Credit derivatives market participants following the Aon Corp. versus Societe Generale case - which was on appeal before the United States Court of Appeals for the Second Circuit - were finally able to exhale last week. The court overturned a 2006 district court ruling that had favored Aon. The decision effectively sealed a Pandora's box full of disgruntled counterparties seeking to argue contract terms, according to industry experts.
The ruling solidified what most in the market would like to assume: The terms of each credit default swap contract independently define the risk being transferred - as long as those terms are clear, or "unambiguous," in the legal world, that is.
At the risk of oversimplifying, the case went as follows: Aon was attempting to collect on a CDS it had entered into with SG in order to hedge a separate CDS, both involving the Republic of the Philippines. When a credit event happened via the terms of one contract, the hedge did not end up working for Aon because the language involved in the other contract was not a perfect match. In essence, it was not a "perfect hedge." Aon took the dispute to court. The U.S. District Court for the Southern District of New York, looking at the related CDS that had experienced a credit event, among other things, determined that the SG/Aon swap, as it was related, must have experienced a credit event as well. Had that thinking been affirmed by the second circuit, contracts within the rapidly growing CDS market could have been put in a position of uncertainty.
"For the purposes of having a good derivatives market, that is the last thing you want," said Mark Adelson, head of structured finance research at Nomura Securities. "You must read the swap, and tell from what you read how it is going to work, and whether or not it is going to pay." Adelson likened the way a CDS contract should be interpreted to a bank's letter of credit, not, say, to a father's guarantee on his 17-year-old son's car loan.
The lesson for credit derivatives market participants is - look closely at contracts, experts said. Even if a counterparty assures a hedge is good, the terms of the contract (as long as they are clear) should ultimately determine which party is paid what, and when. And of course, the contract should be satisfactory at the time of closing, not open for argument later on.
"They are grown-ups in the financial industry," said Janet Tavakoli, credit derivatives expert and chief executive of consultancy at Tavakoli Structured Finance. "If you are not fully hedged, you'll have basis risk. The time to write your contract is before the deal closes, not after."
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