Linklaters publishes article on monoline CDS settlement

Linklaters has published an article written by partner Adam Glass looking at credit default swaps referencing financial guaranty insurance companies. The article points out that recent concern about monolines has generated renewed interest by credit default swap protection buyers in understanding how credit derivatives written using the 2005 monoline supplement will apply if there is a credit event by a monoline.

The article looks at what actions by an insurance regulator could trigger a bankruptcy credit event, the differences between protection bought on a monoline operating company and on a monoline holding company, and at what are deliverable obligations under a credit default swap on a monoline.

Glass says that if a state insurance administrator acts as a receiver for an insolvent insurance company, then the bankruptcy credit event would clearly apply. However, he says, some market participants are curious whether some lesser intervention by the regulator could also trigger a credit event. Glass argues that informal interaction between insurance regulators and insurance companies is not sufficient to trigger a bankruptcy credit event. Similarly, if a monoline is being managed in run-off, a credit event will only have occurred if the regulator is acting as rehabilitator.

The article points out that one obligation that should not be deliverable following a monoline credit event is a credit default swap where the monoline has insured performance by the protection seller of its obligations under the credit default swap. This means that counterparties that have bought credit protection on monolines as a hedge against their exposure to monolines under an insured credit default swap will not be able to deliver that credit default swap to the protection seller under the monoline CDS. This is because a credit default swap is not "borrowed money".

Glass notes that this feature is likely to disappoint those protection buyers who believe that the greatest proportionate losses are likely to be incurred on insured credit default swaps referencing subprime CDOs rather than wrapped CDOs or RMBS bonds.