Failure to deliver CDS physical settlement

[brian.field]

@David Harper CFA FRM

Is failure to deliver on a swap of any kind a formal default event in that it could force a company into bankruptcy?

I am thinking of a company that mistakenly entered into a CDS with physical delivery in a reference asset for which one company owns the entire issuance of the reference asset - like a cornered market.

Then I wondered if failure to deliver on any swap, like an interest rate swap, would force bankruptcy.

My sense is that it should but that it doesn't.

 

[brian.field]

I also feel like I've asked this before but I can't remember!

 

[brian.field]

In other words, I feel like the events that could trigger payment in a CDS are not necessarilly consistent with the notion of default on a corporate debt. Say that Company A issues Senior Unsecured Debt. Now, assume Company A sells protection to Company C on debt issued by Company D.

Assume Company D files for bankruptcy and Company A fails to deliver on its CDS committment to Company C.

Would this necessitate a bankruptcy for Company A? i.e., could Company A's Senior Unsecured Bondholders claim that A defaulted and force A into bankruptcy?

 

[brian.field]

Furthermore, let's say that the event that triggers the CDS is restructuring. This doesn't necessarily imply that Company D's senior bondholders would also claim an event of default on D's debt right?

 

[brian.field]

This is why Bionic Turtle is so valuable!

If you don't get a response immediately from David and team on one of your questions, just keep working; you may find the answer on your own.

Regarding all of my posts above, please see the excerpt below (that I just read from an assigned reading!) I bet you @David Harper CFA FRM knew I was going to come across this answer.

 

[David Harper CFA FRM]

Hi @brian.field Actually, in truth, I couldn't answer your question without further research. You attached file is helpful, but I think (?) it speaks to the potential misalignment between actual bond default and the credit event trigger (per ISDA) according to the credit default swap. Put another way, do the bondholders have the exact same loss experience as the CDS buyers? Answer: no. The quote nicely summarizes how this misalignment can go in either direction, yikes!

But I got stuck on your apparently simple question "Then I wondered if failure to deliver on any swap, like an interest rate swap, would force bankruptcy." .... and, I'm still unclear on the answer. A bilateral OTC derivative contract is a contractual obligation, of course. Failure to pay (for example, netted interest rate swap payment) is a counterparty default. That's a legal issue of the specific contract, I would think; e.g., is there a grace period? But, then to be honest, where I am not clear is: if your derivatives counterparty defaults, where are you in the capital structure? can you force bankruptcy? Thanks!

 

[brian.field]

AWESOME! I stumped The Great One! I will continue to look for an answer to this and would appreciate you sharing anything you find as well!

Thanks!

 

[QuantMan2318]

Beautiful questions that border on the grey areas, Mr. Field.

Your attached file, however talks of the credit event happening to company D in your example. It is not directly relevant to our original question involving A. The file ( I can see the hand of Gregory here ) states that the default event for the Unsecured Bonds of Company D may/may not be considered as the credit event in the CDS that causes the pay out by A to C also, the credit event that causes a payout by A to C may/may not be considered a default event which forces D into bankruptcy by its bondholders (these influence basis risks)

In my opinion, I would say that both are connected, if the seller of the CDS cannot meet on its commitments, it is a clear case of counterparty default and a credit event that triggers a bankruptcy of the seller of the CDS; if he/she doesn't have the funds to meet his/her commitments and buy the reference bonds, it is highly likely that he/she doesn't have the funds to honor any commitment and the guy has a serious cash flow problem. I am not sure whether the Credit Support Annex with every Swap agreement, would call this a bankruptcy event for the seller (A) or if the Bondholders of A can call it an event to pull the company into bankruptcy, however, A will almost certainly run out of cash to honor the Bondholders which in turn will initiate the downgrade and bankruptcy .

In short, the contract might not call the default of the seller of the CDS as an event to force the seller into bankruptcy, considering the spirit of the law, it is. ( Think AIG )

 

[David Harper CFA FRM]

HI @QuantMan2318 Excellent, I agree. In @brian.field 's scenario (ie, A writes credit protection to C which references D), we typically talk about the events which constitute a default by the reference (D), but here I thought the question was: assume D defaults, but then A fails to pay C (indeed, C has counterparty credit exposure to A). Failure by D is a counterparty default, of course, then I think the question is: can C force an involuntary bankruptcy; e.g., http://www.nolo.com/legal-encyclopedia/involuntary-bankruptcy.html?

To further agree with you, this seems like a legal question (says Captain Obvious ) and, also I would think (?) anticipated somewhere in the ISDA Master Agreement; here is a sample (Comerica) http://trtl.bz/isda-master-comerica
see Section 5. Events of Default and Termination Events

I still don't know the answer, I would think, in the event of counterparty default by A, that C is akin to a junior (uinsecured) bondholder with some legal basis for recovery, but I don't assume that means they can force bankruptcy (??)