j. andrew rahl, jr., moderator mark c. ellenberg peter niculescu alexey surkov november 28, 2011...

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J. Andrew Rahl, Jr., Moderator Mark C. Ellenberg Peter Niculescu Alexey Surkov November 28, 2011 DISTRESSED INVESTING 2011 TRADING AND VALUING DISTRESSED DERIVATIVES

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Page 1: J. Andrew Rahl, Jr., Moderator Mark C. Ellenberg Peter Niculescu Alexey Surkov November 28, 2011 DISTRESSED INVESTING 2011 TRADING AND VALUING DISTRESSED

J. Andrew Rahl, Jr., ModeratorMark C. EllenbergPeter NiculescuAlexey Surkov

November 28, 2011

DISTRESSED INVESTING 2011

TRADING AND VALUING DISTRESSED DERIVATIVES

Page 2: J. Andrew Rahl, Jr., Moderator Mark C. Ellenberg Peter Niculescu Alexey Surkov November 28, 2011 DISTRESSED INVESTING 2011 TRADING AND VALUING DISTRESSED

TOPICS

Introduction

CDS on Sovereign Debt: Will it Pay?

The Lehman Valuation Framework

Enforceability of Noteholder Payment Priority on Default: the “Flip Clause”

MF Global Update

Page 3: J. Andrew Rahl, Jr., Moderator Mark C. Ellenberg Peter Niculescu Alexey Surkov November 28, 2011 DISTRESSED INVESTING 2011 TRADING AND VALUING DISTRESSED

Introduction

What is a derivative?

a financial instrument derived

from an underlying asset (reference asset)

Key Concepts

Swaps

Valuation

Posting of Collateral

ISDA Documentation

US Bankruptcy Safe Harbor

Page 4: J. Andrew Rahl, Jr., Moderator Mark C. Ellenberg Peter Niculescu Alexey Surkov November 28, 2011 DISTRESSED INVESTING 2011 TRADING AND VALUING DISTRESSED

Introduction – Credit Default Swaps

Credit default swaps (CDS) are derivatives which pay on default = credit insurance

Reference obligation is the underlying debt

Per ISDA documentation: the insurance only pays on a triggering event, such as a credit default

If the CDS is triggered, the protection buyer gets cash and delivers (swaps) the underlying debt to its swap counterparty

Page 5: J. Andrew Rahl, Jr., Moderator Mark C. Ellenberg Peter Niculescu Alexey Surkov November 28, 2011 DISTRESSED INVESTING 2011 TRADING AND VALUING DISTRESSED

Sovereign CDS

Outstanding Sovereign CDS (Net Notional in USD 11/18/11)

France $24.1B

Italy 21.2

Germany 19.5

Brazil 17.6

Spain 16.9

Greece 3.4

Page 6: J. Andrew Rahl, Jr., Moderator Mark C. Ellenberg Peter Niculescu Alexey Surkov November 28, 2011 DISTRESSED INVESTING 2011 TRADING AND VALUING DISTRESSED

Sovereign CDS Documentation Q: What are the ISDA terms for a sovereign CDS?

A: “You will need to look at several documents together for that answer (it is not in a single document per se).

Will also vary by sovereign.

Good 1st start is to go to the “ ISDA Credit Derivatives Physical Settlement Matrix and Confirmation (Most Recent Version October 2011)". You will get an excel spreadsheet - click on the tab marked "Sovereigns" and there you will see the ISDA standard terms for various sovereign issuers. To make sense of those terms, you will need to look at the 2003 ISDA Credit Derivatives Definitions, as modified over the past 8 years or so through various supplements and protocols.

Wish I could tell you it was easier . . .”Source: 11/23/11 email from Andrew Cross of RS

Page 7: J. Andrew Rahl, Jr., Moderator Mark C. Ellenberg Peter Niculescu Alexey Surkov November 28, 2011 DISTRESSED INVESTING 2011 TRADING AND VALUING DISTRESSED

Sovereign CDS

A Credit (Triggering) Event includes:

Failure to pay

Repudiation/Moratorium

Restructuring: includes haircut, payment deferral,

subordination, change in currency must occur in a form that binds all holders of

the ‘restructured debt’

Page 8: J. Andrew Rahl, Jr., Moderator Mark C. Ellenberg Peter Niculescu Alexey Surkov November 28, 2011 DISTRESSED INVESTING 2011 TRADING AND VALUING DISTRESSED

Sovereign CDS

Per ISDA (10/27/11 Update):

Credit Events are determined by a regional ISDA determination committee (DC)

The question will be submitted to the Euro DC when ripe; it will weigh the publicly available evidence and vote on whether a Credit Event has occurred

All firms entering into ISDA CDS transactions have agreed to be bound by the determination

Page 9: J. Andrew Rahl, Jr., Moderator Mark C. Ellenberg Peter Niculescu Alexey Surkov November 28, 2011 DISTRESSED INVESTING 2011 TRADING AND VALUING DISTRESSED

Lehman Valuation Framework

A comprehensive solution for all counterparties: “rough justice”

Contrary to the ISDA, the defaulting counterparty set the parameters

Reluctance to admit that bid-ask is part of the claim

No supporting data provided for the framework

One size for all counterparties no matter how big or small

Page 10: J. Andrew Rahl, Jr., Moderator Mark C. Ellenberg Peter Niculescu Alexey Surkov November 28, 2011 DISTRESSED INVESTING 2011 TRADING AND VALUING DISTRESSED

Lehman Valuation Framework

Swap spreads by maturity and currency

Volatility spreads for options

Credit spreads for CDS

Liquidity spreads for large size positions

Spreads for complexity

Tables of “Add on” spreads for each major category of instrument, e.g.:

Page 11: J. Andrew Rahl, Jr., Moderator Mark C. Ellenberg Peter Niculescu Alexey Surkov November 28, 2011 DISTRESSED INVESTING 2011 TRADING AND VALUING DISTRESSED
Page 12: J. Andrew Rahl, Jr., Moderator Mark C. Ellenberg Peter Niculescu Alexey Surkov November 28, 2011 DISTRESSED INVESTING 2011 TRADING AND VALUING DISTRESSED

The Flip Clause Dante CDO (structured by Lehman) sold CDO notes to

investors (noteholders) for cash; the notes were rated AAA

The CDO held the cash in trust as collateral for the CDO notes but entered into a credit default swap with Lehman which provided for various payments off the top to Lehman

If the swap terminated due to Lehman’s default, the CDO notes became due and the cash in the trust would repay the notes and thereby cut off payments to Lehman This “waterfall flip” was to take effect if the swap termination

was caused by Lehman’s default

If the swap terminated for other reasons, there was to be a substantial up-front payment to Lehman that would materially impair the CDS notes

Page 13: J. Andrew Rahl, Jr., Moderator Mark C. Ellenberg Peter Niculescu Alexey Surkov November 28, 2011 DISTRESSED INVESTING 2011 TRADING AND VALUING DISTRESSED

The Flip Clause

The documents were governed by UK law

The noteholders sought to terminate their swap before Lehman filed in the US and be paid the cash collateral underlying the swap based on the waterfall flip; UK courts agreed and upheld enforcement of the flip

Lehman asked US Bankruptcy Court to invalidate waterfall flip, ignore UK ruling, and direct BNY to distribute substantial cash to Lehman

Page 14: J. Andrew Rahl, Jr., Moderator Mark C. Ellenberg Peter Niculescu Alexey Surkov November 28, 2011 DISTRESSED INVESTING 2011 TRADING AND VALUING DISTRESSED

The Flip Clause

Bankruptcy Court invalidated subordination of Lehman’s swap claim against the Dante CDO:

held: a waterfall “flip” is not enforceable when it is triggered by the bankruptcy filing of either the swap counterparty or its credit support provider void as an ipso facto clause

ipso facto applied retroactively to bankruptcy filing of swap counterparty or related entity

US bankruptcy law governed the matter despite UK choice of law clause in documents

Page 15: J. Andrew Rahl, Jr., Moderator Mark C. Ellenberg Peter Niculescu Alexey Surkov November 28, 2011 DISTRESSED INVESTING 2011 TRADING AND VALUING DISTRESSED

Flip Clause – Why should You Care?

Can’t rely on waterfall flip even if it is in your contract

Bankruptcy Court can retroactively determine that automatic stay and ipso facto prohibitions apply before the Ch 11 filing of your counterparty – as long as a related entity filed before termination

Where swaps are part of a complex transaction, a Bankruptcy Court may review and interpret a swap independently from related transaction documents

Page 16: J. Andrew Rahl, Jr., Moderator Mark C. Ellenberg Peter Niculescu Alexey Surkov November 28, 2011 DISTRESSED INVESTING 2011 TRADING AND VALUING DISTRESSED

MF Global Update

2011

In the wee hours of Monday October 31, 2011 MF

Global filed its bankruptcy case in SDNY – and $1.2B of customer money is missing?

$ $ $

Page 17: J. Andrew Rahl, Jr., Moderator Mark C. Ellenberg Peter Niculescu Alexey Surkov November 28, 2011 DISTRESSED INVESTING 2011 TRADING AND VALUING DISTRESSED

MF Global Update

Parties:

Louis Freeh, Bankruptcy Trustee

James Giddens, SIPC Trustee

CFTC

Page 18: J. Andrew Rahl, Jr., Moderator Mark C. Ellenberg Peter Niculescu Alexey Surkov November 28, 2011 DISTRESSED INVESTING 2011 TRADING AND VALUING DISTRESSED
Page 19: J. Andrew Rahl, Jr., Moderator Mark C. Ellenberg Peter Niculescu Alexey Surkov November 28, 2011 DISTRESSED INVESTING 2011 TRADING AND VALUING DISTRESSED

Written Materials

Greek Sovereign Debt Q&A page 1 - ISDA Update 10/27/11 (excerpts)

Derivatives Claims Settlement Frameworkpage 5 - May 27, 2011 Legacy Asset Management Co,

Letters to the Lehman Court re Settlement Framework, SDNY Bk Case # 08-13555

page 49 - JP Morgan, October 4, 2011, D.I. 20580

page 52 - Citibank NA, October 4, 2011, D.I. 20570

Page 20: J. Andrew Rahl, Jr., Moderator Mark C. Ellenberg Peter Niculescu Alexey Surkov November 28, 2011 DISTRESSED INVESTING 2011 TRADING AND VALUING DISTRESSED

Written Materials

Bankruptcy Court “Flip Clause” Decision page 54 - SDNY Bk Case No. 09-02142 D.I. 86

District Court Decision Granting Appealpage 79 - SDNY Bk Case No. 09-02142 D.I. 117