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Yesterday, I was at a lecture where the speaker said that the impact of derivatives was often to make senior debt, in effect, subordinated debt (in terms of priority, recovery rates, etc.)?

How do derivatives accomplish this result? Are they usually listed on the balance sheet? (I have thought that most of the time, they were off balance sheet contingent liabilities)? Does one need to "recast" the balance sheet to display their position/impact, even if they are technically off balance sheet? Or is it the case that they weaken the income statement, basically the interest and debt service coverage ratios to the degree that formerly "safe" senior debt is no long so safe?

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  • $\begingroup$ Is n't it the reverse...i.e is not the purpose to make subordinated debt into senior debit? I make a loan to a borrower with a BB rating, then I purchase a credit default swap..effectively turning that loan into a AAA loan. Is it not? $\endgroup$ – Victor123 Apr 26 at 15:19
  • $\begingroup$ @Victor123: Maybe you have the answer. If derivatives make subordinated debt senior debt, then they might make (formerly) senior debt subordinated debt. $\endgroup$ – Tom Au Apr 26 at 15:36
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Accounting for derivatives varies by jurisdiction and by user type, so let's not get bogged down in that. Let's focus on the economics: derivatives are usually legally pari passu with senior debt (have the same seniority in bankruptcy). However, they may in effect get paid earlier- for example, derivatives are usually subject to a CSA (credit support annex) which causes any mark to market losses to be paid on a daily basis. Hence if an entity is heading towards bankruptcy, the derivatives liabilities may get paid before the senior debtholders. In addition, there is new proposed legislation for US banks that would force banks to issue debt that is subject to a "bail-in" provision (this means that debtholders in the event of an insolvency), making this debt specifically junior to derivative liabilities.

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  • $\begingroup$ The worst thing about this, in my humble opinion, is that the average reader of the WSJ or the FT is not aware of these issues, and neither are our elected representatives. They are too obscure and technical to come up for public discussion and are of interest only to banks and their lawyers who draft the rules in the first place. $\endgroup$ – Alex C Dec 7 '15 at 23:51

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