EU proposals to write-down the debt of European banks in the event of another financial crisis could render the billion-dollar market of of credit default swaps referencing European banks worthless if it were to go into legislation in its current proposed form.
The International Financing Review (IFR) did a nice summary highlighting the main issues saying:
On January 7, the EC mooted two potential approaches to boost the capital base of failing institutions, which would not be retroactive and would not apply until 2013 at the earliest. The “comprehensive approach” would endow resolution authorities with the power to impose write-downs or forcibly convert senior bonds into equity once existing equity and subordinated debt buffers had been exhausted. Under the “targeted approach” approach, banks would issue fixed volumes of debt with write-down or equity conversion triggers.
Crucially for the CDS market, both approaches state that the debt documentation should acknowledge the potential for the bond to be written down or converted, which has potential ramifications for the triggering of a credit event and for the deliverability of bonds in CDS contracts.
In Europe, restructuring is classed as a credit event. However, if the potential for the debt to be written down is included in the terms and conditions of the debt – as per the EC’s bail-in proposals – then any write-down of the debt arguably does not constitute a restructuring, as this write-down was already contemplated when the debt was first issued. Similarly, bonds are only deliverable under standard CDS contracts if they are not subject to any contingencies. So if the terms and conditions state the issuer only has to repay the principal on the bond if the bond has not already been written down, arguably the payment of the bond is contingent and does not meet the deliverability criteria stipulated by CDS contracts.
“If the bail-in power is included in the terms of the debt, it could have the effect of not making the write-down a credit event, and making the debt non-deliverable and therefore effectively not protected, even if the credit event was triggered,” explained Benton.
Proponents and industry insiders point out, however, that it is unlikely that the credit default swap market on European financials would just “die off” or become non-existent. Besides the financial industry’s knack for finding a solution to every problem, it is very likely that changes could also be made to the standard trading documentation that is currently used trade CDS on financial firms in Europe.
“It is only a consultation paper, and some people have suggested it could be watered down significantly. However, our analysts think the proposals are unlikely to be changed significantly, because they are very much in line with what already exists in German, UK and Denmark Banking Acts, where regulators have the ability to haircut senior debt at failing institutions in periods of extreme duress. If it does go through, it could have implications for the CDS market,” said Zoso Davies, credit strategist at Barclays Capital in London.
Davies agreed the current form of the proposals could mean bonds issued under future regulation may not be deliverable into existing CDS contracts. “I think that is a hurdle the International Swaps and Derivatives Association would have to cross when it came to it,” he added.
The on-the-run Markit iTraxx Senior Financials index rose to its highest price above 200 bps immediately after the EC proposals came out in mid-January but have since settled back down to the 167 bps level – roughly around the same level it began the year at. The Markit iTraxx Subordinated Financials index (of European sub debt) is currently at 293.5 bps.