When passing the parcel ends
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Published: July 10 2006 20:40 | Last updated: July 10 2006 20:40
For many months, regulators have warned that sloppy back-office practices in the booming credit derivatives world could produce embarrassing law suits if – or when – deals go wrong.
Now, however, a concrete example of this danger has materialised in New York – and left Deutsche Bank nursing a loss of almost $9m as well as a distinctly red face.
Late last week, Denise Cote, a US district court judge, issued a ruling declaring the German bank had violated the terms of a credit derivative deal it had concluded with a subsidiary of Ambac, the US financial group, a few years earlier.
In particular, the judge declared Ambac did not need to make a payment of $8.77m apparently owed to Deutsche Bank on a Credit Default Swaps contract because the German bank had failed to meet a deadline to produce some bonds following a corporate default.
The loss arising from this dispute is trivial for the German bank. However, the case is awkward for the group, given the important role it plays in the CDS market. Deutsche Bank declined comment.
Moreover, its precedent is likely to be watched by lawyers and compliance officers. In recent years, it has not been unusual for banks to miss deadlines on CDS deals, partly because there have been endless delays in completing the paperwork for these transactions. Indeed, Deutsche Bank argued in its own defence at the NY court that delays were so commonplace that failure to meet deadlines was almost an "industry practice".
However, Ms Cote threw out that argument, insisting a CDS deal was no different from any other legal contract meaning that Deutsche Bank should lose the payment due to the missed deadline. "Although the instruments involved [in this case] are somewhat abstruse, the central question can be boiled down to a relatively straightforward question of contract interpretation," she said. "[Ambac] was under no obligation to pay for bonds which were not delivered in accordance with the contractual terms."
The deal at the heart of this case revolves around a transaction called "triplets", which was first agreed in 1998 but later updated in 2000. In this, Ambac entered into a CDS contract which effectively insured Deutsche Bank against the default of about 60 corporate bonds, including those issued by Solutia, a chemical company.
In particular, it promised to pay Deutsche Bank $8.77m if these companies ever went into default. In exchange for this, Deutsche Bank agreed to make a series of fixed-rate payments to Ambac. It also promised that if a corporate default occurred, it would deliver those bonds to Ambac within a month.
In December 2003, Solutia filed for bankruptcy and so Deutsche Bank duly told Ambac it wanted the $8.77m. It also promised to deliver the underlying bonds, as the contract demanded.
But then Deutsche Bank faced a problem. When the German group had cut its CDS deal with Ambac, it did not actually have custody of the Solutia bonds. Instead, it had struck a separate agreement with JPMorgan and Credit Suisse to get those bonds in the event of a default, arranged in the form of second credit default swap.
But when Solutia went into default, this "pass the parcel" process went wrong: Deutsche Bank could not get its hands on actual Solutia bonds in time partly, according to court documents, because it did not chase its counter-parties. Consequently, it missed the deadline with Ambac, which refused to pay the $8.77m.
Some lawyers insist this in an unusual case. Furthermore, this case took place several years ago, and many parts of the industry - including Deutsche Bank - have radically improved their practices since then.
However, the practice of entering into CDS contracts without actually owning the underlying bonds has certainly not vanished. On the contrary, the CDS industry has exploded so dramatically (see chart) that many bankers suspect that if a wave of corporate defaults ever occurs, it would be even harder than before to find enough corporate bonds to meet the terms of CDS contracts.
And though groups such as the International Swaps and Derivatives Association are scrambling to find solutions, such as using netting or auction agreements, it remains to be seen whether this will avoid all the potential confusion if there is a wave of corporate defaults.
In other words, If the credit cycle were to turn, the type of problem Deutsche Bank faced with Ambac might be echoed elsewhere - and create more problems with "pass the parcel" chains. "This case has big implications for the industry," says Janet Tavakoli, a CDS consultant. "It means if an investor buys protection in a CDS contract requiring physical delivery, in the event of a default, that investor might find they are not really protected if they cannot get hold of the bonds in time." |
