IFR - ESM loans unlikely to trigger Spain CDS

Mon Jun 11, 2012 11:40am EDT

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(From the International Financing Review www.ifre.com)

By Christopher Whittall

LONDON, June 11 (IFR) - Credit default swaps on Spain are unlikely to trigger as a result of the 100 billion euro bail-out of the country's banking system announced over the weekend, according to leading derivatives lawyers.

The European Stability Mechanism's senior creditor status has led to questions over whether a subordination credit event will be triggered upon Spain receiving loans from the permanent bailout fund. In contrast to the IMF's preferred creditor status, which is implicit rather than legally documented, the ESM's treaty actually specifies its seniority to other creditors - a clause that some analysts reckon could trigger CDS.

There have been subsequent reports that Spain's emergency loans may be funneled through the temporary bailout fund, the EFSF, before the ESM becomes into force in July to avoid a potential credit event. Such measures may prove unnecessary, though, as derivatives lawyers have cast doubt on the possibility of ESM rescue money triggering CDS.

"I can't see any basis on which this would constitute a subordination credit event as it doesn't change the terms of the claims held by the other creditors," said Simon Firth, a partner in the derivatives practice at Linklaters.

"It's actually impossible to have a restructuring credit event based subordination without something that affects the rights of existing bondholders. In the absence of some kind of agreement or change of law, then I don't see anything that will [do that]," said Firth.

The definition of subordination has two parts, neither of which would apply to the ESM loans, according to Firth. The first pertains to companies in liquidation, which does not apply to sovereign CDS as countries cannot enter insolvency proceedings.

The second states that existing bondholders won't be entitled to receive or retain payments with respect to their claim while the reference entity (Spain) is in default in respect of its senior obligations (in this case the ESM loans).

"There won't be anything that affects the entitlements of the existing bondholders to receive or retain payments," said Firth. "Their entitlement is exactly the same - all you have is an obligation between the sovereign and some other creditors to pay off those creditors first. That is not binding on the bondholders."

PREVIOUS ISDA REJECTION

This is not the first time that questions have been raised about whether the Spain bailout would trigger sovereign CDS.

The ISDA Determinations Committee rejected a similar inquiry last year over whether the IMF's seniority status would trigger CDS after Ireland was bailed out.

One senior sovereign CDS trader said the market was abuzz with discussion of the issue, but insisted it was too early to predict what would happen.

"It depends on the ESM loan documentation - not the treaty - and that hasn't been written yet. If it was formally written in then it would be cause for the ISDA Determinations Committee to determine," the trader said.

"You'd assume would try and avoid a trigger. They did the voluntary Greek PSI to avoid it, even if it didn't ultimately work."

A Spain trigger would constitute the largest CDS credit event on record. At $14.3 billion net notional outstanding, according to the DTCC, Spain is far more widely traded than Greek CDS, for example, which had around $3.2 billion outstanding when it triggered.

The CDS trader said action in sovereign CDS was carrying on as normal today. Five-year protection is currently being quoted at 599bp, having rallied to as low as 555bp earlier this morning.

( www.ifre.com )

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