Traders See Free Money in Derivatives Linked to Monte Paschi

  • Opportunity emerges from difference in price of default swaps
  • Old swaps cost more than new ones protecting against bail-ins

Some credit traders think they’ve found free money in an obscure derivatives trade linked to Banca Monte dei Paschi di Siena SpA. Others are warning it may be a mirage.

The debate centers on a price difference between insurance contracts on the troubled Italian lender’s senior debt. Credit-default swaps bound by rules dating from 2003 are now more expensive than contracts written after 2014. Typically the relationship is reversed because newer contracts offer more protection against losses imposed by governments under a so-called bail-in.

In theory, traders could profit from the distortion by simply selling insurance through the 2003 contracts while simultaneously buying it under the 2014 swaps -- pocketing the higher premiums they’d get paid on the older derivatives. There’s a chance for an even bigger payout if a state rescue triggers the newer contracts and not older ones.

The risk is that if a government bail-in is limited to junior bondholders it wouldn’t trigger protection payments on the new senior contracts that are part of the arbitrage trade, according to Aritra Banerjee, a credit derivatives strategist at Citigroup Inc. in London.

Still, he thinks it’s worth the gamble.

“Given the position will earn a positive carry, to us, this seems like a decent risk-reward way to play what we see as a prominent dislocation,” he wrote in a note to clients. “Wherever 2003 senior protection trades wide to 2014, to us this seems anomalous.”

The discrepancy exists in part because some investors might be betting that a restructuring event is more likely than a bail-in, said Jochen Felsenheimer, the Munich-based managing director of XAIA Investment GmbH. By restructuring only junior bonds, Monte Paschi could trigger payouts on both senior and subordinated 2003 swaps, but not senior 2014s, because of cross-default terms in older contracts.

The reverse of the trade recommended by Citigroup makes sense given Monte Paschi’s efforts to expand a debt-for-equity swap and avoid a bail-in, said Filippo Alloatti, a senior credit analyst at Hermes Investment Management in London, who decided not to place the bet partly because of the risk of a bank resolution.

“It’s the sort of trade that works wonderfully on Excel, but it’s a gutsy one,” he said. “Performance has been good this year and I wouldn’t risk it on this trade.”

Credit-default swaps were overhauled in 2014 when the list of events triggering payouts was expanded to include bail-ins, where investors are forced by regulators or governments to contribute to bank rescues. Greece’s debt restructuring in 2012 and the Dutch government’s seizure of lender SNS Reaal NV’s bonds in 2013 prompted the changes.

Historical Precedent

Given the fact that the 2003 swaps aren’t meant to capture a bail-in, the likelihood that sellers would have to pay out “is not only outright low, based on the historical precedent, but substantially lower” than for sellers of the 2014 contracts, Banerjee wrote.

Monte Paschi’s credit swaps reversed in July, when the European Central Bank raised new concerns about capital levels. The Italian lender’s older contracts are now quoted at 196 basis points more than newer ones, according to data compiled by CMA.

Monte Paschi is racing to find backers for a 5 billion-euro ($5.2-billion) capital boost by the end of the year after the ECB rejected its request to move the deadline to January. The Siena-based bank is increasing a debt-for-equity swap offer to 4.5 billion euros, subject to regulatory approval.

Felsenheimer at XAIA Investment, which oversees 2.3 billion euros of assets, considered both sides of the trade and also decided against participating because it’s too speculative.

“The trade makes sense because even if nothing happens you get a carry, you earn more selling the 2003 contracts than you pay buying the 2014s,” he said, referring to the trade advocated by Citigroup. “This is an obvious discrepancy. Monte Paschi is the only name in the universe of European banks that trades with this kind of spread difference.”

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