SNS Reaal to test CDS auction process

Tue Feb 5, 2013 6:59am EST

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LONDON, Feb 5 (IFR) - The nationalisation of SNS Reaal looks set to test the robustness of the process for determining payouts on credit default swap protection, after the International Swaps and Derivatives Association Determinations Committee accepted a credit event question on Monday.

The Dutch Ministry of Finance announced last Friday it was expropriating various SNS Reaal bonds, including Tier 1 and Lower Tier 2 securities that will be fully written down.

While this should be a clear-cut CDS trigger once the bondholders have been wiped out, there is a danger that inherent flaws in the restructuring credit event could lead to CDS holders not receiving appropriate payouts on the protection they've bought.

"Based on the information available, the CDS should not have triggered at this point in time. All that has happened is the sub debt has been expropriated and there has been a non-binding announcement that it will be converted into equity," said one London-based derivatives lawyer.

"As and when the debt is written down the CDS should trigger. The problem with that is that the bond won't then exist, meaning it won't be deliverable into a CDS auction."

In the normal course of events, SNS Reaal's sub bonds would be used in an auction process to determine a CDS payout that should compensate for losses sustained on bond positions.

This works well for most CDS credit events except for debt restructurings. There is a good chance the bonds in question will already have been exchanged or written down before the CDS auction can take place. This exposes a crucial flaw in CDS, as protection holders are unlikely to receive a fair payout.

In the most high profile example, Greece's EUR100bn restructuring last year, the payout on CDS following the auction was in line with bondholder losses. Credit experts admitted this result was a complete fluke because at the time of the auction the new bonds traded at the same, depressed level (around 20) as where the old bonds had been prior to the restructuring.

The new bonds have since rallied sharply.

ISDA has since vowed to fix the bond deliverability issue as part of its overhaul of its credit definitions.

GOVERNMENT'S CHOICE

As the Dutch government will own the bonds, it will have the final decision on how to handle a potential CDS trigger and auction. It may well be a secondary consideration: in stark contrast to the USD3.2bn of net notional outstanding at the time of the Greek CDS trigger, SNS Reaal does not even figure in the top 1000 CDS names, according to the DTCC.

"Beyond the credit event, there remains uncertainty on the subordinated deliverable, given the bonds are no longer held by investors," BNP Paribas analysts wrote in an investor note last Friday.

"However, they are owned by the Dutch government, unless converted into equity or cancelled, on which we do not have any information."

ISDA may try to follow a tactic deployed in the restructuring of some of the Irish banks, which it also tried in Greece, but which was rejected by the authorities. This involved ensuring that at least one liquid bond was not exchanged in the restructuring until after a CDS auction could be held, in order to provide a potential "old" bond that would be deliverable.

The London-based lawyer said delivering senior debt into the auction may be another option, although this would be unlikely to give an appropriate payout on the CDS as it will be trading at a much higher price than the sub debt. (Reporting By Christopher Whittall; editing by Alex Chambers and Julian Baker.)

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