Photographer: Angel Navarrete/Bloomberg

Wiped-Out Creditors Await Delayed Payout in Debt Swaps Snag

  • Default swaps settlement stalled after government intervention
  • Traders wrangling over value of bondholder rights to litigate

It looked straightforward.

Investors bought insurance contracts that explicitly protect against bond losses imposed by governments or regulators as part of a bank rescue. But more than two months after junior notes were wiped out in Europe’s first forced sale of a failing lender under its new resolution regime, holders of credit-default swaps haven’t been compensated.

Banco Popular Espanol SA subordinated bonds were written off in June, when the struggling Spanish lender was sold to Banco Santander SA for one euro by the European Union’s Single Resolution Board. Within days, the group of traders that makes decisions for the $10 trillion credit derivatives market ruled unanimously that credit-default swaps should pay out. The sticking point is whether bondholders’ rights to litigate should affect the amount paid.

“Calling a credit event was straightforward, but deciding how the payout should work is proving tricky,” said Edmund Parker, global head of derivatives and structured products at law firm Mayer Brown in London. “A gray area has arisen in the new definitions.”

Swaps Overhaul

The so-called credit derivatives definitions, or rules governing the credit-default swaps market, were overhauled in 2014 to address flaws exposed by Greece’s debt restructuring and the Dutch government’s seizure of bonds issued by lender SNS Reaal NV.

Banco Popular’s sale constituted a governmental intervention credit event triggering payouts under the new rules, the International Swaps & Derivatives Association said on June 9. Outstanding contracts covered a net $162 million of Banco Popular’s debt as of that date, Depository Trust & Clearing Corp. data show.

Traders had expected insurance payouts on Banco Popular to vindicate the market overhaul. But so far, the first test under Europe’s new resolution regime is highlighting the challenge of protecting bondholders as regulators shift the burden of bank rescues to creditors from taxpayers.

ISDA’s determinations committee has met at least seven times since June to discuss settlement auction terms and held talks with market participants to establish whether defunct bonds have a market value and have changed hands. They’ll meet again on Friday.

Still Trading

The notes, although officially worthless, are still trading in the high single digits because investors are willing to pay for the residual rights, according to Otto Dichtl, a fixed income analyst at brokerage Stifel Nicolaus, which makes a market for the notes. That means the claims are likely to be included in the auction, he said.

Lawyers representing a group of Banco Popular’s junior bondholders, including Pacific Investment Management Co. and Anchorage Capital Group, are already challenging the decision to impose losses. The EU’s Bank Recovery and Resolution Directive states that creditors shouldn’t be worse off if a bank is resolved than if it were liquidated.

Some holders of credit protection are concerned that including existing legal claims and the right to start future proceedings in settlement auctions would lower the payout on swaps and hurt the credibility of the derivatives market. It’s unfair to some protection holders because the rights aren’t transferable, said Jochen Felsenheimer, the Munich-based managing director of XAIA Investment GmbH, which holds swaps on Banco Popular.

“Credit-default swaps are in all our strategies, so it’s in my interest that the market functions correctly,” said Felsenheimer. “You need to be convinced that insurance is paying you the loss you have suffered, and the loss here is simply 100 percent.”

The determinations committee said it will seek additional public comment after agreeing terms of the settlement auctions. If it can’t agree, the issue could be sent to an external review panel that would further delay the outcome, according to Parker at Mayer Brown.

“You would think this would be simple,” said Robert Montague, a senior financials analyst at ECM Asset Management in London, which doesn’t hold Banco Popular’s bonds or swaps. “There is a lack of confidence in credit-default swaps certainly as far as financials are concerned.”

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