Originally published February 25, 2008

Overview

Recent turmoil in the credit market highlights the precarious position of several of the large monoline insurance firms.1 The monolines have provided irrevocable financial guarantees to a multitude of structured transactions, including many of the sub-prime ABS and CDO's2 (including CDO-squared) currently at high risk of default. The rating agencies have the entire group of monoline insurers under credit review, reflecting the markets' concern that the insurers don't have enough capital to stem losses flowing from downgrades of the securities they guaranteed. The monolines will likely bear the brunt of defaults on the structured transactions, and, in turn, may find themselves the subject of Credit Default Swap ("CDS") credit events. This would impact a broad range of dealers, hedge funds and other entities that purchased CDS protection against a potential default by monolines on their financial guarantees. (A ratings downgrade of a monoline insurer may, as a practical matter, be viewed as a default because of its adverse impact on the value of securities guaranteed by the monoline and the fact that it may preclude the downgraded monoline from writing new business.)

The CDS market has never experienced a monoline credit event. As a result, it is not entirely clear how the monoline CDS protection will be unwound and settled if the collapse of CDO and related structures do pull the insurers down with them.

CDS Monoline Contracts

Currently, monoline CDS contracts are generally governed by the 2003 Credit Derivative Definitions (the "Credit Definitions") and the "Additional Provisions for the Physically Settled Credit Default Swaps – Monoline Insurer as Reference Entity" (the "2005 Monoline

Supplement"), both published by ISDA. The 2005 Monoline Supplement provisions were drafted for physically settled credit default swap transactions in which the party on whom credit protection is written (the "Reference Entity") is a monoline insurer that issues financial guarantee insurance policies (or similar financial guarantee insurance) on obligations for which another party is the obligor. A credit event under a CDS contract referencing a monoline would certainly occur if the monoline defaulted on its own debt or under one or more of its guarantees and could also occur, depending on the terms of the CDS, upon a monoline seeking to restructure either its outstanding debt or the terms of its guarantees.

The Credit Definitions and the 2005 Monoline Supplement provide that, upon a credit event, a buyer who has bought protection on a monoline will be able to deliver the direct debt of that monoline as well as certain debt which is guaranteed by that monoline. There will be many obligations that meet the criteria to be deliverable. Ironically, the very issuances that might set off a monoline credit event are likely to be selected by protection buyers for delivery under physically settled transactions.3

Unwinding After a Credit Event

The CDS market currently favors cash settling transactions via an auction process.4 The current auction methodology was launched in 2005 by Markit Group Limited ("Markit") and Creditex Group Inc. ("Creditex") in collaboration with ISDA and some large credit derivative dealers to facilitate the settlement of credit derivative contracts.5 Auction participants enter 'market orders' and 'limit orders' with respect to a pre-defined list of deliverable obligations and the aggregate amount of obligations that the participant would need to deliver or receive to physically settle all of its CDS transactions. Bids and offers are matched up, and the price of the final limit order bid that is used to fill the open interest is the final cash settlement price of the auction. All orders from the auction trade at that final cash settlement price.

ISDA is in the midst of creating a database of deliverable obligations for monoline insurers as part of an effort to prepare for a monoline credit event and calm the confusion in the market. However, given the array of monoline obligations that can appropriately be delivered under CDS, and the concomitant range in value of those obligations, it may not be possible to use the existing auction methodology to come up with one settlement price. Deliverable obligations under monoline CDS will certainly include CDO's and similar structured products, but will also include plain vanilla municipal bonds whose value may not have been adversely affected by the recent market events. It is unrealistic to expect that protections buyers or sellers will easily agree on the appropriate obligations to include in an auction. And so, the market faces the prospect of having to develop a new methodology to unwind the billions of dollars of outstanding monoline CDS contracts.

Conclusion

Fortunately, documentation standards in the CDS market are dynamic, and guidelines and best practices develop over time as market requirements dictate. The evolution in the guidelines for succession events provides a good example of ISDA's response to market demand to bring more certainty to the CDS market. Similarly, the progression of physical settlement of CDS to cash settlement via auction has addressed the problem of CDS settlement creating a squeeze in the underlying bonds. The auction process has further evolved over time to include single name CDS as well as CDX in order to address index-versus-single-name basis risk. A similar evolution is likely to happen with respect to monoline insurers. ISDA's published list of monoline obligations represents one more step towards the development of a workable solution to this fast-developing challenge.

Footnotes

1 A monoline insurer is an insurance company that insures payments on securities. Typically, a monoline insurer is rated AAA by at least two rating agencies and will issue an insurance policy that insures the timely payment of principal and interest on obligations issued by third parties.

2 Asset-Backed Securities and Collateralized Debt Obligations.

3 To add another wrinkle to the analysis, many CDO are insured by financial guarantees on CDS on the senior tranche, and not on the underlying senior tranche. These guarantees were typically issued through "Transformer" special purpose vehicles set up by the monolines in order to "transform" a typical financial guarantee into a credit default swap. The monolines in turn guaranteed the Transformers' obligations under the CDS. Because the guarantee is not on the CDO tranche itself, but rather on the related CDS, the CDO tranche will not be deliverable into CDS contracts referencing the monoline insurer.

4 As the CDS market on specific reference entities grew to exceed the cash bond notional amount, physical settlement of CDS caused squeezes in the market. Although CDS standard language still specifies physical settlement, the market generally expects to cash settle contracts.

5 Auctions have been held for Collins & Aikman, Delta Air Lines, Northwest Airlines, Delphi Corporation, Calpine Corporation, Dana Corporation, Dura, Movie Gallery and Quebecor.

© 2008 Sutherland Asbill & Brennan LLP. All Rights Reserved.

This article is for informational purposes and is not intended to constitute legal advice.