Banco Espirito Santo Credit Swaps Devalued After ISDA Ruling

Banco Espirito Santo SA’s bailout has left buyers of default insurance on the Portuguese lender’s subordinated bonds holding ineffective contracts after a ruling by the International Swaps & Derivatives Association.

All outstanding credit-default swaps will be linked to a new bank, called Novo Banco, and won’t cover the lender’s outstanding subordinated bonds, ISDA ruled today. The separation of junior swaps from the underlying debt, which remains at Banco Espirito Santo, devalues the contracts.

“Sub CDS is worthless because you can’t deliver anything against it,” said John Raymond, an analyst at independent research company CreditSights Ltd. in London. “It highlights the problem in existing CDS.”

Banco Espirito Santo’s bonds were split as part of a 4.9 billion-euro ($6.6 billion) rescue by the Bank of Portugal, with the best assets moving to the new company and its most “problematic” assets left at the old entity. ISDA ruled this week that the bailout didn’t constitute a bankruptcy credit event that would have triggered payouts on swaps.

Credit-default swaps on Banco Espirito Santo’s senior debt fell 43 basis points to 342 and junior contracts decreased 47 basis points to 628, according to CMA prices at 3:50 p.m. in London. A total of 3,938 swaps covering a net $952 million of the Banco Espirito Santo’s debt are outstanding, DTCC data show.

Market Overhaul

ISDA ruled today that a so-called succession event has taken place at the bank. In an 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 ISDA’s existing rules. Otherwise, swaps are divided.

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. The list of credit events that trigger payouts is being expanded to include bail-ins, when investors are forced to contribute to bank rescues, along with bankruptcy, failure-to-pay and restructuring.

The Lisbon-based bank’s 750 million euros of 7.125 percent subordinated bonds maturing November 2023 have plunged to 14 cents on the euro from about 100 cents at the start of the year, according to data compiled by Bloomberg.

ECB Blessing

New derivatives rules may become increasingly important as bank rescues leave shareholders and junior bondholders with losses, while sparing senior creditors and unsecured depositors. The crisis that led to the rescue of Banco Espirito Santo was contained swiftly, European Central Bank President Mario Draghi said yesterday.

“Given that Draghi was fairly OK with the way Portuguese authorities dealt with this means, going forward, anyone doing the same strategy will expect the blessing of the ECB,” said Abel Elizalde, a strategist at Citigroup Inc. in London. “This reinforces the fact that the current sub CDS contract for banks is not perfect and doesn’t really work.”

A broader benchmark for the cost of insuring junior debt also dropped as the perceived value of the contracts declined. The Markit iTraxx Europe Subordinated Financial Index of credit-default swaps on 25 European banks and insurers fell four basis points to 105 basis points.

Trading in Markit’s subordinated index has slumped, with contracts on the current version of the benchmark covering a net $2.6 billion of debt as of Aug. 1, according to the Depository Trust & Clearing Corp., compared with $4.5 billion on the equivalent measure last year.

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