Damned if it is an event and damned if it isn’t


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Will the Argentine debt restructuring lead to changes being made to the documentation of credit derivative contracts relating to the emerging markets - and, in particular, emerging-market sovereign debt?

The possibility, which is being reviewed by a specially formed emerging-markets subcommittee of the International Swaps&Derivatives Association (ISDA), has been thrust into the spotlight by three lawsuits involving JPMorgan.

The investment bank - the largest user of the credit derivatives market, as a major buyer and seller of protection and also the leading intermediary - is involved in three legal disputes relating to Argentina's $50 billion debt exchange last November.

On the surface, the bank appears to be adopting a simultaneously opposing stance as to whether the debt restructuring - which constituted a voluntary exchange - did or did not represent a credit event triggering the delivery of protection on credit default swaps.

On the one hand JPMorgan says the restructuring was not a credit event. As a result, the bank is being sued by two hedge funds - HBK Master Fund and Eternity Global Master Fund - which had bought protection that they claim should have been paid.

On the other hand the bank says it was a credit event and is being sued as a result by Korea's Daehan Investment Trust Management, which has had to pay protection to JPMorgan relating to the debt exchange.

The Daehan dispute has already figured in earlier litigation in New York and Korea that found in favour of JPMorgan. The bank has been paid in full by Daehan already but a new suit has been launched.

JPMorgan's conflicting views might appear to be a strange position for the market's main mover to be adopting. But it all boils down to the documentation of contracts - and, in particular, the adoption of the 1999 ISDA credit derivative definitions as the standard for the marketplace.

These attempted to replace a degree of legal ambiguity over what constituted credit events with certainty. A template was introduced specifying six credit events: failure to pay, bankruptcy, obligation acceleration, obligation default, repudiation/moratorium, and restructuring.

Although it is still possible for credit derivative users to tailor specific contracts catering for events not covered by these conventions, the vast majority of contracts use the standardized ISDA documentation.

Indeed, in the eyes of many market participants, it is precisely the adoption of the standard contract that has propelled the vast growth of credit derivatives in the last three years.

But already these conventions have been tested in the corporate arena and changes have been made as a result. In October 2000 Conseco and its bankers agreed to a restructuring of its loans, which included an extension of maturity, to head off a liquidity crisis.

Some banks that had bought protection gave notice of restructuring and then delivered long-dated bonds that were trading significantly lower than the restructured bank loans.

To resolve the controversy a restructuring supplement to the 1999 definitions - known as modified restructuring - was adopted in May 2001. Inter alia it requires that the restructuring event occurs to an obligation that has at least three holders - thereby excluding bilateral agreements where there is the potential for moral hazard on the part of the bank lender cum protection buyer - and that at least two-thirds of the holders agree to the restructuring.

It now looks as if the Argentine situation will require similar modifications to be made for emerging-market debt conventions.

It is not the debt moratorium announced by Argentina on December 23 that is the problem. That fell squarely within the repudiation/moratorium definition and has been accepted as a credit event by all and sundry.

The problem is what happened in the run-up to the moratorium, when the Argentine government asked investors to swap $50 billion of 11% and 12% bonds for new bonds yielding 7%.

Since the exchange was not mandatory, most market players did not believe it constituted a credit event. But some protection buyers took a different interpretation and have sued their counterparties.

As far as JPMorgan is concerned, the bank argues that its differing stances stem from the fact that the contract with Daehan was struck before the 1999 definitions came into effect, whereas its contracts with the two hedge funds used post-1999 documentation.

Voluntary exchanges are excluded from the 1999 definitions, it says - although others say it is far from clear that this is the case, or that the Argentine exchange was voluntary. By contrast, says Morgan, in the pre-1999 contract any restructuring that is materially adverse to the creditor in question constitutes a triggering credit event.

In recent months some commentators have suggested that the credit derivatives business is vulnerable to a flood of lawsuits by parties on the basis of ambiguity as to when protection should or should not be paid.

In addition, questions have been raised over the willingness of some insurance companies - which are major sellers of protection - to pay and the worry that counterparties could find themselves being bamboozled by the small print of derivatives documentation.

JPMorgan is taking a strong line, arguing that it is essential for the credit derivatives business that the letter of contracts be upheld. "This is not about whether one feels this is fair or not, or whether the contract completely reflects the actual losses incurred by the buyer," says Blythe Masters, managing director at JPMorgan who is also the New York chair of the ISDA credit derivatives market practices committee.

"The point is whether we can rely on the contractual wording of the contracts being upheld, in the courts if necessary. Prior experience is that the courts have consistently upheld the letter of the contract. And we believe that if any other outcome were upheld, it would be a disaster for the credit derivatives business."

Masters believes that the Argentine situation has highlighted the need for market practitioners to review whether the 1999 definitions and subsequent amendments are as appropriate for emerging-market sovereigns as they are for companies.

"The intention of the 1999 definitions was to reduce the degree of subjectivity required in determining whether a credit event had occured in the context of corporate restructuring," she says. "We all knew that that might lead to some situations that would previously have been regarded as credit events being excluded, and vice versa.

"Buyers, sellers and dealers collectively took the view that certainty was better than ambiguity. However, sovereign credit events present unique circumstances and the industry is working through ISDA to explore whether there are types of losses and situations for creditors that also might need to be covered, and others which might not."

It is likely that some modifications will be made by the ISDA subcommittee to cover mandatory and voluntary exchanges.

The committee was set up in the wake of the Argentine problem to clarify definitions and interpretations as well as to standardize the emerging-market default swap language. But progress has been slow and it is not clear when any new recommendations will be made.

In any event, credit derivatives market practitioners are unlikely to lose sleep over a potential wave of lawsuits swamping their business. They can certainly take heart from the Enron situation. Some $8 billion to $10 billion of credit derivatives contracts were triggered by Enron's collapse. All have been settled, without a hiccup.