European and U.S. credit derivatives documentation is converging--but the restructuring credit event remains the key unresolved issue, according to Chris Francis, managing director and head of international credit research at Merrill Lynch in London.
Credit derivative markets have grown rapidly into a vital cog in the global credit machine. Unlike traditional debt instruments, credit default swaps de-couple credit risk from underlying funding flows, such as loan or bond issues. These instruments can thereby facilitate the efficient global transfer of credit risk between participants--be they banks, insurance companies, fund managers or corporates. The global market potential looks even greater once universal documentation conventions can be agreed.
The market has mostly dealt with emergent documentary problems in an orderly fashion, through new supplements or simplification of existing terms. In April, for example, European contracts dropped the repudiation/moratorium and obligation acceleration credit events, because they were viewed as superfluous.
This left the restructuring credit event as the one remaining major difference between U.S. and European conventions. The U.S. transacts subject to the ISDA Restructuring Supplement (also known as modified restructuring or mod-R) whilst Europe has not adopted this supplement.
The Restructuring Credit Event
Current ISDA definitions set tests for determining whether a restructuring has occurred, which can be summarized as follows.
* Reduction in interest payable or accrued;
* Reduction in principal;
* Deferral of interest or principal;
* A negative change in subordination; or
* Certain changes in currency.
However, any such occurrences, which do not result from deterioration in the creditworthiness or financial condition of the reference entity are excluded. A further significant feature of mod-R is that the reference obligation may not be deliverable in settlement.
The Conseco Case
In October 2000, Conseco and its bankers agreed to a restructuring of its loans, which included an extension of maturity. In the bank loan market this was not seen as especially credit negative since it headed off potential liquidity problems. However, some bankers who had bought protection on Conseco gave notice of restructuring and delivered long-dated bonds trading significantly lower than the restructured bank loans. This outcome shocked the market as economic losses were not expected on soft credit events which although resulting from credit deterioration fell short of a full default or bankruptcy.
The Restructuring Supplement
In May 2001, ISDA issued its restructuring supplement to its 1999 definitions.
Restructuring maturity limitation provisions set somewhat complex restrictions on deliverable obligations when mod-R applies and a restructuring credit event has occurred. In particular, it limits the delivery of long-dated instruments in settlement of the swap. Maturity is capped at:
The earlier of (i) 30 months following the restructuring date or (ii) the latest final date of any restructured bond or loan, subject to the following limitation; at no stage can the restructuring maturity limitation date be earlier than the scheduled termination date of the default-swap contract.
A further provision of this clause is that following such event, only fully transferable obligations are deliverable. Thus, loans that require the consent of the borrower for transfer are not deliverable.
Still No Momentum In Europe For Mod-R
Given the clear benefits that mod-R gives in protecting default sellers from soft credit events, it may appear surprising that the European market has not embraced it. This reluctance is likely due to the following:
* Europe has not yet suffered a high profile Conseco-type of
restructuring where protection sellers incur losses due to
soft credit events;
* The restructuring maturity limitation clause may be too
restrictive for many European balance sheets. Where
corporate debt capital consists of long-dated bonds it is
possible that none will be deliverable.
* Many European loans require the consent of the
borrower for transfer and would not be deliverable
under mod-R.
* Major European banks, the dominant protection buyers in
Europe, are opposed to mod-R. This is due partly to the
above factors and partly to a wish to avoid adverse capital
treatment by bank regulators.
2002 Definitions: A Chance To Stride Forward
ISDA is currently revising its credit derivatives definitions. This exercise provides an opportunity to balance the needs of protection buyers whilst removing moral hazard risk from restructuring. The final outcome may involve a 'pick 'n mix' of the following possibilities:
* Making the reference obligation always
deliverable--although this might encourage buyers to
select the longest possible reference obligation;
* Making the restructured obligation exempt from maturity
limitation caps;
* Allowing delivery of consent required loans provided the
borrower cannot withhold such consent unreasonably.
* Extension of the 30-month maturity limitation to
potentially as long as five years.
A solution will require compromise. However, so long as participants keep their eyes on the prize--a larger, more-active and more-efficient global credit risk transference market--common ground should be within reach.
