Credit default swaps: Monolines face litigious and costly endgame

Credit default swaps: On dangerous ground

These firms have lurched from one downgrade to another as the implications emerge of their exposure not only to sub-prime ABS CDOs but more recently to guaranteed investment contract (GIC) funds. Any list of counterparties at risk of default has to include several big monoline names. "All monolines that have been significantly involved in structured credit will become effectively insolvent," is the bleak prognosis from Andrea Cicione at BNP Paribas.

What does this mean for their outstanding CDS? Most of the CDS written by the monolines are bespoke contracts that are not traded under Isda agreements – and as such fall into the high-risk single-names category that would not be eligible for clearing. They are not subject to mainstream mark-to-market treatment and could therefore represent significant additional losses for banks. "The most conservative assumption is to regard monoline wraps as worthless and to mark the underlying assets as if they had never been hedged," says Hans Peter Lorenson, credit strategist at Citi.

Analysis published by Creditsights at the end of 2007 illustrated the scale of the problem facing the banks if the monoline wraps they bought to hedge their super-senior exposure to ABS CDOs fail. The numbers: $12.4 billion for UBS, $6.1 billion for Credit Suisse, $6.7 billion for Deutsche Bank, were not pretty (see CDOs: Super senior is super bad,  Euromoney, December 2007).

A more recent Standard & Poor’s report illustrates the extent to which the impact of a monoline downgrade would vary between institutions because their write-down practices are so varied. For example, Merrill Lynch had $18.8 billion notional CDS bought from monolines on super-senior ABS CDOs in March this year but had only written down $1.3 billion (6.9%). In contrast, CIBC, which had $7.9 billion exposure in March, has written down a full $4.7 billion (59%) – albeit because it had significant exposure to one of the weakest names, ACA.

If a monoline did default, the situation would be handled via an Isda auction – a process that could be fraught with difficulty. If a monoline defaulted there are so many potentially deliverable obligations that an auction would be a challenge. Isda has collected information on all deliverables for each of the major monolines and posted this in the form of a series of Excel spreadsheets on its website. "If we ran an auction, we would want to identify a subset of obligations," says Robert Pickel, CEO at Isda. "Another alternative is to price a CDS with the monoline." However it is handled, one thing is certain – things are going to get messy.

Just how messy was made clear by Creditsights in a research note published on July 23. "No matter the method of unwind of the structured finance exposures (regulatory or not), the process is likely to be mired in litigation owing to the complex nature of the exposures and the legal entities involved," stated the analysts, headed by Brian Yelvington. This is because the monolines wrote CDS using an unusual structure. The guarantors set up so-called transformer SPVs to which the monoline provides the wrap and then the transformer passes the benefit of the wrap to the protection buyer via a CDS. In the event that a monoline defaults, therefore, the CDS buyer’s claim is against the SPV rather than the firm. "Given the lack of clarity on the true legal and economic construction of the entities, we are hard pressed to determine whether or not the CDS holders will be hung out to dry," warn the analysts. "How a process of risk transfer that would seem to fly in the face of the spirit of the law, if not the outright law itself, was allowed to be constructed and was signed off on by people who should have known better is something we are often asked. The key to this puzzle lies in the fact that the monolines were never supposed to come near failure. The seizure of a monoline was near unfathomable, and so long as that did not occur, the process worked fine."