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) 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.
Indeed, that's exactly the problem that occurred in the dispute between Deutsche Bank and Ambac. In the deal, Deutsche Bank was required to make a series of fixed-rate payments to Ambac for providing insurance against the default on a series of bonds issued by Solutia, a chemical company. In return, Ambac agreed to pay Deutsche Bank $8.77 million in the event of a default by Solutia, as long the German bank could deliver those bonds within a month of after making a demand for the payment. Solutia filed for bankruptcy in December 2003. A few weeks, later Deutsche Bank notified Ambac it intended to collect on the $8.77 million and would soon deliver the underlying bonds as required. But Deutsche Bank had difficulty obtaining those bonds from two other big banks, J.P. Morgan Chase ( JPM) and Credit Suisse ( CSR). It missed the deadline for the delivering the bonds by several months. Deutsche Bank entered into the swap agreement with Ambac without having actual custody of the Solutia bonds. But it had separate deals with JPMorgan and Credit Suisse to get those bonds in the event of a default. In fact, the deal with JPMorgan also was arranged as a credit default swap. In that deal, JPMorgan was buying insurance from Deutsche Bank and promising to deliver the bonds to the German bank in the event of a default. But this round-robin method of locating the Solutia bonds didn't go as smoothly as planned. When Deutsche Bank finally was able to make delivery, Ambac refused to pay, ultimately sparking the dispute that led to the litigation. Such disputes rarely come to the public's attention because they often either arbitrated or resolved through private negotiation. But credit derivative experts say such disputes could become more common once the economy softens and more companies begin filing for bankruptcy.
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."