By Christopher Whittall
Mon Aug 4, 2014 1:42pm EDT
LONDON, Aug 4 (IFR) - Bond investors are set to be given a stark reminder of why the old model of credit default swaps is no longer fit for purpose, less than two months before new improved CDS documentation is rolled out.
A flaw in the old contract means the CDS are unlikely to pay out even though junior bondholders in Banco Espirito Santo were effectively wiped out over the weekend after 4.9bn of public money was injected in the bank and the lender split into a good and bad bank.
The bank's senior debt, which remains intact, will be transferred to the good bank, Novo Banco.
Credit experts say ISDA is likely to rule that a so-called succession event has occurred, meaning that all outstanding CDS contracts on BES debt will be transferred with that debt to the new entity, which would remove the possibility of a credit event being declared - meaning those who held CDS as protection for their sub debt holdings will lose out.
The nationalisation looks set to bring CDS into the headlines once again for the wrong reasons and calls into question the decision to postpone the introduction of new credit definitions - which experts say would have captured the credit event and compensated bondholders for their losses - from last March to September 22.
"There are a lot of people lamenting the fact that the new CDS contracts weren't available before this happened," said the head of European credit trading at a US house.
"If all of BES's senior debt is transferred cleanly to this new entity, then this would have been an example where the new credit definitions would reflect the capital structure of the company: that if there is a write-down of sub debt then there would be a credit event on sub debt."
BES represents the second high-profile bailing in of European sub debt, following the nationalisation of SNS Reaal last year. SNS protection holders did not receive any payout as the junior bonds were wiped out before a CDS auction could be held.
While different in nature to the Dutch lender's debt restructuring, BES has also highlighted that old-style CDS contracts are seemingly worthless in the face of a bail-in of bank debt.
QUESTION
In this case, the decision of the Portuguese government to wipe out junior bondholders while leaving senior debt untouched and transferring it to a new good bank has provoked a succession event question to the ISDA Determinations Committee (DC).
The decision to let senior debt holders off scot free surprised the market, which appeared to have priced in some kind of debt haircut. BES' senior curve re-priced by around 300bp to swaps following the news, while five-year CDS tightened by 380bp to 300bp.
If, as expected, the DC rules a succession event has occurred when it convenes at 12pm BST tomorrow, then all the US$900m of net notional of CDS referencing BES will be transferred to the new entity most likely removing the possibility of a CDS trigger for sub debt holders.
Meanwhile, in a cruel twist of fate, ISDA's credit determinations committee decided on Monday that CDS on Espirito Santo Financial Group - BES's largest shareholder - had triggered a bankruptcy credit event.
This comes after the troubled EFSG filed for creditor protection through a Luxembourg court last month under the "Gestion Controlee", or controlled management provision.
This CDS trigger is unlikely to provide solace to many CDS users, though. ESFG does not make it into the top 1,000 CDS names, according to the DTCC, which currently has US$41m net notional outstanding as the minimum threshold to make the cut.
The tiny size of the outstanding market is probably why ISDA has decided against holding an auction for ESFG. With over 20 times that amount outstanding, BES was undoubtedly the main CDS contract for investors hedging BES risk.
NEW CONTRACT
ISDA originally targeted March for the launch of the new credit definitions, which sought to fix a host of issues with the old contract. However, this was delayed due to fears that the market was not adequately prepared for the roll-out of the new contracts.
Participants grumbled at the time about the postponement. Even though the most substantive changes would only apply to new trades, investors pointed out they could have closed old positions and bought protection on banks such as BES under the more robust 2014 credit definitions.
"We're still going to have these kinds of problems with the legacy contracts going forward - they'll be around for some time. Ultimately, credit is very complicated and it's hard to replicate all the potential outcomes in a CDS contract. I've never seen such a complicated intercompany structure as BES," said the head of credit trading.
While BES has announced that both sub debt and equity will be affected in its restructuring, the size of the write-down junior bondholders face is still uncertain. This led to choppy price action Monday, with bonds trading between high teens and around 30 cents on the euro. (Reporting by Christopher Whittall; Editing by Matthew Davies and Helene Durand)
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