The credit derivatives market could be heading for a bust up on the same scale as last year's Railtrack debacle over a little-known clause contained in the bonds of Marconi Corp., according to industry bankers and lawyers. One trader estimated hundreds of millions of dollars in Marconi credit protection was traded up until last summer when the company hit financial difficulties.
The problem lies in the widely held belief that Marconi bonds are non-contingent, and therefore deliverable if a credit-default swap is triggered. However, a covenant buried in the small print states that the guarantee falls away if Marconi pays back all its loans, and therefore the bonds could be construed as contingent, which would render them ineligible for delivery under standard credit derivative contracts.
One potential problem resulting from the clause is that protection sellers could argue that if a credit event is triggered, the bonds are non-deliverable. Therefore a bond holder long credit protection would have to sell the Marconi bonds to a third party and then buy a Marconi loan to deliver against the credit derivative contract.
The issue is a "hot potato" because Marconi was a widely traded name. A credit event could paralyze the market as traders haggle over how to settle open positions, predicted an attorney. Another said that while it is in the interests of market markers to reach an amicable resolution, real problems could arise with end users. Whereas market makers are likely to have reasonably balanced positions, customers are unlikely to have bought and sold protection and therefore their exposure will probably be one way.
An International Swaps and Derivatives Association user guide states, "The "Not Contingent" Obligation Characteristic should not be read to exclude guarantee obligations." An official at ISDA said it does not comment on individual cases.
However, all this could be avoided if Marconi restructures its debt, at which time this covenant could be removed. Wolfgang Draack, senior v.p. and telecom equipment analyst at Moody's Investors Service in Frankfurt, said it rates Marconi Ca, which means it is predicting a default in the near term.
