhaul the documentation to allow a wider range of securities to be deliverable into CDS auctions to ensure appropriate settlement prices. "You should be able to deliver into the auction whatever the bond has become, which a lot of the time is equity," said the head of credit trading at a major European house. "In 2003 the debate was around asset managers not being able to have equities delivered, but by catering for that we're now in a situation where CDS may not trigger when there is a default." WIDER OVERHAUL ISDA confirmed the issues raised by bail-in debt and the Greek restructuring form part of the to-do list in the project of fixing CDS documentation. The current CDS definitions date back to 2003, and participants point out a lot has changed in the meantime, including increased standardisation in the market, CDS auctions, central clearing, and sovereign CDS volumes soaring. Various niggles have been exposed along the way in what is still a relatively immature financial instrument. "We went to ISDA two years ago saying the CDS definitions didn't work and we needed a big overhaul. It was frustrating because the US dealers weren't interested in engaging," said the head of credit trading. "The Greece event has helped the ISDA credit steering committee to get buy-in from other dealers to overhaul the definitions." The issue around deliverable obligations is top of many people's lists, not least because of the prospect of another sovereign restructuring in the eurozone in the future that may result in a messier outcome than Greece. Parker said the market may also wish to look at instances where governments try to avoid CDS triggers - another potential issue raised by Greece. Elsewhere, the credit trading head points to complaints around CDS referencing senior debt triggering when there is a credit event in a bank's subordinated debt - an issue highlighted by the Irish banks. ISDA has also admitted it will seek to address problems with so-called "look-back clauses", which have prevented Greek CDS trading of late. Any changes could take time to get signed off, though. "It's at least a one-year project. Most people are on the same page, but it's a huge project and there can be disagreement. It doesn't help that a lot of the dealers involved have net sold CDS protection," said the credit trading head. "Ultimately, though, these changes are needed to protect the buyer of CDS to persuade them it is a useful product." (Reporting by Christopher Whittall) Link this Share this Digg this Email Reprints

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