"By John Glover
Jan. 22 (Bloomberg) -- Governments would need to take over all the assets of a bank and take charge of daily operations for a nationalization to trigger payouts on credit-default swaps, according to Bank of America Corp. analysts.
Simple nationalization wouldn’t be enough to settle the derivatives, which protect investors against a company defaulting on debt repayments, New York-based strategist Glen Taksler wrote in a note today. A collapse in share prices of New York-based Citigroup Inc. and Royal Bank of Scotland Group Plc is stoking speculation the U.S. and U.K. will be forced to take full ownership of some financial institutions.
“It’s worth noting the high threshold that would be required for bank nationalization to trigger credit-default swaps,” New York-based Taksler wrote in the note. “Simply taking a substantial ownership stake through equity is not enough.”( ISN'T THAT WHAT WE'RE DOING NOW? )
Events last year provide a guide to what may have to happen to trigger payouts on the contracts, Taksler wrote.
In the U.K., the nationalization of Northern Rock Plc in February 2008, which had the first run on a British lender in more than a century, didn’t prompt payments on credit-default swaps. This was because the government took over the bank’s equity and not its debt, agreed to manage it at arm’s-length and stated the institution was solvent, the note said.
A statement that a lender is insolvent( AREN'T THEY? ) may be required to start the process of paying out on default-swap contracts, he said.
Bradford & Bingley
Because Bradford & Bingley Plc, which was nationalized last year, wasn’t considered by the U.K. government to be definitely unable to meet its obligations, credit-default swaps on the Bingley, England-based lender weren’t triggered, Taksler wrote.
However, when the U.S. government took over mortgage-finance companies Fannie Mae and Freddie Mac in September, it placed them into conservatorship, which did trigger default swaps, Taksler said.
More than $1 trillion in losses and writedowns by financial companies around the world are weighing on banks’ stock prices and their ability to repay debt. Citigroup fell 45 percent in New York trading this year, RBS, based in Edinburgh, lost 72 percent and Lloyds Banking Group Plc slipped 57 percent. The U.S., U.K. and other nations implemented bank-rescue packages including asset buyouts and debt guarantees seeking to unfreeze lending.
Anglo Irish
Ireland seized control of Anglo Irish Bank Corp., the nation’s third-largest bank, on Jan. 15 after a scandal that forced the resignations of its chief executive and chairman.
Credit-default swaps on RBS fell seven basis points to 145, according to CMA Datavision at 12:15 p.m. in London. Barclays narrowed to 190 from 198 and Lloyds fell to 130 basis points from 137. Anglo Irish widened to 422.5 basis points from 415, according to CMA.
Timothy Geithner, President Barack Obama’s nominee for Treasury secretary, said yesterday the new administration will take “ substantial action” to stabilize the banking system and ensure credit reaches small businesses.
Geithner indicated the administration is looking at using some type of a “bad,” or “aggregator” bank to remove toxic asserts from bank balance sheets. He gave no indication he’s planning outright government takeovers.
Credit-default swaps are contracts for protecting bonds against default and are used by traders to speculate on changes in credit quality. The swaps pay the buyer face value in exchange for the underlying securities if a borrower fails to adhere to its debt agreements.
A basis point on a credit-default swap contract protecting 10 million euros ($13 million) of debt from default for five years is equivalent to 1,000 euros a year."
By John Glover and Shannon D. Harrington
Jan. 28 (Bloomberg) -- A default by a bond insurer such as ACA Capital Holdings Inc. may trigger a ``settlement disaster'' for credit-default swaps because of uncertainty over how to make good on overlapping contracts, according to Bank of America Corp. analysts.
Some investors including Merrill Lynch & Co. bought credit- default swaps from financial guarantors to guard against losses on mortgage-linked securities, and then later bought protection for the possibility those guarantees may be worthless. The structure of such contracts means some may not be able to redeem their hedges in the event of default, the analysts wrote.
``We see huge potential problems for settling CDS contracts,'' the analysts, led by Glen Taksler in New York, wrote in a Jan. 25 report. ``Even a credit event for a relatively small monoline, such as ACA, could have significant implications.''
ACA Capital, which guarantees more than $75 billion of debt, may face delinquency proceedings next month from the Maryland Insurance Administration if it can't win another forbearance on $60 billion of credit-default swap contracts, about half of which is linked to securities backed by home loans to people with weak credit.
Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt or to hedge against losses. The buyer gets face value in exchange for the underlying securities or the cash equivalent should a borrower default.
A 2005 supplement to industry documents made it possible for investors to use credit-default swaps to hedge against both losses on the debt sold by bond insurers and losses on securities that the insurers guaranteed, Taksler said.
Merrill Lynch's Hedges
Merrill Lynch bought $19.9 billion in credit-default swap protection from financial guarantors to protect against losses on mortgage-linked securities known as collateralized debt obligations, the New York-based firm disclosed in a statement last month. The bonds and loans underlying the securities have been defaulting at a record pace.
The possibility that the bond insurers themselves fail prompted Merrill to buy an additional $2 billion of protection as of Dec. 28 that would pay it if an insurer defaulted, according to the company's disclosure.
An actual default could cause problems for Wall Street in determining who can collect on such hedges and how much, the Bank of America analysts wrote in their report titled ``Monolines: A Potential CDS Settlement Disaster?''
The bond insurance units of Ambac Financial Group Inc. and Security Capital Assurance Ltd. were stripped of their AAA grades by Fitch Ratings this month, and Moody's Investors Service and Standard & Poor's are considering downgrades as well. Moody's said it may also lower ratings on MBIA Inc.'s bond insurer, the world's biggest. Downgrades would throw doubt on the $2.4 trillion of bonds the industry guarantees.
Default Scenario
Under the most basic scenario, someone who bought credit- default swap protection on a bond insurer would have to deliver either a bond or loan issued by the insurer or a security guaranteed by it, they said. Many guarantees, or so-called wraps, from bond insurers on CDO securities were in the form of credit- default swaps and done through an affiliated entity.
``Because the wrap is not on the CDO tranche itself, the CDO tranche would not be deliverable into'' credit-default swap contracts linked to the bond insurer, Taksler wrote.
Wall Street could create a system where such contracts could be cash settled, as they have done after past bankruptcies.
That would require the industry to agree on a market value for every security deemed eligible for delivery, ``a time consuming and difficult process, which could exceed the 30 calendar days within which parties normally settle credit-default swaps,'' Taksler wrote.
New Problems
Banks that raised $72 billion to shore up capital depleted by subprime-related losses may require $143 billion more if bond insurers are cut, according to analysts at Barclays Capital.
Losses at ACA Capital caused Merrill to write down $1.9 billion of securities this month, and Toronto-based Canadian Imperial Bank of Commerce to sell more than C$2.75 billion ($2.7 billion) in stock to cover writedowns.
The credit-default swap market has never had to cope with a credit event involving a bond insurer before, Charlotte, North Carolina-based Bank of America's Taksler wrote. Every time a new problem affects the market, bankers discover they should have written the contracts in a different way, he said."
I don't even know what to say about this. It's a legal mess.
NEW YORK, Jan 9 (Reuters) - U.S. banks may need to increase the amount of capital they hold after changes are introduced to credit default swap contracts( YIKES ), which the banks use to hedge against defaults on corporate bonds and loans.
Credit default swaps are used to insure against a borrower defaulting on their debt or can be used to bet on a company's credit quality.
A protection buyer can be paid out the insurance when a borrower files for bankruptcy, fails to make an interest or principal payment on their debt or, in some cases, when a company restructures its debt.
Changes expected to roll out as early as next month, however, will remove the restructuring trigger for standard contracts in North America. Buyers of protection may still request restructuring triggers in tailored trades, although it would cost more.
The changes will standardize contracts on single company debt with those on indexes, which do not include restructuring. Standardized contracts are part of an industry push to set up a central clearing system for the $47 trillion CDS market.
The changes will also remove confusion over how to settle contracts paid out on a restructuring, which could be significantly more complicated to close out than those sparked by bankruptcy or failure to pay.
For banks, however, the move may prove expensive. It will reduce by 40 percent the capital relief awarded by using use CDS to hedge bond and loan holdings, said Bank of America analyst Glen Taksler.
"The downside to removing restructuring is that banks get full capital relief from buying CDS with restructuring, but only 60 percent capital relief without restructuring," Taksler said.
A protection buyer wanting to include a restructuring trigger in a CDS contract would pay a higher premium of 2 to 10 percent than if they bought a contract without restructuring, based on market valuations, Taksler said.
Banks may react to the change by selling bonds and loans, which could pressure their valuations.
"In the absence of regulatory capital relief, it is possible that banks that buy bonds, or lend loans, and buy protection may find their capital requirements increase significantly," Taksler said.
"Given current capital constraints, this may force the unwinding of some existing cash positions," he said. "The result would be wider bond spreads and lower loan prices."
Market participants are in discussions with regulators with the hope of removing or reducing the penalty for excluding restructuring as a trigger in contracts, said a person familiar with the discussions who declined to be identified.
STANDARDIZATION
"Right now, if you try to net index and single name trades, you're left with restructuring risk because one contract has restructuring and the other doesn't," said Sivan Mahadevan, head of credit derivative and structured credit research at Morgan Stanley in New York.
Credit derivative dealers have large portfolios of trades, in which they both buy and sell protection on corporate and other debt.
As defaults increase, banks have been simplifying these portfolios by reducing their offsetting positions, a process known as netting.
"Given how important the indices are and how much trades there, netting between the indices and the single names would be so much easier," said Mahadevan.
Restructuring is also complicated as it makes the incentives different for the protection buyer and the protection seller, said Karel Engelen, head of technology solutions at derivatives trade association, the International Swaps and Derivatives Association.
This is because the debt backing the contracts is different depending on whether the protection buyer or the protection sellers calls payments on the contracts.
If a protection buyer seeks to be paid out after a restructuring they are only able to settle the swaps with debt that has a similar maturity as the swap. If a protection seller triggers payments, debt of any maturity can be used.
"If the incentives to trigger on the buy and sell side are not identical, then it becomes a lot more difficult for a central counterparty to manage those two trades," Engelen said."
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