Posts by: Editorial Board

BIS Releases OTC Derivatives Semiannual Report

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On May 10th, the Bank for International Settlements (“BIS”) released a report on the OTC derivatives market in the second half of 2009 (the “Second 2009 Report”).  According to the Second 2009 Report, the total notional amounts outstanding of OTC derivatives increased by two percent (2%) to $615 trillion by the end of 2009, after an increase of ten percent (10%) in the first half of 2009. Interest rate swaps remain, by far, the largest segment of the OTC derivatives market, with approximately $350 trillion in notional amounts outstanding. Commodities transactions and credit default swaps (“CDS”) each registered a reduction in notional amounts outstanding of twenty-one percent (21%) and nine percent (9%), respectively.[1]

According to the Second 2009 Report, despite the increase in total notional amounts outstanding, the gross market value of all OTC derivatives positions (i.e., the cost of replacing such contracts) declined in the second half of 2009, as did the overall gross credit exposure of such transactions (i.e., gross credit exposures after taking into account enforceable bilateral netting agreements, excluding CDS for all countries except the United States).  Gross market value declined by fifteen percent (15%) and overall gross credit exposure declined by six percent (6%) in the second half of 2009; each had also substantially declined in the first half of 2009.

[1] Note, however, that CDS positions on sovereign debt increased ten percent (10%) from the first half of the year.  For a discussion of the renewed calls to regulate sovereign debt CDS, see the March 2010 Derivatives Month in Review.

Crisis in Greece Leads to Renewed Calls for CDS Regulation

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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

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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

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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

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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 →

Lehman Bankruptcy Court Issues Decision on Dante Case

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On January 25, 2010, the United States Bankruptcy Court for the Southern District of New York issued a decision in the Lehman bankruptcy case holding that provisions that subordinate a swap counterparty’s rights to payment when the swap counterparty or one of its close affiliates goes into bankruptcy are unenforceable.  These types of provisions are used in many structured finance transactions, and thus this decision may have implications for the structured finance markets and the ratings of structured finance transactions. For more information on this case and its potential impact, read the related Orrick Client Alert.

Industry Meeting on OTC Derivatives Held at Federal Reserve Bank of New York

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On January 14, 2010, the Federal Reserve Bank of New York (the “Federal Reserve”) hosted a meeting of major market participants, including both major dealers and buy-side participants, industry groups (including the International Swaps and Derivatives Association, Inc. (“ISDA”), the Securities Industry and Financial Markets Association and the Managed Funds Association) and domestic and international supervisors.  The purpose of the meeting, the sixth such meeting with industry participants held at the Federal Reserve, was to discuss efforts to improve the infrastructure supporting the over-the-counter (“OTC”) derivatives market.

At the meeting, William C. Dudley, president of the Federal Reserve, noted that the industry needed to continue its efforts to bring greater transparency to the derivatives markets and reduce systemic risk.  Market participants updated the Federal Reserve on developments in the derivatives market and agreed to effect additional changes to reduce risk and increase transparency.  In particular, the market participants agreed to: (i) expand central clearing for interest rate swaps and credit derivatives (including expanding the range of products eligible for central clearing), (ii) expand reporting on OTC derivatives transactions to regulators and (iii) improve risk management for derivatives transactions that are not centrally cleared by formalizing “best practices” for managing the risks inherent in these transactions, including through collateralization.  These commitments are in addition to the commitments market participants have made to regulators to report non-cleared trades to central repositories and to work with central clearing parties to broaden the range of cleared products.  The market participants agreed to provide a letter to the regulators by March 1, 2010 detailing their progress on these new commitments.

ISDA Publishes Portfolio Reconciliation Feasibility Study

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On December 18, 2009, the ISDA Collateral Committee published a study (the “Study”) on the feasibility of extending collateral portfolio reconciliations (the complete Study may be found at this link).  Since July 2008, ISDA and derivatives markets participants have made a series of commitments to regulators regarding collateral management.  These commitments have included enhancing portfolio integrity between pairs of derivatives counterparties, known as portfolio reconciliation.  In particular, industry groups and market participants have recognized the need to (i) agree to the existence and general economic terms of the transactions between them and (ii) agree to the mark-to-market value of those transactions (within some reasonable tolerance of difference). READ MORE →

ISDA Publishes Common Principles for Central Clearing Give-Up Agreements

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Against the backdrop of impending comprehensive regulation of the derivatives marketplace, on November 10, 2009, the International Swaps and Derivatives Association, Inc. (“ISDA”) recommended common principles (the “Principles”) for “give-up” arrangements to facilitate the negotiation of relevant agreements across different clearing platforms with central counterparties (“CCPs”). The Principles were derived from a series of meetings among representatives of prospective customers, dealers and clearing houses. In preparing the Principles, the drafting group acknowledged that its recommendations may be affected by the evolution of pending derivatives legislation. READ MORE →

Fitch Revises Counterparty Criteria for Structured Finance Transactions

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Fitch Ratings has revised its ratings criteria for counterparty risk in connection with structured finance transactions. Fitch also published a related “Derivatives Addendum,” which detailed its counterparty criteria specific to derivatives contracts used in securitization.

Fitch’s criteria continue to require counterparties (including derivatives counterparties) to structured finance transactions to have minimum long-term issuer default ratings of at least “A” and minimum short-term issuer default ratings of “F1” (or, where the requisite collateral is posted from the time of the structured finance transaction closing, at least “BBB+” and “F2”) for Fitch to support note ratings of the “AA” category or higher. Among other changes, the revised criteria treats counterparties that are on Rating Watch Negative as one notch below their actual current rating for eligibility purposes to mitigate any potential short-term rating action; shortens the period in which remedial actions are expected to be taken where collateralization is possible from 30 days to 14 days; and increases collateral expectations as a counterparty’s credit profile deteriorates. However, Fitch chose not to pursue the primary item outlined in the exposure draft it released for comment in March 2009, i.e., its proposal to require the collateralization of derivatives from the time of the structured finance transaction closing. In electing not to pursue the change, Fitch acknowledged that this change would have restricted the universe of eligible counterparties, hence undermining the replaceability of counterparties, a critical assumption of the criteria.

In its revised criteria, Fitch also refers to ongoing litigation connected to the bankruptcies of the Lehman Brothers entities, particularly the validity of the subordination of derivatives termination payments. Specifically, Fitch’s Derivatives Addendum states that if pending litigation overturns the subordination of such payments, this “may result in substantial rating action on transactions in which the counterparty could be subject to bankruptcy proceedings that could overturn subordination.” It further states that, “[i]n the meantime, Fitch expects this aspect to be addressed by unqualified transaction legal opinions. If such opinions are not provided, the agency will determine the rating impact for a transaction on a case-by-case basis with the effect that note ratings above the rating of the counterparty may not be possible.”