Bankruptcy professors are known for their exciting social lives, and thus the previous weekend found me flipping through the annual reports of several bond funds to see what was happening in the “spicy†end of debt investing.
I thus noted with interest the following table from an emerging markets fund:
| $50 | Bank of America | France |
| 30 | Bank of America | Saudi Arabia |
| 25 | Bank of America | Qatar |
| 25 | Bank of America | Qatar |
| 20 | JPMorgan Chase | Abu Dhabi |
| 30 | JPMorgan Chase | Abu Dhabi |
| 50 | JPMorgan Chase | Czech Republic |
| 50 | JPMorgan Chase | France |
| 20 | JPMorgan Chase | Saudi Arabia |
These are all trades involving credit default swaps. The fund is the protection buyer on all of the trades, which expire at various points in 201! 7, and I have left out a few columns for simplicity.
First, I commend the fund for the straightforward presentation of the data. It’s not often that you find such transparency. More typically, “buy credit protection†is as far as it goes.
But that “counterparty†column reminds us that even post-Dodd-Frank, the world is still a very interconnected sort of place. And some banks really are too big to fail, at least too big to fail easily.
But then there are a couple of entries that caused me to do a double take.
What the heck is an emerging markets fund doing buying protection against France And since the fund is not likely to own any French debt, doesn’t this run afoul of that European Union ban on “naked†credit default swaps that was in the news a while back
First, note that the annual report shows that the fund does not own long positions in any of the jurisdictions shown above, on either the corporate or sovereign side. That is, the trades are all in some sense “shorts†of sovereign debt.
But the table also highlights the real limitations of the European Union’s ban. Even if the fund were subject to the ban - as a United States-based entity, its not likely applicable anyway - the ban included an exception for hedging.
And before you say “but they don’t own French debt,†remember that the ban’s terms included indirect hedging by buying credit default swaps that is correlated with debt actually owned.
Who knows what France is correlated with (OK, investors know, but law professors and regulators generally don’t).
Which takes us back to the first quest! ion I ask! ed: What is a retail emerging markets fund doing buying credit default swap protection on France The amounts are relatively small, $100 million total notional value, while the rest of the fund’s portfolio is worth more than $5.5 billion - but still, France
We don’t really know, and even the investor that bothers to read the annual report won’t get that question answered. Has even retail debt investing has become too complex to understand
Stephen J. Lubben is the Harvey Washington Wiley Chair in corporate governance and business ethics at Seton Hall Law School and an expert on bankruptcy.
