Credit Default Swaps (Part 2)

In a CDS transaction, the borrower seeks to obtain a loan from the protection buyer in a CDS. For protection, the protection buyer avails of the CDS by paying a default protection fee from a protection seller based on tradable CDS Index. The borrower can be a private entity or a government (for sovereign debts). The borrower pays interest to the protection buyer for his loan using the LIBOR (London Interbank Offered Rate). The borrower should repay the loan to the protection buyer upon maturity date. In case of default of the borrower, the protection buyer will seek recovery from the protection seller. There are two kinds of settlement to be done by the protection seller depending on the agreement: Physical settlement and Cash Settlement. If a physically-settled CDS is triggered, the protection seller pays the face value of the debt (or another pre-specified amount) to the protection buyer in exchange for the debt itself, which would be worth less than face value given the recent credit event. Triggering a cash-settled CDS would require the protection seller to make a payment to the protection buyer of the difference between the original value of the debt (typically the face value) and the current value of the debt based on a specified valuation method.


Innovation and Current Trends of the CDS

There is a need to place clear and unambiguous terms of “credit event” and “reference entity” in the contract. The ISDA, International Swaps and Derivatives Association, sets standards for all derivative contracts.

In the case of in Ursa Minor Ltd. v. Aon Fin. Prods., Inc., 2000 WL 1010278 (S.D.N.Y. 2000) , Escobel Land Inc. (a company in the Philippines), obtained a $10M loan from Bear Stearns for the construction of condominiums in the Philippines. Escobel also secured a surety bond from Government Service Insurance System ("GSIS"), a Philippines government entity, which guaranteed Escobel's payment to Bear Stearns (BS). BS in turn obtained 1) a CDS from Aon Financial Products Limited ("Aon") as well as 2) an unconditional guarantee ("Guarantee") from Aon Corporation ("Aon") “for whatever reason or cause,” together promising to pay BSIL $10 million plus expenses if GSIS failed to satisfy its obligations under the surety bond. To reduce its own exposure, Aon entered into its own CDS agreement with Société Générale ("SG"), wherein SG agreed to pay Aon upon the occurrence of a defined "credit event," which is default of the Republic of the Philippines or any of its successors.” When Escobel's payment under its BS loan came due, Escobel failed to pay, triggering a demand on GSIS. GSIS refused, arguing that the surety bond might not be enforceable against GSIS because the GSIS representative who supposedly assigned the bond to BS did not have the authority, and because GSIS already had canceled the bond after discovering the collateral that Escobel had offered to secure the bond was not genuine. Due to GSIS' refusal to pay, BS was able to recover from its CDS with Aon agreeing to cover GSIS' default "'for whatever reason or cause," even if the underlying obligation was illegal or invalid.

By this reason, Aon sought to recover from SG based on the same credit event and by its reference entity, which is default of GSIS which is a successor or agency of the Republic of the Philippines. Unfortunately, Aon was not able to recover from SG because the basis or reference entity, the default of GSIS was held not to be a default of the Republic of the Philippines. The GSIS was held not to be a government of the Republic of the Philippines, being a separate entity altogether.

In the case of Eternity Global Master Fund Ltd. v. Morgan Guar. Trust Co., 2003 WL 21305355 (S.D.N.Y.), Argentina obtained a loan from Eternity Global in turn obtained a CDS from JP Morgan for a guarantee and promise to pay Eternity Global in case of Argentina’s bankruptcy or default in payment. Subsequently, Argentina sought a “voluntary debt exchange” by exchanging its debts to other foreign bonds in order to minimize payment of interests. By this reason, Eternity Global sought to recover from JP Morgan by reason of such “voluntary debt exchange”. It was held that Eternity Global cannot recover from the CDS because a “voluntary debt exchange program” does not constitute a term for bankruptcy or default in payment.

Another innovation in the over the counter CDS market is the reduction of the notional amount of CDS through a series a portfolio compression cycles, also known as tear-ups (according to ISDA) and has reduced operational, legal and capital costs and improved efficiency of the CDS market. Portfolio compression reduces the number of line items in CDS portfolios without changing the risk parameters of the portfolio. It is done by terminating existing trades and replacing them with smaller number of trades with the same risk profile and cash flows as initial portfolio.

CDS contracts are subject to clearing house rules and regulations. In the US, the Depository Trust and Clearing Corporation (DTCC), considering one of the world’s largest clearing houses.

REFERENCES:

Mike Jakola, Kellog School of Management, Northwestern University, Credit Default Swaps Index Options, June 2, 2006.

“Central Clearinghouse Planned to reduce Counterparty Risk in Credit Default Swaps Market,” Global Finance, July-August 2008.

“Credit Default Swaps Market Outstandings Shrinks as Dealers Tear-up Offsetting Agreements,” Global Finance, December 2008.

“Credit Default Swaps 101: A Primer on Legal Remedies,” Robins, Kaplan, Miller & Ciresi, February 16, 2009 (i.e. visit www.google.com)

“Credit Default Swaps: The Next Crisis?” by Janet Morrissey, March 17, 2008, (i.e. Search time.com)