Sunday, July 5, 2009

The Debts of the Spenders: Basic CDS Legal Definitions and Case Law

Credit default swap (CDS) rulemaking remains wrapped in a byzantine array of arbitration and legal settlements. As such, case law is scant and federal regulatory reform even less so. This legal mine field is behind much of the push for a single national or several, competing regional CDS exchange(s). Regulators believe that the introduction of exchanges will bring much needed oversight and transparency to the process.

For non-CDS traders, the closest conceptual comparison are that CDS instruments are like futures and/or options contracts - except when they're not.

Instead of having standardized delivery and settlement procedures, CDS instruments function as bilateral contracts w/nominal industry supervision. A "self-regulating" industry group, ISDA (International Swaps and Derivatives Association) is nominally in charge of overseeing all disputes. However, as events last year demonstrated, they have little power to compel uniformity or performance among market participants.

Generally, a single master agreement governs the relations between the parties to a CDS. From here, individual swaps, confirmations, and other changes branch off from the main body or "tree."

The master agreement will also specify the terms of the CDS contract such as the identities of the "reference entity", "reference obligation", payment triggers, coverage period, settlement procedures, margin requirements, and notice requirements.

Unlike futures contracts, NONE of these terms is standardized by an exchange (although there is some general language that remains the same). The terms can - and are - in flux.

Reference entity refers to the specified debtor and is typically a company or nation. Reference obligations specify the particular debt that is covered - which infamously includes tranches of debt such as CDOs or MBS.

While parties can generally agree on whether a SINGLE entity defaults, confusion reigns when ONE entity among a multitude of entities defaults (such as in a tranche type situation). Has the entire tranche lost its worth when only one issue has defaulted? What about the % of that issue in relation to the entire tranche? What about the relation of that tranche to the same sector? What about the relation of that sector to other neighboring sectors? And so it goes. There were instances when the underlying assets in the tranche were marked to zero. And there were others, when the underlying assets were marked at par value. The truth is somewhere in between.

The MOST critical - and litigated - issue is the margin requirement. This is the cost that a seller must provide to insure that the buyer is able to take full delivery of his purchase should the contract move "in the money" by the settlement date. Like futures and options sellers, the CDS seller does NOT necessarily have to pay out the cost of the entire contract (b/c the contract can move back "out of the money" again) by the settlement date.

But if the OVERALL margin requirement increases - or the NUMBER of scheduled margin payments increase (which both depend on the specific clauses in the contract), then they can represent a crippling blow to the cash flow of a CDS seller. If the CDS seller is an insurance company, consumer bank, or other financial body that is required by state or federal law to have OTHER margin requirements, then the cash flow problem becomes even more crippling. All of a sudden, there is a need for the CDS sellers to liquidate assets at will in order to meet their other obligatory margin requirements.

In 2008, the CDS sellers wrote naked options w/no regulatory oversight from the CFTC or SEC to check their actions. In fact, mounting evidence shows that federal regulators who knew of these problems decided to abandon their duties and instead capitalize by making calculated bets that exacerbated the problem (Ahem...Henry Paulson).

So, what has changed between then and now? Quantitative easing and FASB rule relaxations for fair value. Financial institutions can once again mark the value of their collateral to mythical standards. Regardless of the deteriorating fundamentals.

I don't have time to provide full coverage of the following cases. It is also doubtful whether this information would be of much use to market skeptics and retail traders (the intended audience of this web site).

VCG v. Citibank N.A.
2008 WL 4809078

Aon Financial Products v. Societe Generale
476 F.3d 90 (2nd Cir. 2007)

Deutsche Bank v. Ambac Credit Products, LLC
WL 1867497 (S.D.N.Y. 2006)
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