Back in April, I mentioned a story about BTA, a bank in Kazakhstan that had been nationalized by the state in February. The interesting bit about the story was that interested parties from abroad (including Morgan Stanley) had significant Credit Default Swap contracts (CDS) written against losses in the banks bonds. In essence, foreign investors would be better off if BTA failed than if it had not been seized by the State. And this interest in the bank’s failure created a self-fulfilling prophecy. See my post “CDS contracts and the implosion of several Eastern European economies” for more details.

Fast forward to today and now we learn of a gargantuan $7.9 billion loss at BTA. DealBook reports:

BTA, the largest Kazakhstani bank, confirmed losses and write-downs for 2008 of $7.9 billion in a financial statement issued Monday, even as it pursues the restructuring of its debt. According to the bank’s financial statement, actions by previous management led its portfolio to deteriorate for the year, resulting in the loss of 1.188 trillion tenge, the Kazakh currency. Explaining the causes of the loss, the bank said: Certain loan documentation, including collateral and associated additional agreements, primarily relating to financing of projects outside Kazakhstan, is no longer available. In addition, many loans were transferred to new borrowers that do not have adequate sources of repayment. Moreover, no collateral was provided by these new borrowers. Consequently all transferred loans are unsecured. A number of significant borrowers, primarily registered outside Kazakhstan, have ceased servicing their loans, have not allowed the Bank to monitor collateral or failed to provide information about their financial performance. BTA spokespersons were not immediately available for comment.

Fraud is an issue and the bank is now being sued by shareholders. But, I do want to concentrate on the CDS issue and its role in forcing the bank’s hand. In my view, CDS contracts should be seen as a major change in how parties to a bankruptcies react. They distort incentives for interested parties, and create a whole new group of ‘stakeholders’ through naked CDS (i.e. where the holders of the CDS have no underlying interest in the bonds).

In situations of systemic stress as we have just witnessed, CDS have the potential of increasing the number of bankruptcies and volatility in the financial system. In my view, that is why they must be regulated – and not just in the United States, but globally, as this case in Kazakhstan attests. If CDS contracts could help drive a major foreign company into bankruptcy and an American finance firm could suffer massive losses as a result (not the case for Morgan Stanley here), I imagine this is something that U.S. regulators would want to know and prepare for.

Source

Kazakh Bank Confirms $7.9 Billion in Losses – DealBook