What’s a credit event? It’s a difficult question. Dealbreaker is exercised on this, or more specifically on the issues with imagesCDS protection holders getting paid on some unusual credit-event-like happenings:

  • There are bonds.
  • You buy CDS that is supposed to pay off if something goes wrong with the bonds.
  • Something goes wrong with the bonds, insofar as they poof into some weird garbage-y thing or assortment of garbage-y things.
  • You can scoop up garbage-y things to your heart’s content, but the contract doesn’t let you deliver them into CDS in a way that achieves the sensible result.
  • Sensible Result = Face Value of Bond minus Value of Package of Garbage-y Things You Got For Your Bond
  • So you get less than Sensible Result, and are screwed, and the CDS seller has a windfall.

This is a reasonable criticism. Certainly it seems odd that in something like the SNS Reaal bail in, sub CDS have not yet triggered (although they might of Feb 12 2013..). Moreover, even if the CDS do trigger, because in SNS’s case the bonds have been expropriated, physically settled CDS holders may not have anything to deliver. Thus there are really two issues: the problem of what is and is not a credit event (a perennial issue in the CDS market); and the problem that even if there is a credit event, the things that the bond turned into (including, err, thin air) might not be deliverable. As Dealbreaker says

It may be “difficult to formulate contracts in an entirely watertight fashion,” but getting to a seaworthy concept doesn’t seem all that hard: essentially, define “Reference Obligation” to mean “(i) the Reference Obligation or (ii) whatever package of things the Reference Obligation poofed into in a Credit Event.”


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