Thomson credit event to test mettle of new CDS protocol
Issue: 1118 - 21 August 2009
The “small bang” protocol for new contract provisions in the European CDS market was introduced only last month but is to be tested in coming days as the market wrestles with the possibility of insufficient deliverable obligations following the Thomson credit event.


On August 12, the ISDA ruled that Thomson’s failure to make a principal repayment would be classified as a restructuring event rather than a failure to pay. A restructuring event triggers a bucket auction.


Most of Thomson’s deliverable obligations are thought to be complex private placements and little is known about their documentation. It is possible that none will be deemed eligible for delivery. And that spells trouble for the protection buyers.

“Much depends on how much is deliverable. Each piece is bespoke, and nothing might be deliverable. In that case, there is no payout,” said a senior credit strategist in London.
Such an extreme outcome is unlikely, but it is very likely that there will be a shortage of deliverable obligations and a scramble to get hold of what is available. The consequent short squeeze will drive up prices and the recovery rate much higher than it would otherwise be — good news for protection sellers but bad news for the buyers.


For example, the most likely and liquid deliverable obligation, according to Citigroup analysts, is the June 2012 revolver, which would fall in the 2-1/2 to five year maturity bucket. It has been pushed from a 40% price to 70% in recent days.


But the real difficulties lie in the 0 to 2-1/2 year bucket. Thomson, a French media firm, was a regular member of the main iTraxx Europe Index from series 1 to series 7 and was thus much referenced in index CDOs. There are a lot of single name hedges against the name with maturities between now and 2012, putting particular pressure on the 0 to 2-1/2 year bucket.
The bucketing system was introduced in April as part of the big bang protocol to reorganise the CDS market and applies to restructuring cases.


Thomson deferred a $72.5m principal payment derived from a 6.05% private placement due from June 17 to July 25. The new International Swaps and Derivatives Association Determinations Committee, also a product of Big Bang, decided that this constituted a restructuring credit event rather than a failure to pay.


The firm is dealing in the CDS market at 50% upfront and 500bp running for five year protection, the equivalent of 3500bp running, said dealers in London.
Some Thomson investors may choose not to participate in the auction as the recovery rate will be too high. They are entitled to do so as ISDA has labelled the credit event as a restructuring; failure to pay would have forced all counterparties to participate.


If a failure to pay credit event follows this one then all maturities will be treated the same in the auction process and there will be less pressure upon the short term maturities. Protection buyers might be inclined to hold out for this.


Analysts and dealers generally believe that the Thomson credit event will have few profound ramifications upon the CDS market and the new protocol will hold out.


But it is also possible that protection buyers will go home empty handed, and this may shine an unfavourable light upon the CDS market when it needs all the helpful publicity it can get.
Simon Boughey

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