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Fine Print Bites Deutsche Bank in CDS Suit

Credit derivatives may be some of the most sophisticated financial instruments bought and sold on Wall Street these days, but at their core they really are nothing more than detailed contractual agreements that must be abided by.

Or so says a New York federal judge in a court ruling that could have big ramifications for the booming $12 trillion market for credit derivative swaps -- complex financial arrangements that are used as a form of insurance to hedge against the decline in the value of a corporate bond.

The buyer of a credit derivative swap typically makes a fixed payment to another financial institution to insure against the prospect of a corporation defaulting on a bond. If such a default occurs, the buyer need only exchange the bonds to the derivative's sponsor to be indemnified for his losses.

U.S. District Court Judge Denis Cote, in a 44-page decision released late Thursday, ruled that Deutsche Bank (DB - Get Report) violated the terms of a credit derivative deal it had with a subsidiary of Ambac Financial Group (ABK). The judge said Ambac wasn't required to make an $8.77 million payment to the German bank because Deutsche Bank had failed to deliver the bonds that it had bought insurance on in a timely manner.

Ambac, the judge said, was under "no obligation to pay for the bonds since they weren't delivered in accordance with the contractual terms.'' Judge Cote rejected Deutsche Bank's argument that it was a common industry practice on Wall Street for parties to ignore delays in delivering the underlying bonds.

At first blush, the court ruling appears to be of little consequence. The loss of an $8.77 million payment is chump change to a financial institution the size of Deutsche Bank.

But the ruling touches on an issue that has become a matter of concern for federal regulators, who worry that investors are overlooking some of the risks associated with these relatively newfangled financial products. One thing the Federal Reserve is particularly concerned about is the inability of buyers of credit derivative swaps to make good on their contractual promise to deliver the underlying asset in the event of default by the company issuing the bond.
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