Documentation risk in credit default swaps: When is a hedge not a hedge?

Abstract

In March 2000, Ecobel Land Inc. defaulted on a Bear Stearns International US$10m loan initially believed to be backed by a surety bond. Bear Stearns International had hedged the non-payment risk with a credit default swap with Aon Corporation. Despite alleged fraud, documentation errors and a lack of due diligence which rendered the surety bond worthless, the credit default swap represented an appropriate hedge. Aon Corporation, in turn, believed it had hedged its position with a credit default swap with Société Générale. However, documentation errors resulted in Aon Corporation being unhedged and liable for the US$10m plus legal fees and associated costs resulting from honouring the swap and related litigation. This paper highlights the importance of documentation in establishing appropriate hedges.