How to settle a credit event
By Euan Hagger: Creditflux Newsletter, September 2008
With defaults set to rise in the near future, credit event settlement is about to be tested as never before. So first the good news. Huge expenditure has gone into the development of cash settlement auctions: a major weapon for ensuring that credit event management runs smoothly. Isda chief executive, Robert Pickel made the point earlier this year, when he said that operationally the mechanisms are in place to run “serial auctions” in the immediate future, if needs be.
Credit event auctions have indeed passed muster, albeit with the occasional hitch. Most notably, the auction to settle merchant power company Calpine’s default was accompanied by a dispute over deliverability. However, there is no doubt that auctions have provided a workable solution to the problem of price squeezes under physical settlement of credit derivative trades.
Now for the bad news. The credit derivatives market has had it easy so far. One has to go a long way back to find anything other than a US corporate making a clear-cut filing for bankruptcy. Although, as Calpine shows, such credit events are not entirely free from legal wrangling, they are the most straightforward. Notes a credit derivatives lawyer at a US bank: “In the US market every trigger has been bankruptcy. Triggers have been very uncontentious.”
The next round of defaults will be a lot more varied and complicated.
For example, market participants say that a monoline parent company credit event would be very likely to result in contested deliverability. Meanwhile, defaults in Europe will bring a largely forgotten dimension of credit event settlement back into focus. The last significant credit event in that market was way back in 2003, with the default of Italian milk company Parmalat.
Restructurings raise particular problems for credit event settlement in a European context. In the US, the chapter 11 bankruptcy code makes restructuring very unlikely as a credit event. However, there has been a relatively messy history of credit events triggered by restructurings in Europe. On the plus side, restructuring events have historically accounted for only a small proportion of overall credit events.
However, credit derivative lawyers concede that ambiguity over how restructuring events are defined increases the chances of disputes. Notes a lawyer at a London-based credit derivatives dealer: “On the one hand you have particular facts: a change in interest rate or an extension of maturity. Those are easy. But there is also an extra element, which is a decline in creditworthiness or in financial condition. In the past it has been questioned whether that has been satisfied. My personal view is that it should be obvious.”
Another issue for restructuring events is that their incorporation into cash settlement auctions looks unlikely.
Restructuring is a specific thorny issue in Europe and Asia. But a more general worry is the extent to which the European market is prepared for the coming spike in defaults. Physical settlement of a restructuring event might possibly serve to highlight the issue. Understanding of physical settlement mechanics is described as being pretty patchy among European market participants.
However, Anna McAndrew at derivatives advisory firm DCG Consultants says that familiarity with physical settlement workout procedures and timelines is likely to be particularly important in Europe, given the difficulties of bringing restructuring events into auctions.
She adds that lack of experience in settling European credit events is leading to plenty of demand for legal and operational guidance. “Europe hasn’t seen a significant market wide credit event since Parmalat in 2003, so many people haven’t been through the process,” she says. “There is a lot of interest in gaining legal and operational know how.”
DCG provides training in credit event settlement as well as other operational support services around credit events. The training covers anything from basic physical settlement mechanics or cash-settlement market standards to the potential problems and pitfalls that credit events might create. McAndrew, who runs the training programmes, says that around half-a-dozen large investment banking institutions have participated. The training is primarily aimed at middle offices but also extends to traders.
On the operational side, identification of non-standard trades is one of the main areas that could complicate credit event management. “That is the key,” says McAndrew. “People might struggle with identifying the entire population of affected trades. For example, there might be problems identifying affected structured trades. Trades might have been booked off-system or they might have been done out of a different legal entity. There could also be problems identifying trades if they have been booked using spreadsheets. Another issue could be simply coping with the volume of affected trades.”
Cutbacks that are leaving operational staff stretched are hardly helping. “A large credit event or series of credit events will place an additional operational strain in times of tightened head count,” she says.
As an indication of how desperate things can get, there is the comment from an operations veteran who was in charge of a bank’s management of auto maker Delphi’s credit event: the largest default of recent years. It was, he says, “the 30 most stressful days of my life”.
From another perspective, Delphi was a model credit event: it did not involve legal disputes. However, together with restructuring events, monoline credit events could provide another area where the going is less straightforward. It seems probable that the deliverability of financial insurance policies and the bonds that they wrap will be contested if there is a monoline bankruptcy or failure to pay.
The important document is Isda’s 2005 monoline supplement. “There may be certain technical issues that arise in respect of the 2005 monoline supplement which have to be tested against each specific bond,” says John Williams, partner, Allen & Overy in New York. “There is a wide range of qualifying policies and some may give rise to interpretation issues in certain cases, which can be a bit tricky given the relatively new vintage of the monoline supplement and the lack of interpretative guidance.”
Another lawyer points out that interest shortfalls on wrapped RMBS bonds could provide a particular context for differing interpretations. The 2005 monoline supplement excludes insurance policies from being deliverable if carve-outs exist that could reduce payments to the insurance holder. Reductions in interest payments due to prepayments are not intended to fall into this bracket. However, this distinction could be challenged, depending on the specifics of the underlying bond documentation.
One market participant says that CDO obligations could also be challenged based on the fact that deliverables under credit event definitions exclude “contingent” bonds.
Some would argue that an equity tranche of a CDO should be considered contingent - since its payment in full is contingent on their being no defaults in the CDO portfolio. But this question remains unchartered territory.
The fact that the wrapped RMBS bonds and ABS CDOs may have little or no value attached to them makes disputes over deliverability seem even more probable. In addition, monolines throw up plenty of other complications. For example, the sheer number of obligations guaranteed by a monoline that could be deliverable (running into the thousands) has already prompted Isda to change its auction methodology for monoline parent company credit events. Bidding will occur on a credit derivative transaction instead of in relation to specified reference obligations. Auctions to settle monoline holding company credit events (involving bonds or loans issued by the reference entity) would be conducted as normal.
Besides restructuring events and monoline credit events, market participants say there is continuing scope for “oddities” leading to legal disputes, along the lines of Calpine’s credit event. In that instance, deliverability of two convertible bonds was disputed. The argument came down to whether the bonds fulfilled the requirement of being ‘not subordinated’ under credit derivative definitions.
The European market might provide the conditions for similar situations to Calpine. “In an LBO context there are more changes to issue structure in Europe,” says one market participant. “There are more bonds layered into issue structures, so potentially we could see this sort of thing happen.” He adds that it is equally possible that subordination issues could crop up again in the US.
One thing is clear. With forecasts suggesting that the number of meaningfully sized corporate defaults could hit triple figures in 2009, credit event settlement is about to get a lot more arduous. Acrimonious and challenging times are ahead for hard pressed operations staff.
