In response to my recent postings regarding credit default swaps (CDSs), a professional acquaintance was kind enough to refer me to a relatively recent decision. Aon Financial Products v. Societe Generale, 476 F.3d 90, issued nearly one year ago by the Second Circuit Court of Appeals, provides a fascinating insight into the risks posed by credit default swaps, and demonstrates how even financial institutions and hedge funds that have used such instruments prudently may find themselves facing unexpected damages in the coming months as default rates begin their inexorable upward climb.
The facts are unremarkable. Several years ago, a Bear Stearns 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 (NYSE:AOC) in turn hedged its own exposure by buying a credit default swap from SocGen (OTC:SCGLY) 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.
The Second Circuit reversed and ruled in favor of SocGen, stating that “[t]he terms of each credit swap independently define the risk being transferred.” The court parsed the language of CDS 2 with precision. Simply put, it noted that “the risk transferred to Aon and the risk transferred by it were not necessarily identical.” Aon had sold Bear Stearns protection that expressly included a failure to pay by GSIS as a Credit Event. However, what it bought from SocGen was slightly different. CDS 2 contained protection against “a condition . . . resulting from any act or failure to act by the government of the Republic of the Philippines . . . or any agency . . . thereof . . . that has the effect of . . . causing a failure to honour any obligation . . . issued by the government of the Republic of the Philippines.” The Court of Appeals declined to interpret GSIS’s claim that it was not legally obligated to pay under the surety bond as a “condition” caused by “an act or failure to act by the government of the Republic of the Philippines.”
The risks for which protection was sold under CDS 1 and CDS 2 did not match up. Aon, instead of making $100,000, lost $10 million.
This case, which is now binding precedent in New York and will probably be followed elsewhere, will garner greater attention as default rates mount and payments are sought under CDSs.
As noted previously on this site, the notional amount of the CDS market has grown from less than $2 trillion in 2002 to in excess of $45 trillion today. The Office of the Comptroller of the Currency estimates that major financial institutions hold about 40% of these instruments, equally split between buyer and seller positions. As Aon vs. SocGen demonstrates, these positions might not be as precisely balanced as they may need to be for what lies ahead.