Will the Credit Default Swaps Market Become Less Predictable?

Yesterday's Wall Street Journal (8/30/11) reported on P. C11 that a hedge fund manager named Mark Brodsky asked the International Swaps and Derivatives Association to rule that a "bankruptcy credit event" (which triggers a dealer's obligation to pay under a credit default swap) has occurred for a company that hasn't actually entered into bankruptcy proceedings. A lot may ride on the response to this request. Brodsky runs a hedge fund called Aurelius Capital Management LP, which holds credit default swaps for Texas Cooperative Electric Holdings Co. According to Aurelius Capital, Texas Cooperative Electric is insolvent and has admitted as much. Aurelius Capital would like to collect on its CDS's without having to wait for an actual bankruptcy filing (which would constitute a bankruptcy credit event triggering a dealer obligation to pay on the CDS's).

A decision by ISDA that the insolvency of Texas Cooperative Electric is enough to trigger the obligation to pay on the CDS's may transform the CDS market. CDS's have been regarded as similar to insurance contracts, which pay when discrete, well-defined events occur. If the debtor doesn't pay the underlying debt on time or files for bankruptcy, then the dealer that sold the CDS has to pay its customer. But insolvency is a much broader concept, and may depend on how one defines and assigns valuations to the debtor's "assets" and "liabilities." Lawyers and accountants can argue until pigs fly about whether or not a debtor is insolvent. It's not unreasonable to believe that just about all major American banks were insolvent in parts of 2008-09; and it's possible that one or more remain insolvent today. Perfectly sane people rationally entertain suspicions that Europe's major banks might now be insolvent. Very possibly, most industrialized nations of the world are insolvent. There are shiploads of CDS's outstanding with respect to the debt of all the major banks and just about all the world's industrialized nations.

If Aurelius Capital can collect on its Texas Cooperative Electric CDS's without an actual bankruptcy filing, a lot of market participants holding an exponentially larger quantity of bank and sovereign debt CDS's might be similarly entitled to collect because the relevant underlying debtors are insolvent. The major CDS dealers might become shaky at that point--assuming they can even figure out their net claims or liabilities, which could be a convoluted process given that we still don't have much transparency in the trading, settlement or clearance of CDS's, Dodd-Frank notwithstanding. Since the major CDS dealers are among the world's largest banks, a lot might be at stake.

Financial crises, like the debacle in 2007-08, tend to occur because something unexpected happens. In the case of the events in 2007-08, it was the drop in the real estate market on a national basis, something that hadn't happened in a very long time and therefore wasn't expected to happen again. Today, the European sovereign debt crisis could trigger another financial crisis because market participants continue to believe that there is no problem so great that some expedient muddling by EU governments can't forestall the denouement for yet a couple more months. Excessive expediency allows underlying problems to fester and fester--and then blow up when least expected.

A change in the way CDS's are interpreted, as requested by Aurelius Capital, could fluster a lot of people playing in the CDS market. That market might become less predictable, and then who knows what would happen. If there's one thing the CDS market hasn't expected, it would be a legal interpretive issue like this one, which could, in one fell swoop, affect the length and breadth of the market--and with it, the entire financial system. So keep an eye out for the outcome.