Normally when a corporate credit defaults, the purchasers of Credit Default Swap (CDS) protection receive a payout to compensate them for losses. In the case of Europcar, some holders of protection were compensated and more were left penniless, depending on the settlement terms of their CDS contract.
A CDS is a form of insurance on corporate debt. The protection holder pays a premium, usually to an investment bank, with the expectation of a payout to cover losses in the event of a default.
The original method to calculate the payments is known as “physical settlement”. The buyer of protection (the holder) delivers the defaulted bonds to the protection seller and receives 100% of the value. In this case, the holders are hedging a position they already hold.
In 2005 another method became popular called “cash settlement”, which does not require the protection buyer to deliver the bonds.
This method evolves as many investors started to used CDS to take a view on the market, without actually holding the underlying debt. So if they expect a company to default they buy protection in the hope of a payout, if there is no default then they merely lose their premium.
This was the mechanism that the hedge funds in the film The Big Short used to get exposure to the housing market. This marked the evolution of CDS from hedging tools to trading instruments.
In “cash settlement” there is no requirement to deliver the underlying defaulted debt, the seller of protection makes a cash payment to the protection buyer for the amount of loss sustained.
The main method to determine the level of cash payments is the “credit event auction”. Very simply the auction process involves dealers who are usually the investment banks submitting prices at which they would buy and sell the defaulted bonds. Bondholders can sell their defaulted bonds to the dealers at these prices. The clearing point where the bonds trade sets the cash price at which the CDS are settled.
In the case of Europcar, there was a technical factor that impacted the auction. Part of the restructuring deal, which triggered the default, involved a debt-equity swap and effectively restricted bondholders who wanted the equity from trading their bonds
In the first round of the auction, Europcar defaulted bonds were trading at an average price of €73, meaning that protection holders would receive €27 in compensation. In the second round, the restriction on existing bondholders meant that demand outweighed supply by €7.4m (total bonds eligible for the auction were about €1bn)!
Under the terms of the auction, if all bids are not satisfied, the auction automatically settled at 100% or €100 in the case of the Europcar bonds.
Consequently, Europcar CDS protection holders who had physical settlement received their payout, those who had cash settlement received no payout!