The revelation that distressed Italian dairy producer Parmalat Finanziaria had purchased self-referenced credit-default swaps has provoked debate on the ethics behind corporates selling protection on their own name. By purchasing self-referenced default swaps corporates dive into a sticky ethical and legal situation, said derivatives pros. Parmalat, which has come under the microscope for having purchased self-referenced default swaps in 1999, became distressed after it failed to pay back principal on a bond and had its rating slashed to CC.
Critics charge that creditors of corporations are not always made aware that of the nature of the credit-default swaps. Although swaps may appear to creditors as high quality assets they can lose as much as 50% of their value quickly in the case of default, a fact which isn't always made transparent, explained one attorney. As corporations become distressed, and the swaps subsequently blow out, corporations also need to pledge more collateral against the swaps, which in turn can provoke a vicious cycle contributing to even further widening, added another derivatives pro. Legal issues also complicate self-referenced derivatives, with defaults being subject to attack under the anti-forfeiture bankruptcy code, added the attorney.