The credit derivatives market is taking another step on the long road to maturity with the International Swaps & Derivatives Association 2003 credit derivatives definitions. The changes may seem insignificant for all the hours of research that went into them. But for buyers and sellers of credit protection it will be a huge leap forward.
The definitions replace the 1999 version, which has been given the piecemeal treatment during the last four years as various credit events have poked holes in it – the default of Conseco, National Power restructuring and the crisis in Argentina, for example. ISDA expects dealers to begin using the new format in March.
Restructuring remains the biggest bone of contention among the dealer community. “This is probably the part of the agreement that took the longest to negotiate, is one of the most difficult and raises the most questions,” says David Geen, senior counsel at Goldman Sachs. Already, there are three forms of agreement in use. In the US, protection contracts on high-yield bonds are written without a restructuring clause.
The issue dates back to the default of Conseco in 2000. After restructuring, the bonds traded at 94 cents to the dollar. However, because of the “cheapest to deliver” option in the contract, protection sellers were able to make a killing by delivering cheap, long-dated bonds trading at around 40 cents to the buyers. So modified restructuring was introduced. This states that the deliverable obligation must mature no earlier than the original security and no later than 30 months after the original maturity date.
Europe didn’t like the catchily dubbed “Mod R” though. In particular, traders felt uncomfortable with the 30-month time frame, which they felt impeded their ability to deliver appropriate securities. Because most credit protection sold in Europe is on loans, the universe of deliverables is smaller. Moreover loans, unlike bonds, often cannot be transferred to another lender without the consent of the borrower.
So while the US used either Mod R or, in high-yield contracts, excluded restructuring altogether, the European dealer community continued to use restructuring as it stands. In an attempt to bring the two together, the 2003 definitions include Mod Mod R. This includes an extended maximum maturity date for deliverable obligations of 60 months and the proviso that the obligation must be “conditionally transferable” to the transferee, which means that consent can’t be withheld without good reason.
Valid reasons for not consenting to the transfer might include a corporate perceiving a conflict of interest in being indebted to a particular bank or not wishing to have a hedge fund take over the loan. In this case the protection seller can nominate a third party to take delivery of the obligation instead. That third party would then make arrangements with the protection buyer.
The European norm
Mod Mod R is expected to become the norm in Europe as an alternative to full restructuring because it gives buyers protection against the “cheapest to deliver” clause that proved expensive for those who bought credit default swaps on Conseco. Practitioners say they are ready to adopt the changes. “There are still residual concerns, as with any new standard, but I think it will be used,” says Helen Oldfield, a vice-president at Merrill Lynch.
Restructuring is not the only credit event that has been changed in the 2003 definitions. Bankruptcy has also been given the once over. The 1999 document seemed to define this too loosely and allowed for bankruptcy payments to be triggered by corporations entering into discussions on bankruptcy. Now protection buyers have to wait until the corporate has admitted in writing in a judicial, regulatory or administrative context that bankruptcy has occurred.
In the case of sovereign borrowers, the repudiation or moratorium trigger has also been tweaked. “During the Argentina crisis there were frequent changes of key government officials and it was a very confusing time for the credit market,” explains Oldfield.
Many statements were made by key figures in the Argentine administration during that time that could be construed as repudiation. To prevent this happening in the future, an admission of repudiation or moratorium is only valid if made by an authorised officer. There is also a grace period of 60 days during which an admission can be withdrawn to prevent default swaps being triggered prematurely.
Besides credit events, another big topic for ISDA is the successor issue. Like restructuring, this also has a long history. It has been under discussion since UK utility National Power was split into International Power and Innogy, producing confusion about which company’s debt was covered by outstanding protection. The ISDA definition of the successor as being the one that took on “all or substantially all” of the obligations proved inadequate. This has now been replaced with detailed numerical thresholds to be used where the successor reference entity – the corporate on which default protection has been purchased – becomes unclear following a demerger, for example.
Next on ISDA’s to-do list look set to be guarantees. The 1999 definition of the obligation that triggers default being “any obligation of the reference entity” has been tightened to include direct obligations, those of a downstream affiliate guaranteed by the reference entity and those of third parties guaranteed by the reference entity.
The last category is not automatically included in default swap contracts but can be if the two parties agree. Jake Scrivens, head of legal derivatives at Barclays, says that at a recent meeting of London dealers there was “a warm fuzzy feeling” towards the idea of using all the guarantees.
That may not be the case in the US. “We expect that Europe and the US will gravitate towards different versions of the guarantee language, with Europe tending towards including all guarantees,” says ISDA CEO Bob Pickel.
So it looks as if modified modified guarantees could be on the cards too. Don’t all these modifications defeat the purpose of a core agreement, though? Pickel admits that it’s not always ideal to have different versions being used in difference geographies. “In terms of efficiency in pricing, availability and liquidity, the greater the standardization the better,” he says, stressing, however, that flexibility is essential. “While efforts are being made to standardize contracts, ultimately these are bilateral agreements and the parties involved are free to vary them.”
Now ISDA has done its work on credit derivatives for 2003, it’s down to practitioners to use the definitions. They now face the challenge of prioritizing and revising agreements drawn up using the 1999 definitions. Pickel warns that this could take years. Some people have not yet updated 1992 agreements and, amazingly, some are still using the 1987 version, he says.
