The ongoing debate over the definition of restructuring as a credit event has edged closer to all-out confrontation with last week's circulation of a draft supplement by the International Swaps and Derivatives Association and the increasing probability that an argument over Xerox's restructuring will end up in court. The ISDA draft has raised the hackles of a group of major insurers, which believe the association has weaseled out of providing a workable definition of restructuring, industry officials told sister publication Derivatives Week. Officials at the ISDA did not return calls.
At the heart of the debate is concern among protection sellers that loan houses are in a position to unfairly benefit from a restructuring that would raise the quality of their assets--in this case the loan--and also receive a pay-out on credit protection that is triggered by the restructuring. In addition, sellers note that a restructuring could result in improving the quality of a loan, for example raising the level of collateral and juicing up the coupon, which would have a deleterious impact on the value of outstanding unsecured bonds.
The restructuring credit event has become the greatest source of uncertainty and potential for dispute in what is a crucially important risk-distribution channel for banks, according to Blythe Masters, portfolio manager at JPMorgan, in a recent letter to ISDA.
The dispute, which has driven a wedge between the U.S. and European credit derivatives markets, has prompted the group of insurers to call for drastic change. In a letter to ISDA, the group said: Ultimately, restructuring should be removed as a credit event. The group includes Ambac Credit Products, Chubb Financial Solutions and XL Capital Assurance. Officials at the firms declined to comment.
The insurers are upset about Wall Street firms recent decision to classify Xerox restructuring of its loan facility as a credit event, which therefore triggered protection. They argue this is wrong because, among other things, the refinancing did not directly or indirectly result from a deterioration in Xerox's creditworthiness of financial condition. The protection buyers disagree, saying that Xerox had no chance of repaying the loan and were forced into a restructuring. One head of legal consul said, Everyone is preparing for litigation on this issue.
Restructuring has not been dropped before because loan houses have insisted it is required for regulatory capital purposes. However, Masters letter said, JP Morgan, acting in its capacity as an end user, will drop restructuring from its required credit events in our "standard" contract for non-sovereign credit derivatives. Other banks have not followed JPMorgan's lead, but several said they would look at buying protection with a longer maturity than the asset they are hedging to cover the risk of a forced extended maturity.
Several bankers told DW that while the Xerox case is a restructuring according to the letter of the definition--and they would therefore expect to defeat any legal challenge--they concede that this is not the type of restructuring the definition was intended to capture.
