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The Fine Print of Nationalization

Posted by Larry Doyle on February 23, 2009 11:27 AM |

Many leading economists and market mavens are calling for the formal nationalization of certain banking institutions in ourfine-print country. There are numerous arguments for and against nationalization. While many of these arguments are philosophical in nature, perhaps it is the fine print in CDS (credit derivatives) contracts that are the major hurdle.

In a communication with a European derivatives expert this morning, I received some truly enlightening color on this fine print.  From what is being shared with me, the contractual agreement embodied in standard CDS transactions addresses the nationalization topic.  What occurs?

Nationalization of an institution serves as a “trigger” event for detonating the CDS counterparty market.  Cross default provisions in the holding company indentures would likely bring about the bankruptcy of hundreds of billions of dollars of holding company debt which in and of itself would probably have a a systemic impact on the global finance market. (Cross default provisions mean that a holding company of a bank is responsible for the obligations of its’ subsidiaries.)

What does that mean? Effectively, the formal full blown nationalization of a banking institution would serve as a trigger to cause a domino effect throughout the global markets. As one bank holding company defaults on its debt obligations it will cause its’ counterparties to default as well and  right on down the line.  I am not a derivatives expert, but if in fact this is the case then we will likely see prolonged government intervention into distressed banks in the form of public-private partnerships.

I do not think that is a healthy arrangement nor one that promotes long term growth.  That said, the global markets may not have any other alternatives.

I will be watching and writing.


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