DISTRESSED INVESTING 2011
TRADING AND VALUING DISTRESSED
DERIVATIVES
November 28, 2011
J. Andrew Rahl, Jr., Moderator
Mark C. Ellenberg
Peter Niculescu
Alexey Surkov
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
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
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
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
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
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’
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
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
Lehman Valuation Framework
Tables of “Add on” spreads for each major category of instrument, e.g.:
 Swap spreads by maturity and currency
 Volatility spreads for options
 Credit spreads for CDS
 Liquidity spreads for large size positions
 Spreads for complexity
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
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
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
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
MF Global Update
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?
MF Global Update
 Parties:
 Louis Freeh, Bankruptcy Trustee
 James Giddens, SIPC Trustee
 CFTC
Written Materials
 Greek Sovereign Debt Q&A
page 1 - ISDA Update 10/27/11 (excerpts)
 Derivatives Claims Settlement Framework
page 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
Written Materials
 Bankruptcy Court “Flip Clause” Decision
page 54 - SDNY Bk Case No. 09-02142 D.I. 86
 District Court Decision Granting Appeal
page 79 - SDNY Bk Case No. 09-02142 D.I. 117