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Banco Popular rescue poses CDS conundrum

The contingent convertible (CoCo) bank capital market received all the plaudits on Wednesday, when Banco Popular Español was forced into a “rescue” by Santander.

By Gavan Nolan, IHS Markit

But another, more established financial instrument will also be tested by the Spanish bank’s resolution. A question was put to the ISDA Determinations Committee on Wednesday, asking if a restructuring/governmental intervention had occurred.

On the face of it, this case looks tailormade for the ISDA 2014 definitions. The European Central Bank’s Single Resolution Board, in conjunction with the Spanish Fund for Ordely Bank Restructuring (Frob), declared the bank no longer viable. That led to the writedown of additional tier one and tier two subordinated debt. This includes the reference obligations for Banco Popular’s subordinated credit default swaps.

Under the 2014 definitions this appears likely to be a governmental intervention credit event, though we will have to wait until the ISDA committee has made its decision.

The market is certainly treating it as such. The subordinated 14 five year CDS has jumped from trading 20 points upfront to 95 points. The probable recovery rate is zero, accurately reflecting the loss of bondholders.

Santander would succeed Popular as reference for its senior CDS — remember 2014 definitions split out senior and sub — and the market is again pricing in this outcome. The bank’s senior 14 CDS have rallied from nearly 500bp to 90bp, converging on Santander’s 78bp.

If such a scenario emerges, it would show the CDS instrument functioning as it should, comparing favourably with the debacles surrounding SNS Bank and Banco Espírito Santo.

But we also need to remember that there are many existing trades that use the 2003 ISDA definitions — indeed, there continues to be liquidity in these — and we know from painful experience that this framework struggles to cope with state intervention in banks. If a restructuring credit event is declared by the ISDA DC, it would trigger both sub and senior CDS using 2003 definitions.

Without asset package delivery, the recovery would be determined by the remaining senior bonds, which would have been boosted considerably by the Santander takeover. So a scenario where the recovery is again unrepresentative of the cash market — as with SNS — could result.

The CDS market has made great strides in recent years, and its legal structure is built to cope with the new bank resolution regime in Europe.

But market participants, vendors and clearing houses still need to be aware of the market’s history and use their expertise to meet the challenges posed by cases such as Banco Popular.

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