Most of the growth in the credit derivatives market has come during a time of economic growth when there have been few corporate bankruptcies, meaning few occasions for buyers to go scrambling to look for the underlying bonds.
The Fed, to avoid a dire situation from developing, has begun working with banks and brokers to make sure that the buyers of credit derivative swaps are able to locate the underlying bonds in the event of a default. The Fed is concerned, because no one knows for sure how the credit derivatives market will react when an economic downturn hits.
But the ruling from Judge Cote says the courts will not offer any sanctuary for credit derivative buyers who are unable to locate the corporate bonds they need in the event of a market meltdown.
Credit derivatives experts say the court ruling is a warning sign to Wall Street that it must pay careful attention to the language in these sophisticated contracts, because the courts will hold them to it."Watch your language in the contracts you write,'' says Janet Tavakoli, a Chicago-based structured-finance and derivatives consultant "The implication is if you bought protection, you might find you are not really protected if you're not able to deliver the bonds."