The Unlawyer

I nearly sputtered my morning coffee onto my laptop when I read this piece of news from today’s Business Mirror: Investors see RP defaulting.

“[Asian Development Bank] senior economist Dr. Cyn-Young Park said the widening credit default spreads lead many investors to think that the Philippine government may default on its debt, or not pay these when it becomes due.

““This is the investors’ assessment of the creditworthiness of the Philippine government,” Park said in a seminar organized by the Yuchengco Center and the De la Salle University.”

I read the article with much concern, until I finally discovered that this sentiment echoed by Dr. Park was merely the result of the malaise generated by the global financial crisis. This is not to say, however, that the Philippines was ever considered as being in the pink of fiscal health even before this financial meltdown exploded on the world’s collective laps.

At any rate, at least one credit ratings agency has fortuitously stepped into the breach and sort of reassured investors with a stake in the Philippines’ economy: Creditworthiness not an issue.

“… Fitch Ratings does not see a decline in the Philippines’ creditworthiness despite a continued global downturn but it warned that increased revenues were necessary to see the country through the crisis.”

With economic activity expected to slow down in the Philippines in 2009 and with the government about to implement an economic stimulus package of its own, where will this extra money come from? By improving its tax collection efforts, raising already-established taxes or imposing new ones, or by borrowing from domestic and overseas investors.

Returning to the Business Mirror article I linked to, it mentioned an arcane – to non-finance types, that is – financial instrument that many are blaming as one of the reasons why the world’s financial system is in such a fine mess: the credit default swap. What on earth is it?

“A credit default swap (CDS) is a credit derivative contract between two counterparties. The buyer makes periodic payments (premium leg) to the seller, and in return receives a payoff (protection or default leg) if an underlying financial instrument defaults.”

In other words, a credit default swap is obtained by a buyer in order to mitigate the risk it obtained in investing in another financial instrument, say a loan that it extended to another party, in the event that the borrower in the latter contract is unable to perform its obligations, like being unable to pay off its debt. The CDS may be sold by its original purchaser to another party, and so on.

A CDS may be likened to an insurance contract, if you will. This New York Times graphic illustrates how it works – and the particular risks attendant to this financial instrument.

“Because these contracts are sold and resold among financial institutions, an original buyer may not know that a new, potentially weaker entity has taken over the obligation to pay a claim.

X X X

“It would be as if homeowners, facing losses after a hurricane, could not identify the insurance companies to pay on their claims. Or, if they could, they discovered that their insurer had transferred the policy to another company that could not cover the claim.”

Newsweek describes the nature of the risk as one essentially involving human nature:

“AIG’s fatal flaw appears to have been applying traditional insurance methods to the CDS market. There is no correlation between traditional insurance events; if your neighbor gets into a car wreck, it doesn’t necessarily increase your risk of getting into one. But with bonds, it’s a different story: when one defaults, it starts a chain reaction that increases the risk of others going bust. Investors get skittish, worrying that the issues plaguing one big player will affect another. So they start to bail, the markets freak out and lenders pull back credit.”

There are proposals in the United States to regulate so-called naked credit default swaps and limit their sale “only to those with exposure to economic loss in the instrument being insured.” At present, credit default swaps may be purchased even by parties with no risk exposure to the underlying financial instrument being secured, and whose only purpose in investing is to reap whatever profits that may be earned from speculating on them.

Do you know that a case involving a Philippine debtor and a state-owned retirement fund helped shaped United States jurisprudence on credit default swaps? Read the curious case of Aon Financial Products v. Societe Generale. 476 F.3d 90:

“Several years ago, a Bear Stearns (BSC) affiliate provided a loan of $10 million to a Philippine entity for a construction project. Bear demanded that the borrower obtain a surety bond from a Philippine government agency, the Government Service Insurance System (GSIS), and then sought to further hedge its exposure by purchasing a credit default swap from Aon for $425,000 (CDS 1). Aon in turn hedged its own exposure by buying a credit default swap from SocGen for $328,000 (CDS 2).

“Aon acted in a textbook manner. It balanced its position, and booked a profit of nearly $100,000. So, what went wrong?

“The Philippine borrower defaulted, and GSIS refused to pay on the surety bond. Bear Stearns’ assignee successfully sued Aon for payment under CDS 1. Aon in turn sued SocGen under CDS 2, and moved for summary judgment. Aon argued that the court’s finding in the first action, that a “Credit Event” requiring payment had occurred under CDS 1, mandated a similar result with respect to CDS 2. The district court ruled in favor of Aon, and SocGen appealed.”

You can read more about the Philippine aspect of this matter here: Fact-finding and Intelligence Bureau v. Campaña.

At any rate, Aon lost on appeal for a very simple reason:

“Rejecting Aon’s argument, the Second Circuit stated that the “risk transferred to Aon and the risk transferred by it were not necessary identical. The terms of each credit swap agreement independently define the risk being transferred.” [References omitted - Ed.] The court examined the language of the agreements, finding that while the First CDS defined a “credit event” to include a failure to pay by GSIS on the surety bond, the Second CDS explicitly did not. The court ultimately found that a “credit event” did not occur and, as a result, that Aon could not recover.”