Novo Banco Decision Adds to Letdowns in Default-Swap Market

  • ISDA decides against amending any contracts tied to lender
  • Ruling follows transfer of bonds to Portuguese bad bank

Investors facing huge losses on Novo Banco SA bonds suffered another defeat.

The group that oversees the credit-default swaps market declined to amend any contracts insuring the Portuguese bank’s debt, probably killing off swapholders’ last chance of getting a payout following the transfer of about 2 billion euros ($2.2 billion) of bonds to a bad bank. All committee members voted against changes, the International Swaps & Derivatives Association said in a release on Wednesday.

The rejection may add to doubts about the insurance offered to bondholders through the $13 trillion credit-default swap market after investors failed to get payouts from contracts tied to Novo Banco debt last month. The two decisions also suggest that rules introduced in 2014 still aren’t enough to give bondholders full protection when governments or regulators intervene in banks.

“If the credit-default swap doesn’t work as anticipated, and you’re holding the bonds, you lose on both sides,” said Florian Steiger, a portfolio manager at Cape Capital AG in Zurich. “It’s like your house is burning down and your insurance doesn’t pay.”

ISDA’s committee of 15 money managers and dealers said that the Novo Banco bond transfer didn’t meet the criteria for a so-called succession event. A ruling in favor would have resulted in at least some Novo Banco credit-default swaps being rewritten and linked to the bad bank. More than 25 percent of an issuer’s “relevant obligations” have to be shifted to another entity to trigger a succession event, according to ISDA’s rules.

Bond Slump

Holders of five senior Novo Banco bonds were left facing losses in December when the Bank of Portugal decided to transfer the notes to a bad bank, Banco Espirito Santo, SA to boost capital levels. The bonds slumped to around 10 cents on the euro from more than 90 cents because the bad bank is set to be liquidated and is unlikely to repay the debt.

Last month, a panel of lawyers rejected a request for credit-default swaps to pay out because of the bond transfer. ISDA’s Determinations Committee sent the question for external review after being unable to reach a ruling. The decision was the first test of rules designed to boost protection against losses imposed by governments or regulators. 

“What happened at Novo Banco was so surprising that it wasn’t a credit event,” said Jochen Felsenheimer, the Munich-based founder of XAIA Investment GmbH which oversees 2.3 billion euros of assets.

Citigroup Inc. is asking clients if the definitions governing the contracts need to be changed even further to improve creditor protection and reflect credit risk.

‘Exceptional’ Transfer

While decisions about credit events such as bankruptcy or failure to pay are clear-cut, it’s difficult to address all possible scenarios, ISDA said in commentary on its website. The transfer of securities from Novo Banco was “exceptional”.

It’s unlikely to happen again. New European Union rules effective from January rule out selectively imposing losses on bondholders within the same class to fund recapitalizations.

ISDA’s ruling on Wednesday means all 2,658 credit-default swap contracts outstanding will stay linked to Novo Banco and won’t cover the five bonds that were moved. A net $387 million of Novo Banco debt was protected as of Feb. 26, Depository Trust & Clearing Corp. data show.

“This adds to the list of setbacks suffered by the derivatives as an effective tool,” said Roger Francis, an analyst at Mizuho International Plc in London. “It adds to people’s worries that credit-default swaps won’t do what they expect or hope.”

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