Or adventures in unintended consequences, bank burdensharing edition.
Last week’s bail-in proposal for bank debt, from the European Commission, marks a step-change for capital markets — so it’s no wonder there could be plenty of those known unknowns (or even unknown unknowns) to go along with it.
Here’s a dramatic one from Chris Whittall, formerly of Risk and now at IFR:
Under the current proposals, which are subject to a two-month comment period, lawyers say credit events would not be triggered when a bond is written down, while bonds that have been written down would not be deliverable under standard CDS contracts.
“The general expectation of the CDS market was a bail-in involving a write-down would constitute a restructuring credit event, and that the underlying bond would be deliverable in standard CDS to the extent not already written down. So if the bail-in happened, protection buyers would be able to realise some protection,” said David Benton, partner at law firm Allen & Overy in London.
“The EC working paper caused a stir because it stated a statutory bail-in power should be included in the terms and conditions of the underlying debt. That is highly significant for CDS.”
In short, CDS would no longer be providing any credit protection.
Basically, as the piece itself notes, restructuring in Europe is currently categorised as a credit event — that is, it triggers CDS pay-outs on the underlying debt. But if all the potential for a bail-in (writedown) is included in the debt’s documentation, then it might be possible to argue that a writedown wouldn’t count as a restructuring. The possibility was there in the sales doc (or wherever) and was a known to the buyer.
Of course, this is all very hypothetical at the moment. The above is based on opinions from lawyer types (which will no doubt differ once lawsuits are brought) and the proposals themselves are undergoing a comment period that will last until March.
But still, we bet it’s something the European Commission will be thinking about.
Related links:
The problem with Europe’s bail-ins – FT Alphaville
Guest post: what colour is your credit event? - FT Alphaville