Banco Espirito Santo Swaps Seen Devalued in Restructuring

The restructuring of Banco Espirito Santo SA threatens to leave buyers of default insurance on the Portuguese lender’s subordinated bonds holding ineffective contracts.

The cost of credit-default swaps tumbled today on speculation the contracts will in future be linked to a new company, called Novo Banco, and won’t cover the lender’s outstanding subordinated bonds. Holders of those securities, along with shareholders, will be left with the bank’s most “problematic” assets, the Bank of Portugal said yesterday.

“Effectively the protection you bought could turn out to be worthless,” Andy Li, a London-based fund manager at GLG Partners LP, which manages $37.2 billion. “What you bought to provide you protection on subordinated debt might not do what you thought because ultimately there is nothing to deliver.”

The International Swaps & Derivatives Association said today it will rule whether a so-called succession event occurred for credit-default swaps on Banco Espirito Santo after the asset split. That will determine whether the swaps transfer to the new bank or remain covering the existing junior debt.

Swaps on the junior debt fell to 565 basis points from the equivalent of 1,300 basis points last week, according to CMA. There were 3,692 contracts covering a net $899 million of Banco Espirito Santo’s junior and senior debt as of July 25, according to the Depository Trust & Clearing Corp.

Senior Swaps

The cost of insuring Banco Espirito Santo’s senior debt also tumbled, with swaps falling 247 basis points to 420, according to CMA. That’s because the Bank of Portugal said senior bondholders won’t be hurt after it took control of Banco Espirito Santo’s assets and deposit-taking operations.

ISDA ruled today that a bankruptcy credit event had occurred for Espirito Santo Financial Group SA, which owns about 20 percent of Banco Espirito Santo. That would trigger all outstanding credit-default swaps on ESFG, though the group isn’t among top 1,000 entities tracked by DTCC.

In a succession event such as a company dividing into two, the debt can remain whole with one entity or be split between each. If an entity takes on 75 percent or more of a company’s obligations that can be guaranteed by swaps, then the derivatives become linked solely to that entity, according to definitions published by the International Swaps and Derivatives Association. Otherwise, swaps are divided.

“If they decide the CDS has succeeded to the new bank, then the CDS can’t really trigger however gruesome it gets at the bank,” said Richard Thomas, an analyst at Bank of America Merrill Lynch in London. “There will simply be no CDS at BES.”

Credit Event

The subordinated contracts will retain some value by protecting against a credit event at the new entity, according to Abel Elizalde, a strategist at Citigroup Inc. in London. In that event, junior contracts would be settled with senior bonds, he said.

The credit derivatives market is being overhauled and new contracts offering better protection will start trading next month. The planned changes address flaws revealed during the financial crisis, with the list of credit events that trigger payouts being expanded to include bail-ins, when investors are forced to contribute to bank rescues, along with bankruptcy, failure-to-pay and restructuring.

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