Cash-settlement auctions working, says Isda

“Following the Lehman Brothers situation and the conservatorship of [government-sponsored mortgage lenders] Fannie Mae and Freddie Mac, we have been running auctions virtually weekly. The story you can tell across all of it is that the process has operated smoothly,” he said.

He noted that the past seven months had seen large firms and a major dealer collapse, European and sovereign credit entities defaulting, as well as multiple simultaneous credit events occurring on widely-traded entities.

Pickel also referred to various issues that had come up in the course of the recent auctions. These included a controversial decision over whether some principal-only bonds could qualify as deliverable obligations for the Fannie and Freddie auction, as well as the effect of technical market factors on the auction’s outcome.

In the event, a lack of market participants willing to physically deliver subordinated paper led to the unusual outcome of recovery rates for subordinated bonds ending up higher than those for senior debt.

More recently, Pickel said, there had been questions over whether or not the financial situation of New York-based clothing firm Liz Claiborne constituted a credit event or not. On January 13, the company completed an amendment and extension of its revolving credit facility, apparently prompting queries from some Isda members.

“In all these situations there’s been a real commitment among market participants to deal with these issues, to deal with them expeditiously and come up with a result that works to facilitate these auctions going forward,” said Pickel.

Later, Dan Cunningham, a partner at law firm Allen & Overy in New York, made a spirited defence of the master agreement architecture around CDSs. “This ship has been through some incredible storms, but it’s not the Titanic,” he said.

Complaints that the outcome of cash-settlement auctions such as those for Fannie Mae and Freddie Mac had changed the nature of CDSs as an instrument were untrue, he said.

Isda is pressing ahead with a plan aimed at hardwiring the cash settlement auction process into CDS documentation. The group intends to release a draft ‘big bang’ protocol by early February, which will update outstanding contracts on a multilateral basis.

Under pressure from regulators, the organisation originally pledged to complete hardwiring by the end of last year, although the Lehman bankruptcy and ensuing market turmoil has seen it delayed. The association now hopes to launch the final protocol by early March.

At the moment, individual protocols are required to cater for credit events among CDS reference entities.

Numerous other auctions are planned over the next month. On January 30, auctions will be held to cash-settle credit derivatives trades linked to Equistar Chemicals, Lyondell Chemicals and Millennium America, three US-based subsidiaries of the Dutch chemical firm LyondellBasell which filed for bankruptcy on January 6.

The first cash-settlement auctions to be held for European LCDSs are scheduled for February 5 and 9 respectively, after Helsinki-based bathroom company Sanitec and chemical firm British Vita failed to make repayments on various loans. The auctions will also be the first to be held on reference obligations included in the Markit iTraxx LevX indexes of European LCDSs.

Additionally, auctions to cash-settle CDSs referencing Toronto-based communications equipment firm Nortel Networks are expected on February 10, after the firm sought creditor protection in Canada on January 14.

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