Wednesday, November 18, 2009

Debt restructurings spark CDS confusion

Posted on Reuters by Karen Brettell:

Recent debt restructurings by Mexico's Cemex (CMXCPO.MX) (CX.N), French electronics firm Thomson (TMS.PA) and Japanese lender Aiful Corp (8515.T) have raised new concerns in the credit default swap market over when reorganizations should trigger payments on the contracts.

The use of restructuring as a means of sparking CDS payments in this $26 trillion market has also been criticized as enabling lenders to game the contracts to time payouts.

CDSs, which can protect lenders against debt defaults, need to be paid out when a company or other borrower misses a debt payment or files for bankruptcy.

In some cases a debt restructuring can also trigger payments, through the decision can be subject to interpretation and sometimes lead to unexpected results.

"Restructuring is the last bit of the CDS market that remains fuzzy," said Sivan Mahadevan, head of credit derivatives research at Morgan Stanley in New York.

An industry committee is currently divided on whether payments on around $600 million in CDSs protecting Cemex should be made after creditors in August agreed to extend the maturities on $15 billion in bank and bond debt.

Key to the decision is whether the maturity extension resulted from a deterioration in Cemex's creditworthiness. Deliberations are for the first time being put to an outside panel for resolution.

An auction to settle CDS on France's Thomson last month also raised complaints after technical factors swayed valuations far from what participants viewed as fair values.

Attempts to trigger payments from contracts on Japanese consumer lender Aiful have also been frustrated, either as a restructuring or failure to pay, in large part because of the private nature of its loan agreements.

Debt restructuring has been removed as a CDS trigger in the U.S., however it remains common in other countries where the use of bankruptcy court to reorganize is less common.

Lenders in these countries often seek protection against a restructuring that could radically decrease the value of the debt. Regulators also give European banks 100 percent capital relief for CDS hedges that include the trigger, compared with only 40 percent without it.

"Its more important to have a restructuring in Europe than it is in the U.S. because the likelihood of a restructuring hurting the value of the loan you're hedging as a bank hedger is more significant," said Andrew Scott, managing director at NetDelta, a CDS platform at Knight Capital.

When a restructuring qualifies under terms of the CDS, however, is not always clear.

"One of the obvious issues is that it isn't as objective as other credit events, when you have a failure to pay or bankruptcy those are very clear," said Michael O'Brien, partner at law firm Winston & Strawn in Chicago.

"There are circumstances where you can have significant modifications to a company's capital structure but they don't really rise to the level of a restructuring," he said.


The use of restructuring to trigger CDS can also allow market participants to game payments to suit the maturities of the contracts they hold.

"There are concerns that someone can play the timing of it," said Matthew Magidson, counsel at law firm Lowenstein Sandler PC in New York.

A restructuring credit event can take months to settle because a contract is only paid out when the restructuring is complete. CDSs linked to a failure to make debt payments, however, are triggered almost immediately.

In some cases, including one recently seen at Canadian pulp and paper producer Abitibi-Consolidated, lenders can turn a restructuring into a different CDS trigger by adding certain terms to credit agreements.

"Bank credit agreements can include terms that provide that any attempt at restructuring will trigger a default, which requires all the company's debt to be repaid and then precipitates a failure to pay," said Magidson.

Efforts to further clarify restructuring in CDSs, meanwhile, are expected though they are unlikely to be able to capture all of the complications of a debt reorganization.

"I don't think anyone disagrees restructuring is a vague definition, but what's more clear? What timeline are we talking about? How do you measure deterioration?," said Knight's Scott. "These are questions that aren't easily answerable."

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