Credit default products have a payout that is contingent upon a credit event occurring. The ISDA provides definitions of what credit events are. The 1999 ISDA Credit Derivatives Definitions (referred to as the “1999 Definitions“) provides a list of eight credit events: (1) bankruptcy, (2) credit event upon merger, (3) cross acceleration, (4) cross default, (5) downgrade, (6) failure to pay, (7) repudiation/moratorium, and (8) restructuring. These eight events attempt to capture every type of situation that could cause the credit quality of the reference entity to deteriorate, or cause the value of the reference obligation to decline.

Bankruptcy is defined as a variety of acts that are associated with bankruptcy or insolvency laws. Failure to pay results when a reference entity fails to make one or more required payments when due. When a reference entity breaches a covenant, it has defaulted on its obligation.

When a default occurs, the obligation becomes due and payable prior to the scheduled due date had the reference entity not defaulted. This is referred to as an obligation acceleration. A reference entity may disaffirm or challenge the validity of its obligation. This is a credit event that is covered by repudiation/moratorium.

FundsThe most controversial credit event that may be included in a credit default product is restructuring of an obligation. A restructuring occurs when the terms of the obligation are altered so as to make the new terms less attractive to the debt holder than the original terms. The terms that can be changed would typically include, but are not limited to, one or more of the following: (1) a reduction in the interest rate, (2) a reduction in the principal, (3) a rescheduling of the principal repayment schedule (e.g., lengthening the maturity of the obligation) or postponement of an interest payment, or (4) a change in the level of seniority of the obligation in the reference entity’s debt structure.

The reason why restructuring is so controversial is a protection buyer benefits from the inclusion of restructuring as a credit event and feels that eliminating restructuring as a credit event will erode its credit protection. The protection seller, in contrast, would prefer not to include restructuring since even routine modifications of obligations that occur in lending arrangements would trigger a payout to the protection buyer. Moreover, if the reference obligation is a loan and the protection buyer is the lender, there is a dual benefit for the protection buyer to restructure a loan. The first benefit is that the protection buyer receives a payment from the protection seller. Second, the accommodating restructuring fosters a relationship between the lender (who is the protection buyer) and its customer (the corporate entity that is the obligor of the reference obligation).

Because of this problem, the Restructuring Supplement to the 1999 ISDA Credit Derivatives Definitions (the “Supplement Definition”) issued in April 2001 provided a modified definition for restructuring. There is a provision for the limitation on reference obligations in connection with restructuring of loans made by the protection buyer to the borrower that is the obligor of the reference obligation. This provision requires the following in order to qualify for a restructuring: (1) there must be four or more holders of the reference obligation and (2) there must be a consent to the restructuring of the reference obligation by a supermajority (66 2/3%). In addition, the supplement limits the maturity of reference obligations that are physically deliverable when restructuring results in a payout triggered by the protection buyer.

As the credit derivatives market developed, market participants learned a great deal about how to better define credit events, particularly with the record level of high- yield corporate bond default rates in 2002, and the sovereign defaults, particularly the experience with the 2001-2002 Argentina debt crisis. In January 2003, the ISDA published its revised credit events definitions in the 2003 ISDA Credit Derivative Definitions (referred to as the “2003 Definitions“).The revised definitions reflected amendments to several of the definitions for credit events set forth in the 1999 Definitions. Specifically, there were amendments for bankruptcy, repudiation, and restructuring.

The major change was to restructuring, whereby the ISDA allows parties to a given trade to select from among the following four definitions: (1) no restructuring; (2) “full” or *old” restructuring, which is based on the 1998 Definitions; (3) “modified restructuring,” which is based on the Supplement Definition; and (4) “modified modified restructuring.” The last choice is new and was included to address issues that arose in the European market.

The ISDA’s confirmation form for credit derivative transactions, “Exhibit A to 2003 ISDA Credit Derivatives Definitions,” sets forth the terms and conditions for the transaction. The definitions for a credit event are in check box format.

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