Credit Default Swaps, Defaults and What Really Happens David Gustin - September 5, 2014 3:44 AM | Categories: Risk Management | Tags: Credit Default Swaps When Banco Espirito Santo SA credit-default swaps were devalued last month after the Portuguese bank was rescued and restructured by the government, it was a real test for the Credit Default Swap market. For those that are not familiar with this risk mitigation tool, Credit Default Swaps ("CDS") offers an alternative to trade credit insurance to protect companies when lending to either corporates, banks, or sovereigns. One of the key differences with credit insurance is that CDS only covers bonds and bank debt on public companies and also do not cover corporate receivables. It is a sizable business, with $19 trillion in credit derivatives outstanding. Credit-default swaps pay the buyer face value should a borrower fail to adhere to its debt agreements. They’re used to hedge against losses or speculate on creditworthiness. The big issue with CDS is how you define default. The ISDA, an industry group controlled by banks, provides those definitions. So it may not come as a surprise that while the corporate CDS market still appears to work relatively well, it is less clear if the bank and sovereign CDS market offers effective “insurance” against default. Businessweek did a good piece on how to solve flaws that have stopped some contracts paying out as buyers anticipated. In Banco Espirito’s case, bondholders were not paid because when the borrower was reorganized, the swaps did not necessarily stay tied to the securities they were meant to protect. As we know, documentation matters. Just ask Greek bondholders. As Businessweek pointed out, problems with sovereign contracts were highlighted by Greece’s restructuring in March 2012. There was a concern that buyers of protection could be short-changed because bondholders were forced to write off more than 100 billion euros of debt in return for new bonds worth 31.5 percent of their original investment. This all matters in the trade world, especially as banks look to distribute trade finance assets using securitization and special purpose vehicles where CDS are a critical part of the structure. It’s the age old problem that insurance is only good until an event triggers the need for it. Then the real work begins to make sure the 8-point font documentation you signed covers what you thought was hedged. Stay in touch with TFM and receive our weekly digest by clicking here. Related Articles Is trade credit insurance always good value? Corporations Boost Finance with Trade Credit Insurance Promoting Receivables Insurance – Interview with Mark Attley of Receivables… Your Largest Unprotected Asset – Accounts Receivable Discuss this: Cancel reply Your email address will not be published. Required fields are marked *Comment Name * Email * Website Notify me of new posts by email.