TheInternational Swaps and Derivatives Association over the next several weeks will canvass credit derivative dealers, hedgers and investors with a view to revising so-called 'soft' credit event definitions in credit derivative documentation. Bob Pickel, executive director and ceo of ISDA in New York, told DW there will be changes to the credit event definitions, declining to put a timeframe on the move. The issue has been a focus of discussion as the synthetic CDO and credit default swap markets have grown but raised eyebrows recently when Moody's Investors Service and Deutsche Bank engaged in a skirmish--via conflicting research reports--on the potential magnitude and probability of soft credit events, according to market professionals.
The debate centers on credit events that are short of outright bankruptcy or default, being included in credit derivative contracts. ISDA documentation recognizes credit events that do not necessarily entail a default, such as the 'in furtherance of' clause of the bankruptcy definition, which could cover an obligor considering filing for bankruptcy, explained Jeffrey Tolk, v.p. and senior credit officer at Moody's in New York. If publicly reported, Tolk continued, these considerations could trigger a loss payment under a credit default swap, even if the obligor does not enter bankruptcy.
In a report published at the beginning of the month Deutsche Bank concedes that "synthetic credit instruments may carry an element of documentation basis risk that is not present in a conventional cash security." However, John Tierney, the report's author, continues: "We think Moody's goes too far in implying that the presence of certain credit events in synthetic securities exposes investors (ie protection sellers) to a materially greater degree of default risk and loss."
"It's an unquantifiable risk and that makes us and investors uncomfortable," said Moody's Tolk. Rather than overstating the issue the rating agency asserts that the definition of these soft credit events is so broad that their inclusion in documentation exposes investors to an unknown level of risk. "ISDA seems to be considering our point of view," he continued. ISDA's Pickel confirmed that the association is moving towards Moody's definitions.
The association's G-6 subcommittee of the Credit Derivatives Market Practice Group met last Tuesday to set an agenda for tackling the credit definitions.
Several investors said they share Moody's concerns with the inclusion of soft credit event definitions in ISDA documentation. "That's where it gets a little dicey," one investor noted, adding that the soft credit definitions should be dropped.
A credit derivatives trader in London noted ISDA is in the early stages of looking at the definitions, but agreed that some credit event definitions might be taken out of the ISDA documentation. "You don't have to wait for ISDA," he said, adding that counterparties can agree to strike the language from their documentation when they enter transactions.
