This commentary was published with permission from Tavakoli Structured Finance in LIPPER HedgeWorld with the title: “Mon Ami ISDA: Crisis in Credit Derivatives.” Tavakoli Structured Finance retains the copyright.
By Janet Tavakoli
Monday, May 22, 2006
What would happen if every credit derivatives contract written by hedge funds were open to dispute? We may be about to find out.
According to the International Swap Dealers Association (ISDA), the credit derivatives market is approximately $17.1 trillion in size. Hedge funds make up a large part of this market, and for some financial institutions, hedge funds make the majority of their trades. In the spring of 2005, Lehman Brothers estimated that hedge funds were responsible for 57% of its trading volume.
Hedge funds can gain credit exposure to an entity, usually a corporation, by either buying bonds or by selling credit default protection in the form of a credit default swap contract, the most common form of credit derivative. Hedge funds are also buyers of credit default protection, but are usually net sellers of credit default protection.
Credit default swaps are bilateral contracts. The protection buyer makes payments to the protection seller, and in exchange, the protection seller agrees to make a payment if a credit event occurs on a reference credit, usually evidenced by default on a pre-named reference obligation. For example, if I bought protection on GM and it defaulted on payment of its bonds, my counterparty, a hedge fund that sold me protection, would allow me to deliver a GM bond selling at a drastically discounted price, and would pay me par for the bonds. Alternatively, we might settle up for the cash difference instead. The difference between these contracts and insurance is that I do not actually have to own bonds, I do not have to actually suffer a loss, and the counterparty who sold me protection does not have the right to sue the entity that caused me the loss to recover the amount it paid me.
Since the mid 1990s, I have been a critic of the ambiguities embedded in the language of ISDA documentation. I have encouraged counterparties to change unwanted effects of the original documentation, and to clarify ambiguous language. I have continued to make that recommendation as the ISDA language continually evolved to make up for previous shortcomings. While ISDA may claim the documentation is unambiguous and should be the “standard,” the credit derivatives market has had several disputes when defaults have actually occurred.
Since the inception of the credit derivatives markets, disputes erupted on credit default swap contracts on up to 40% of defaulted reference entities. ISDA documentation is used in 90% of outstanding credit derivatives contracts, and every dispute I have seen has been based on this documentation. Arbitration and settlements ensure that most never receive coverage in the popular press and do not set precedents for the credit derivatives markets. Investment banks, banks, monoline insurers, investors and hedge funds have all been involved in disputes ranging from settlement terms, timing of settlement, definition credit events, and attempts to recovery payments made to counterparties who had superior knowledge.
In a strange twist of fate, ISDA is attempting damage control in a situation that could have hedge funds and their counterparties running in panic from the credit derivatives market. On May 8, 2006, ISDA filed a brief of amicus curiae supporting Société Générale (Soc Gen), the defendant in a credit derivatives dispute with Aon Financial Products (Aon). Soc Gen seeks to reverse a Southern District of New York court ruling in favor of Aon in the amount of $10,128,917.42, the award of attorney fees and costs with interest.
One can only sympathize with the courts. I disagree with one of the most clearly written sentences in ISDA’s brief: Confirmations document the precise risk that the parties wish to transfer and price. Sometimes they do. Many times—as evidenced by the number of post-default disputes—they don’t. I do agree, however, that confirmations should be enforced according to the express terms in the contract. Therein lies the rub. Often there is room for disagreement on the meaning of the terms.
Unfortunately for the credit derivatives market, the court seemed to have several misunderstandings, including the meaning of the original contract language, the mechanics of the credit default market, and market practice.
Aon bought credit default protection from Soc Gen on the Republic of Philippines and defined its reference obligation specifying the ISIN number of the 8.875% Republic of Philippines bonds maturing April 15, 2008. If there were a default, then Aon could deliver any bond obligation of the Republic of the Philippines, including USD denominated obligations guaranteed by the Republic of the Philippines provided the debt was equal in seniority. In a separate and independent transaction, Aon sold credit default protection to Bear Stearns referencing a surety bond issued by the Philippines’ Government Service Insurance System. One might ask what Aon’s contract with Bear Stearns had to do with Aon’s contract with Soc Gen. It is the right question. They should have nothing to do with each other.
One might take a guess that Aon intended to hedge its risk in the Bear Stearns transaction by entering into a contract with Soc Gen. If so, it did exactly that. It hedged; it did not engage in an arbitrage. The hedge had basis risk, presumably the only reason it would make any economic sense in the first place. A hedge is not an arbitrage, and when hedgers take basis risk, they must bear that risk.
The court did not seem to see things that way. It seemed to attempt to link the two transactions, and tried to interpret Aon’s transaction with Soc Gen by looking at the terms of Aon’s contract with Bear Stearns. First, the court engaged in mind reading. It stated the intent of Aon’s contract with Soc Gen was to guarantee that Aon would be paid if Aon’s contract with Bear Stearns required it to make a credit protection payment. If so, Aon’s contract should have referenced liability under the Bear Stearns’ contract as a credit event and redefined the reference obligation, but it didn’t.
The court also referred to the surety bond as a reference obligation and therefore that it qualified as a deliverable obligation under the terms of Aon’s contract with Soc Gen. This is such a mess that it is difficult to know where to begin. The surety bond is not a reference obligation in Aon’s contract with Soc Gen, but it may qualify as a deliverable obligation if there is a default of the actual reference obligation, the Republic of Philippines bonds, which were clearly specified.
Finally, the court did not seem to grasp that conditions to payment must be satisfied before the swap is settled according to the contact’s specific settlement terms. It is fair to consider the intent of parties in interpreting ambiguous terms in a contract. But when terms are clear, it is not fair to rewrite unambiguous terms, just because one wishes the outcome were different.
In this article, I relied on the representations in ISDA’s brief, since I have not read the original case documents and filings. One can only wonder how the legal process went so badly wrong that it created a host of messy issues capable of changing the economic landscape of the global credit derivatives market.
At one point in its brief, ISDA chides the court: “Any interpretation that fails to give effect to the Settlement Terms is squarely at odds with New York law and the economics and risks agreed to by the parties.” While I agree that is true, it seems ISDA might have spent more time clearly defining the terms and issues in a way that would make it easier for the court to follow. It is what I have been advising counterparties to do all along.
Aon never thought it would win this case. But it had the budget to litigate and felt it had a long shot at shaking Soc Gen down for payment on a credit event that never actually happened, and meanwhile it tied Bear Stears (Ursa) up in litigation on the separate credit derivatives transaction to delay (and potentially avoid, if it could get away with it) payment. The United States Court of Appeals for the Second Circuit overturned the 2006 district court ruling on the credit derivative contract between Aon Financial Products and Société Générale. Aon didn’t get away with this stunt; the court ruled in favor of Société Générale, and a crisis was averted.
See also: Credit Derivatives & Synthetic Structures 2nd Edition, by Janet Tavakoli (Wiley 1998, 2001)
Read more finance articles by Janet Tavakoli