Month: March 2010

Crisis in Greece Leads to Renewed Calls for CDS Regulation

 

Greek Prime Minister George Papandreou urged global action to curb speculation in credit default swap (“CDS”) transactions, particularly those relating to sovereign debt. During a visit this month to the United States, Papandreou said: “We need clear rules on shorts, naked shorts and credit default swaps. I hope there will be a positive response from this side of the Atlantic to bring this initiative to the G20.” At a joint news conference with German Chancellor Angela Merkel in Berlin on March 5th, he also referred to CDS as a “scourge” that threatened the Greek and global economies. Merkel added: “Credit-default swaps, where you insure your neighbor’s house just to destroy it and make money from it, that’s exactly what we have to curb.”

Fear of contagion from Greece’s fiscal troubles have led to concern across the European Union, particularly in the eurozone. In an effort to calm market concern over its spending, the Greek government passed extreme austerity measures in early March, including a sharp cut in civil servant entitlements and an increase in the value-added tax rate. These measures are intended to result in savings of some €4.8 billion. But Greece remains in desperate need to access the capital markets as well, as it must roll over €53 billion of its approximately €300 billion of debt this calendar year, €20 billion of it by the end of May. The sixteen eurozone members remain divided on whether—and how—to assist Greece. Concerns exist over the prospect of their failure to provide standby loans or other support to Greece, which could harm the credibility of the Euro if Greece instead seeks support from the International Monetary Fund. Additional pressure for a solution was put on eurozone members by the March 24th downgrade of Portugal’s debt rating to “AA-” from “AA” by Fitch Ratings.

As the Greek debt crisis has unfolded, the country’s borrowing costs have skyrocketed. On March 4th, the country issued €5 billion of heavily-oversubscribed 10-year bonds at 6.25%, or approximately twice the rate payable on German bunds. Papandreou and some commentators blamed this 300 basis point premium over the German benchmark, at least in part, on speculators buying protection through CDS contracts. The purchase of such protection by speculators effectively bets on a default on debt which, in turn, drives up CDS premiums and reinforces the market perception that Greece will indeed default; this negative market perception is reflected in the borrowing costs of bonds issued. Of course, the primary driver of Greece’s high bond rate is the inherent risk of its ability to repay its debt.

Despite substantial industry efforts to increase standardization and transparency for CDS in the wake of the AIG crisis,[1] the product remains viewed by certain vocal critics as a major contributing factor to the financial meltdown that should be subject to stricter regulation, or even outright ban. Indeed, the Greek crisis has led to renewed calls for regulation and bans of the product across Europe, including by Jose Manuel Barroso, the European Union Commission President. This spotlight shines on CDS as comprehensive financial reform legislation continues to be considered by federal legislators in the United States and in the European Union.


[1] CDS transactions were subject to condemnation by politicians and the media alike in connection with the AIG crisis in the fall of 2008. Among other things, this crisis led to a short-lived effort by New York State insurance regulators to make certain CDS transactions (i.e., those under which buyers of protection own the underlying asset on which protection is written) subject to insurance regulation (see Client Alerts: September 2008 and November 2008). More recently, the New York Senate released draft legislation this month under which, among other things, certain credit protection sellers would need to be licensed as providers of “credit default insurance.” It is not clear whether this proposed legislation would be redundant with (or be precluded by) any final federal regulation of CDS.

ISDA Publishes Whitepaper and Market Review on Collateral

 

On March 1st, the International Swaps and Derivatives Association, Inc. (“ISDA”), the Managed Funds Association and the Securities Industry and Financial Markets Association jointly published a Whitepaper (the “Whitepaper”) on Independent Amount.  On the same date, ISDA also published a market review of over-the-counter (“OTC”) bilateral collateralization practices (the “Market Review”).  The Whitepaper and Market Review were developed for the purpose of better understanding current derivative market practices surrounding collateralization, a key method of mitigating counterparty risk in exchange-traded and, especially, OTC derivatives.  The documents make specific recommendations (including for legislative and regulatory changes in certain jurisdictions) for market participants to improve or enhance their collateral management practices. READ MORE

Italian Senate Finance Committee Acts to Restrict Municipal Derivatives

 

As we reported in our May 2009 publication, on April 27, 2009, Italian financial police, acting on the order of a judge, seized millions of Euros of assets of four large banks in connection with a probe relating to derivatives transactions entered into by the city of Milan.  On March 17th, these four banks, eleven bankers and two former city officials were charged with fraud in connection with these transactions.  Prosecutors claim that the banks fraudulently profited €100 million in fees from the city which were not properly disclosed under these transactions.  Moreover, it has been reported that at least one of these transactions included an interest rate “collar”, which required the city to make payments to the bank if interest rates went below the specified floor, which they did.  It is not clear whether, and to what extent, the banks disclosed the risks inherent in such transactions and whether city officials adequately understood these risks.

Against the backdrop of this ongoing case involving Italy’s financial center, on March 11th, the Italian Senate Finance Committee (the “Committee”) unanimously approved a proposal (the “Proposal”) that would restrict the use of derivatives by municipalities.  The Proposal is the culmination of a year-long review by the Committee prompted by a rash of losses incurred (and negative values accrued) by many Italian municipalities during the credit crisis.  In all, Italian municipal entities reportedly face potential losses of €2.5 billion on derivatives.

Among other things, the Proposal would limit the use of derivatives to towns having at least 100,000 residents (other than capitals of provinces), ban upfront payments and compel municipalities to obtain an opinion from the Economy Ministry (until now, they only had to show the contract to the ministry) before execution of any transaction.  According to the chairman of the Committee, the Proposal would require municipalities to prove that execution of a derivative transaction would put them in a better position than repaying their current debt.

As we reported last May, concern about municipal derivatives is not isolated to Italy.  Local governmental entities in Germany and the United States (including, most notably, Jefferson County in Alabama) continue to struggle with the aftermath of trades that went significantly out-of-the-money to them.

ISDA and Market Participants Send Commitment Letter to Supervisors

 

On March 1st, ISDA and twenty-five (25) market participants submitted to the Federal Reserve Bank of New York, as well as to other global supervisors, a letter (the “Industry Letter”) detailing the steps the industry has taken to improve the framework for OTC derivatives transactions and making additional commitments.  The Industry Letter is the sixth in a series of letters addressing how the industry will work to, among other things, strengthen the robustness of OTC derivatives markets infrastructure and improve transparency. READ MORE