The controversy involving the home builder, Hovnanian Enterprises, Inc., has renewed market participants’ concerns that the fundamental assumptions underlying CDS as a hedging tool are no longer valid. Last week's federal ruling shows courts are unlikely to be sympathetic to the plight of CDS market participants and are reluctant to enjoin an issuer from creating a credit event to obtain restructuring financing from a capital provider that benefits from the credit event. The dispute has captivated traders and investors in the US$1.4trn credit default swap market, whose existence, some say, is threatened by the affair.
RK&O partner Julia Lu told reporters from International Financing Review that she believes changes to existing standard derivatives contracts would help to prevent engineered credit events. “In writing contracts that are not specific to a transaction you invariably run into situations where the wording of the contract is too general and clever people could find ways to arrive at the result they want. It depends on how much [an issuer-created credit event] is going to come up again. If people think this is going to be a recurring problem going forward, they will have an incentive to make rule changes" she said.
"Hedge fund seeks damages over CDS fraud" International Financing Review (subscription required)