Friday, August 8, 2014

Argentina, Credit Default Swaps, and ISDA

On August 1, the International Swap and Derivatives Association (“ISDADeterminations Committee for the Americas decided that a “Failure to Pay Credit Event [had] occurred with respect to the Argentine Republic.” The vote was unanimous.
Argentina, of course, argues that it has not defaulted, having deposited the funds necessary to pay the interest on its bonds (except those bonds not exchanged in a restructuring held by the “holdouts”) with the trustee bank, the Bank of New York Mellon. It is not Argentina’s fault if BNY Mellon, obeying a federal district judge in New York, has not forwarded the funds to the owners of the bonds. This seems to be  a not entirely ridiculous argument, even if, as it appears, many lawyers specializing in this area consider it to be weak. Of course, the bondholders did not get paid.

Whether or not the ISDA committee was correct in its determination for the purpose of credit default swaps (“CDS”), the committee making the decision could hardly be called neutral and objective. Argentina’s principle legal tormentor, Elliot Management, is on the committee and it did not recuse itself. Whether or not Elliot Management holds CDS on Argentinian government bonds, it is obviously conflicted. (Reuters says according to “sources,” the holdout firms do not have positions in CDS on Argentinian government debt. Argentina is investigating.) The other members of the committee likely have positions on one side or the other in CDS on Argentinian government bonds.
The ISDA committee has yet to announce the specifics of the auction procedures to settle the CDS. These auctions are notoriously complex and few people understand them. The details are important and apparently will be decided by people who represent firms which may be participants.

In my experience at Treasury, I found ISDA to be a very professional organization which hired good staff and had excellent (and no doubt expensive) outside counsel. I do find it strange, though, that the Treasury Department and the various financial regulators have not appeared to question the role of ISDA , which is not a self-regulatory organization overseen by federal government regulators, in  determining whether and how CDS should be settled in the event of a default. While the ISDA committee could well be correct in this case, there are likely to be other credit events in the future where the application of legal definitions is tricky and arguable.
Sometimes it is argued or implicitly assumed that the 2008 financial crisis was due to OTC derivatives. This is of course not the case; the housing bubble and the associated high levels of debt were the main cause. Most types of OTC derivatives had nothing to do with the financial crisis, whatever other problems one might see with these contracts. CDS, though, did contribute to the financial crisis. It concentrated an amount of risk which proved intolerable at one firm, AIG, and CDS were used to construct “synthetic” mortgage securities when the mortgage supply, despite the lending frenzy, was not sufficient to meet the demand for these types of securities, which had tranches that the rating agencies, to their everlasting shame, rated triple A. One would have thought that if there was one market that the regulators would want to examine closely and do something about, it would be the market for CDS. It is striking that the regulators still countenance a situation where a trade association that lobbies Congress, regulators, and whatever Administration is in power continues to make key decisions without oversight about this market through committees composed of conflicted members.   

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