Revisiting the restructuring issue

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Robert Pickel
The rapidly evolving credit default swap market advanced a few steps this month when the International Swaps&Derivatives Association (Isda) reached a breakthrough agreement on restructuring. Its amendment states that when a default swap is triggered by a restructuring event the maximum maturity of the obligations the buyer of protection can deliver to the seller is 30 months.

Since the end of last year the credit default swap market has been plagued by uncertainties over restructuring, so Isda's conclusion has been eagerly awaited. Restructuring has easily proved to be the most troublesome of the events identified by Isda in 1999 as being individually sufficient to trigger a default swap. The remaining conditions are bankruptcy, failure to pay, repudiation or moratorium, obligation default and obligation acceleration.

Though there has been a general mood of discontent over the issue among market participants for some time, the catalyst for Isda's move was the Conseco incident.

In December, Conseco, a financial services company, restructured its debt following a year of catastrophic results. With the agreement of the banks to which it was indebted, Conseco extended the maturity of its loans - a total of over $3 billion. This triggered a default swap on the grounds that the credit quality of the company had deteriorated. So default swap counterparties that had written protection for Conseco found themselves having to pay out and received in return long-dated bonds at a deep discount.

In the months following this, regulators and rating agencies expressed concern over the opacity of credit default swap contracts and warned that investors were entering these agreements without understanding the risks they were taking on. The key issue as far as they and the sellers of protection were concerned was what was deliverable in the event of a credit event. Because the language of the standard credit default swap contract - as worded by Isda in 1999 - is relatively vague, the concept of cheapest to deliver has been allowed to creep in. This meant that the buyers of protection could agree to restructure a company's debt, trigger the swap and deliver new bonds - of any maturity they chose - to the protection seller.

If restructuring is such a contentious issue then why not strike it out altogether? Some market participants have elected to do just that. Following the Conseco fiasco a bunch of New York-based traders decided not to include restructuring in any future credit default swap agreements. These derivatives are currently trading at a discount to those that do feature the restructuring clause. The dealers responsible for this development say that by removing restructuring they are giving protection sellers what they want - a less risky deal. However the primary buyers of protection - the banks - argue that without it, credit default swaps lose much of their appeal. It is essential that banks are able to buy protection from losses that may result from restructuring in order to offset their credit risk properly and keep the regulators happy.

Given the contradictory aims of participants in the market - some want to use credit default swaps to hedge receivables, others as a synthetic asset class or to hedge loans - Isda was the natural mediator. As predicted, its focus has been deliverables. "If you've bought five-year protection on a five-year loan, the issue of restructuring is more likely to come up as you get near the maturity date of that loan and so inevitably, you're going to be pushing out that maturity. The question is, how far are you allowed to push it out?" says Robert Pickel, chief executive officer of Isda.

Reaching that compromise was a lengthy process entailing discussions within and between six industry groups representing buyers of protection, investors and dealers in the US and Europe. The consultation process began in early March and, says one of the dealers involved, meant "conference calls lasting several hours on every other day for a total of three weeks." That market participants were happy to devote so much time is an indicator both of how contentious the issue is and how keenly they felt the need to resolve it.

The outcome of Isda's extensive consultation efforts was a decision to limit the obligations that could be delivered in the event of a restructuring to 30 months from the date that restructuring occurs or the maximum maturity of the existing loan if sooner.

There's nothing magic about this number - according to Dennis Oakley, an Isda board member, it was the product of extensive negotiations. No doubt a major sticking point was the banks' feeling that the time limit should be less restrictive and the sellers' desire for a shorter time scale. "By and large though," says Oakley, "the vast majority of corporate restructurings have resulted in maturities that lie inside two and a half years."

Blythe Masters, a managing director at JP Morgan who coordinated the group of US dealers, stresses that though Isda is pleased to have reached agreement the new definition is at best a consensus. "You can't impose standards on a marketplace, the market finds its own equilibrium," she says. She is also realistic about the limits to what this agreement can achieve. "There will always be credit derivatives that trade without restructuring and those that require further tailoring to meet special regulatory, agency or accounting needs. As with any OTC derivatives, one of the inherent benefits of credit default swaps is that they are essentially flexible."

In the minds of the regulators, however, flexible has become synonymous with dangerous in the realm of credit derivatives. That's a view Isda is keen to dispel. Masters says that there has been a lot of unhelpful publicity on this issue that has led to the perception - in her view erroneous - of credit default swaps as being somehow more risky than other types of derivatives. In fact, in the few cases where default swaps have been triggered, she says, including the Conseco credit event, the issue has never been whether or not the contract was legally binding. "What we're not doing is addressing a fundamental lack of enforceability," she stresses. "What we are addressing is a need on the part of the market to ensure that the documentation reflects the economic intent of the participants."

Isda is confident that the increased clarity surrounding the issue of restructuring will contribute to the continued expansion of the credit default swap market. "We believe that new entrants will be attracted by this consensus and that's been our motivation in putting this together," says Pickel.

But the reaction from market participants has so far been unenthusiastic. "Frankly this represents a very large compromise," says one. "There are the same basic issues and conflicts underlying this decision." And though Oakley predicts that contracts featuring the new definition will trade at a discount of around 8 basis points to those with the old definition, this could be some time in coming. "We're sort of in the waiting room at the moment," says Gordon Black, a managing director in credit derivatives at Bear Stearns. "The new definition doesn't really exist at the moment. People are happy to talk about it, but until it's all printed and finalized I don't think anyone will do anything."