The Year of the Synthetic CDO - No Holds Barred

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Despite ongoing warnings and calls for restraint from credit risk managers, the burgeoning synthetic derivatives market is here to stay. Synthetic collateralized debt obligations ("CDOs") are leading the way and recent U.S. bankruptcy legislation is facilitating the further expansion of this massive $800 billion market.

2005 has been a banner year for the derivatives industry. The growth in derivatives trading has been exponential, especially in the area of credit derivatives driven by the investment zeal of hedge funds worldwide. So far this year, the average dealer is at a pace to have more than doubled the number of credit derivatives trades as handled last year, and the number of 2004 trades was already a doubling over 2003 volume. While as recently as July 27, 2005, policy makers like the Credit Risk Management Policy Group II cautioned restraint on the "undisciplined" use of complex derivative products, recent legislation in the derivatives product area in the United States makes derivatives trading all the more enticing.

Buried in recent bankruptcy legislation to take effect on October 17, 2005, under Title IX of the U.S. Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the “Act”), is a statutory safe-harbor from the automatic stay provisions of the Bankruptcy Code for hybrid derivative products. The coverage of the safe harbor includes credit derivatives and some of the very types of complex derivatives trades that the hedge funds have been ardently pursuing in recent months.

The safe-harbor is not new as to plain-vanilla swaps, but it does add certainty as to application for all manner of other types of trades that constitute "financial contracts" that did not even exist when the safe-harbor concept first came into play. The world of now statutorily defined "financial contracts" is large, be they repurchase agreements, equity derivatives, weather swaps, or just about anything that can be documented on an ISDA (tm) master agreement. The new law provides for uniform treatment of a wide variety of derivative products and much needed legal certainty for the termination, liquidation, and acceleration of financial contracts in accordance with their terms in the event of counterparty bankruptcy.

What does bankruptcy law have to do with derivative products? Avoidance of a market liquidity crisis. Derivatives deals need liquidity: recurrent payments on time and certainty of termination payments when scheduled. Normally, the filing for bankruptcy by a party to a commercial contract in the U.S. causes a number of disruptions in the free flow of business activities with that entity. As a bankrupt debtor, the entity is protected from the claims of creditors under the automatic stay provisions of the U.S. Bankruptcy Code. The non-debtor party is not able to terminate the contract and exercise its contractual remedies without permission of the bankruptcy trustee. The bankruptcy trustee, in turn, has the power to avoid certain transfers otherwise due to the non-debtor party. In short, no one gets paid very fast, and often not at all.

In the world of financial contracts, which include swaps, forwards, repurchase agreements, commodities contracts and security contracts, the market disruption and ripple effect of liquidity events that the bankruptcy of a counterparty could entail are severe. In 1990, legislation was enacted to provide a safe harbor for swap agreements from the automatic stay provisions of the U.S. Bankruptcy Code when a swap counterparty filed for bankruptcy. Similar amendments were made to the regulatory regimes affecting banks in receivership. However, over the course of the last 15 years, the derivatives markets have outpaced the statutory understanding of what constitutes a swap agreement under bankruptcy legislation.

New products such as debt and equity swaps, and credit derivatives such as credit default swaps and total return swaps have developed into vast markets of their own. Moreover, these derivative instruments have been the motor for a new industry of synthetic securitizations that now dwarfs the cash-based securitization deals. According to the Financial Times, recent estimates by industry specialists have put the market size of synthetic collateralized debt obligations at $800 billion.

Title IX of the Act provides for uniform treatment of all these derivative products, including those not yet created, and much needed legal certainty for their termination and pay-out upon the insolvency of a bank or bankruptcy of a corporate or other entity. The Act provides for amendments to the Federal Deposit Insurance Act and related bank insolvency statutes so that both bank and non-bank entities have similar safe-harbor treatment available to them upon bankruptcy or receivership. Although procedures in commercial bankruptcies differ from bank receiverships, the amendments extend equally between them to cover basic assurances against cherry-picking of executory contracts and to provide a safe-harbor from the automatic stay for new types of financial products.

For 2005, competing forces of caution and industry drive have not yet evened out. It is the year of the derivative product and there is little that policy groups can do to stem the tide.

For further information about the Act and the ramifications of Title IX on derivatives trades, please contact Ellen H. Clark, Esq., Head of the Derivative Products Group, in Salans New York Office at +1 (212) 632-8375 or (917) 213-9409.

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