Crocodilian

Financial Company Default Risk

Thanks for this. I've been interested in the precise terms of the CDS contracts-- and what precisely constitutes a default. We've had any number of complex transactions, and these companies often have a holding company/operating subsidiary structure.

I've yet to see any discussion about the particulars of WaMu, for instance, were the operating subsidiary was purchased by JPM/Chase, but the holding company (and its debt) were left outstanding.

In cases like these, or like Bear Stearns, I assume that the CDS is not triggered -- but that would depend on the specific language of these. In starting to read up on these intruments, there's a remarkable opacity and complexity to them, along with room for disagreement . . . "credit events" are determined by a "calculation agent", usually a third party.

But grounds for disagreement and litigation are many, and there's no reason to believe that these instruments will speedily resolve. Here's a description of a recent litigation:

"The court first examined whether a credit event had
occurred. Citibank argued that a particular credit event applicable under the contract—an “Implied Write- down”—had occurred because the securities held by the Millstone CDO (which had issued the Class B notes) had decreased in value. VCG argued that the Implied Writedown provision only applied if there was a writedown in the Class B Notes themselves, regardless whether there was a decrease in the value of the securities in the Millstone CDO. After analyzing the CDS contract and the indenture for the Millstone CDO, the court concluded that the Implied Writedown provision referred to collateralized assets held by the CDO and not to the notes issued by the CDO. Accordingly, the court found that Citibank’s determination that a credit event had occurred in the form of an Implied Writedown was proper and that Citibank was entitled to judgment on the pleadings on that issue."

(from "Manhattan Federal Court Enforces ‘Clear’ Terms of Credit Default Swap Contract on Pillsburylaw.com website)

The point of all this is that not only are the amounts of outstanding CDS contracts huge, but their terms are not necessarily crystal clear . . . imagine if you had to litigate to effect settlement of your options trades!