Conflicts in the credit-derivatives market threaten to undermine it
SHAKESPEARE WAS a fan of the quibble. His plots often hinge on the gap between word and intended meaning. Macbeth was supposed to be invincible because he could be harmed by “none of woman born”—but his killer, Macduff, was delivered by Caesarean section. In “The Merchant of Venice” Portia saves Antonio by arguing that though he agreed to forfeit a pound of flesh to Shylock if he defaulted on a loan, he did not agree to lose blood.
Traders in credit-derivative markets are keen on quibbles, too. Credit-default swaps (CDSs) are insurance-like derivatives designed to compensate lenders when a company goes bust. A simple enough aim, you might think, but there are plenty of devilish details. A company can go bust in many ways: it can close and have its assets sold off, or restructure its debt and keep operating. And CDS contracts pay out the difference between a bond’s face value and the price of the cheapest bond available, even though the underlying characteristics of a company’s various bonds can differ widely.
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In 2018 GSO, a branch of Blackstone, the world’s largest private-equity firm, came under fire for offering cheap financing to Hovnanian, an American house-builder, on condition that Hovnanian would default on a payment to a subsidiary, triggering the CDS contracts. Financing took the form of a long-term, low-coupon bond that traded well below face value, meaning the CDS would pay out handsomely when valued against that bond—even though Hovnanian’s other bonds were trading close to face value. (Blackstone says that its arrangement with Hovnanian was fully compliant with the rules of this market.)
Later that year traders started trying, so far without success, to get CDS contracts on Rallye, the parent company of Casino, a French supermarket, to pay out because an obscure covenant on one of its bonds required shareholder equity to exceed €1.2bn ($1.4bn), a condition it no longer met.
Last week, however, quibblers were given pause by an arbitration ruling that appeared to break with the convention of sticking to the letter of contracts, rather than trying to divine their intentions. The case arose when $600m-worth of CDS contracts plunged in value. Traders realised that the entity they were written on, VodafoneZiggo, a Dutch telecoms company, had been wound down. Its bonds had been transferred to a new entity, rendering its CDSs potentially worthless.
This would not have mattered if market supervisors had been informed within 90 days. But investors did not notice for almost a year. So they turned instead to a clause saying that the CDS could be transferred to a new entity if it had assumed “all of the obligations” of the old one.
CDS documents usually capitalise the word “obligation”, a cue that the writer is referring to the entity’s bonds. But in one place it was written in lower-case, implying that it referred to any obligations, for example tax liabilities, that the old VodafoneZiggo entity might still have. An ad hoc committee of lawyers from ten banks and five fund managers was convened to hear the dispute. It ruled that the ongoing obligations were “immaterial”, and that the CDS should be transferred. Markets were astonished: its value shot back up.
The decision matched the spirit of the CDS. But deviating from the letter of the contract raises broader issues. The perception that the value of a CDS might be determined by an unaccountable committee could undermine the CDS market. It is already shrinking: according to the Bank for International Settlements, the notional value insured by CDSs has fallen from $61.2trn in 2007 to $9.4trn in 2017. This is partly because of welcome regulatory changes, such as netting of contracts. But it has also reduced liquidity.
If the market vanishes, it would be a loss. CDSs allow banks to lend to a wider range of firms, since they can hedge their credit exposure. They allow pension funds, which are often required to protect their capital, to invest in higher-yielding bonds. Quibbles about contracts always exist; the fight over who resolves them will go on.