Looking a bit tarnished.

Photographer: Thomas Meyer/Bloomberg

Toss a Derivatives Grenade Into Portugal's Bond Mess

Mark Gilbert is a Bloomberg View columnist and writes editorials on economics, finance and politics. He was London bureau chief for Bloomberg News and is the author of “Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable.”
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Just as last year was ending, the Portuguese central bank sent its bond market into a tizzy. It chose five bonds worth about 2 billion euros ($2.2 billion) and assigned them to the bad bank it had just created, destroying about 80 percent of the value of the securities. The body that helps oversee the derivatives market has an opportunity to help right this wrong. But to do so, it will first have to make the situation even worse.

Europe's Banking Union

Here's a quick recap. Last year, Portugal divided Banco Espirito Santo, previously the nation's largest lender, into a "good" bank and a "bad" bank. Senior bonds were initially assigned to Novo Banco, the good bank; but on Dec. 30, five of them were reassigned to the bad bank, called BES. By taking the debt off Novo Banco's balance sheet, the authorities were able to fill a 1.4 billion-euro hole in its balance sheet that the European Central Bank's stress tests had revealed in November.

The decision caused an uproar because it ignored the legal documentation that says all bonds with the same ranking in a company's capital structure should be treated equally -- a doctrine known as pari passu. Last week, Portuguese Prime Minister Antonio Costa said he'd warned his central bank that he was "apprehensive about the systemic effects" of the switch, with bondholders discovering that "what they considered to be protected wasn’t protected."

The International Swaps and Derivatives Association is wrestling with whether the Portuguese move counts as a so-called credit event. If it does, then insurance contracts on the bonds, known as credit-default swaps, would be triggered, and bondholders can cash in on their insurance policies. ISDA's 15-strong committee, though, has failed to reach a decision, and is now recruiting an external panel to decide.

Here's the rub: If ISDA rules that the five reassigned bonds are effectively in default, then in theory a legal clause called cross default kicks in -- and more than 50 Novo Banco bonds worth almost 18 billion euros might be deemed to be in default.

In another twist, the Jornal de Negocios reported Wednesday that the Portuguese central bank has hired Deloitte LLP to assess bondholders' losses, and is considering paying compensation. It would be weird for bondholders to get government compensation at the same time as ISDA says there hasn't been a credit event.

On the surface, this all seems quite parochial. It isn't; it has far-reaching ramifications for the European Union's Bank Resolution and Recovery Directive, which came into force at the start of the year. The directive is designed to stop taxpayers being on the hook for bank failures, partly by 'bailing in' senior bondholders so their capital is at risk. The arbitrary nature of Portugal's move -- even though it came just prior to the new rules coming into force -- has undermined confidence in how the bail-in mechanism might be implanted in other bank failures.

So here's hoping the external panel decides to trigger the Novo Banco default swaps. It will cause chaos, for sure -- but it might bring the Portuguese central bank to its senses. It might even persuade the authorities to reverse a decision that Scott Thiel, the deputy chief investment officer at Blackrock, said earlier this week has made investors "wary" of putting money into Portuguese debt. 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Mark Gilbert at magilbert@bloomberg.net

To contact the editor responsible for this story:
Therese Raphael at traphael4@bloomberg.net