BES may test CDS rules

The legal machinations of the CDS market are probably not the main concern of Portugal's national government and its biggest bank. But the travails of Banco Espirito Santo (BES) are certainly capturing the attention of credit investors, not least because of its potential significance in a changing regulatory environment.

BES has been under pressure since its parent disclosed accounting irregularities last month, and its situation worsened this week with the release of its first-half results. The bank said it made a net loss of €3.5bn, far larger than expected. Impairment costs of €4.25bn relating to its exposure to other companies in the Espirito Santo group did the damage, and cut its common equity tier one capital ratio to 5%, below the regulatory minimum of 7%.

Credit investors, understandably, reacted negatively to BES's increasingly precarious position. The bank's senior CDS spreads were trading at 730bps, some 357bps wider than where they started the week. BES's subordinated spreads were at 1,200bps, nearly double last Friday's level.

Its inadequate balance street strength means that BES will have to raise capital sooner rather than later, and the source of this capital will have a great impact on the bank's CDS. If BES manages to raise funds privately, then a default will be averted and its spreads will no doubt tighten. But if it is forced to seek help from the government, it seems likely that subordinated bondholders will be bailed-in. Depending on how the bail-in is organised, this will probably trigger a restructuring credit event.

The timing of BES's problems holds particular significance for the CDS markets. Under current ISDA definitions, a restructuring of subordinated debt can trigger both sub and senior CDS. But the new definitions due to be introduced in September mean that a subordinated restructuring would no longer trigger senior CDS. It is also likely the new Governmental Intervention credit event - it was, after all, designed for exactly this type of scenario.

It is expected that subordinated CDS (ISDA 2014) will trade significantly wider than CDS using current definitions, as there is an additional credit event and higher probability of a trigger. Senior CDS, meanwhile, could trade tighter, as they will no longer be tied to subordinated restructurings on bail-ins.

So, if BES fails to raise private capital and the government intervenes to force a bail-in of subordinated bondholders, it could provide a timely reminder of the need for the new definitions. The current rules were found wanting in the case of SNS Bank and Bankia, and we may see them tested again with BES.

BES's problems have contributed to the broader market sell-off in recent days, as has the default in Argentina. ISDA has just determined that the missed payment on July 30 was a failure to pay credit event. Markit's composite recovery rate was 45.67% at Thursday's close, and we can expect a credit event auction in the coming weeks.

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This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.