What Is a Credit Event?
A credit event is a rapid and tangible (negative) change in a borrower’s ability to satisfy its payment commitments that triggers a credit default swap (CDS) contract settlement. A CDS is a credit derivative investment instrument with a two-party contract. In a credit default swap, the buyer pays regular payments to the seller in exchange for protection against credit events such as default. In this scenario, the default is the event that would cause the CDS contract to settle.
Consider a CDS to be insurance that protects the buyer by shifting the risk of a credit event to a third party. Credit default swaps are unregulated and are marketed via intermediaries.
There has been substantial discussion about restructuring and regulating the CDS market since the 2008 financial crisis. The ISDA’s 2019 proposed revisions to its 2014 Credit Derivatives Definitions, which address difficulties pertaining to “narrowly tailored credit events,” may finally bring this to fruition.
Types of Credit Events
According to the International Swaps and Derivatives Association (ISDA), the three most prevalent credit events are 1) bankruptcy, 2) payment default, and 3) debt restructuring. Obligation default, obligation acceleration, and repudiation/ moratorium are less frequent credit occurrences.
- Bankruptcy is a legal procedure that refers to an individual’s or organization’s inability to fulfill their existing obligations. In most cases, the debtor (or, less often, the creditor) files for bankruptcy. A bankrupt corporation is also insolvent.
- Payment default is a particular occurrence that refers to an individual’s or organization’s failure to pay their obligations on time. Payment failures on a regular basis may be a forerunner to bankruptcy. Payment default and bankruptcy are sometimes confused: A bankruptcy informs your creditors that you will be unable to pay them in full; a payment default informs them that you will be unable to pay when it is due.
- Debt restructuring is a modification in the terms of the debt that makes it less beneficial to debtholders. A reduction in the principal amount to be paid, a fall in the coupon rate, a deferral of payment responsibilities, a longer maturity period, or a change in the priority ordering of payments are common instances of debt restructuring.
Understanding Credit Events and Credit Default Swaps
A credit default swap is a transaction in which one party, the “protection buyer,” makes a series of payments to the other party, the “protection seller,” throughout the period of the arrangement. In effect, the buyer is purchasing insurance against the potential that a debtor could suffer a credit event that jeopardizes its ability to satisfy its payment commitments.
Although CDSs have the appearance of insurance, they are not. They are more like options since they wager on whether or not a credit event will occur. Furthermore, unlike traditional insurance products, CDSs are not subject to underwriting and actuarial research; rather, they are reliant on the financial soundness of the organization providing the underlying asset (loan or bond).
Buying a CDS may be a hedge if the buyer is exposed to the borrower’s underlying debt; but, since CDS contracts are traded, a third party might be wagering on the outcome.
- the likelihood of a credit event would grow, increasing the value of the CDS; or
- A credit event will occur, resulting in a lucrative monetary settlement.
If no credit event occurs throughout the length of the contract, the seller who gets the premium payments from the buyer does not need to settle the contract and instead benefits from collecting the premiums.
- A credit event is a negative change in a borrower’s ability to make payments that causes a credit default swap to settle.
- The three most prevalent credit occurrences are 1) bankruptcy, 2) payment default, and 3) debt restructuring.
Credit Default Swaps: Brief Background
The desire for more liquid, flexible, and sophisticated risk-management instruments for creditors paved the way for the eventual birth of credit default swaps in the 1980s.
The Mid-to-Late 1990s
JPMorgan Chase (NYSE: JPM) invented the credit default swap in 1994 as a mechanism to shift credit risk for commercial loans and free up regulatory capital in commercial banks. A commercial bank moved the risk of default to a third party by engaging into a CDS contract; the risk did not count against the banks’ regulatory capital requirements.
CDSs began to be marketed for corporate and municipal bonds in the late 1990s.
The Early 2000s
By 2000, the CDS market had grown to almost $900 billion and was functioning reliably, including CDS payments connected to certain Enron and Worldcom bonds. Because the early CDS transactions included a small number of participants, these investors were well acquainted with one another and knew the CDS product’s rules. Furthermore, in the vast majority of situations, the buyer of the protection also owned the underlying credit asset.
In the Mid-2000s, the CDS Market Changed in Three Significant Ways:
- Many new players entered the CDS market through a secondary market for both sellers and purchasers of protection. It was difficult to keep track of the real owners of protection, much alone which of them was financially strong, due to the vast number of participants in the CDS market.
- CDSs were first issued for structured investment vehicles (SIVs), such as asset-backed securities (ABSs), mortgage-backed securities (MBSs), and collateralized debt obligations (CDOs), and these investments no longer had a known entity to follow to determine the strength of a specific underlying asset.
- Speculation grew so prevalent in the market that sellers and buyers of CDSs were no longer owners of the underlying asset, but were simply wagering on the chance of a credit event involving a particular asset.
The Role of Credit Events During the 2007–2008 Financial Crisis
Credit default swaps were perhaps the most quickly accepted financial instrument in history between 2000 and 2007, when the CDS market surged 10,000%.
The CDS market had a notional value of $45 trillion at the end of 2007, while the corporate bond, municipal bond, and SIV markets totalled less than $25 trillion. As a result, at least $20 trillion was made up of speculative wagers on the chance of a credit event occurring on a particular asset not held by either party to the CDS contract. In reality, some CDS contracts were routed via 10 to 12 companies.
The risk is not avoided with CDS investments; rather, it is transferred to the CDS seller. The risk is that the CDS seller will suffer a default credit event concurrently with the CDS borrower. One of the key causes of the 2008 credit crisis was the default of CDS sellers such as Lehman Brothers, Bear Stearns, and AIG on their CDS commitments.
Finally, a credit event that causes the first CDS payment may not cause a subsequent payment. Professional services business AON PLC (NYSE: AON), for example, engaged into a CDS as the supplier of protection. AON resold its stake to a different entity. The underlying bond defaulted, and AON paid the $10 million owed as a consequence.
AON then attempted to recoup the $10 million from the downstream buyer but was unsuccessful in court. As a result, despite selling the protection to another party, AON was left with the $10 million loss. The legal issue was that the downstream contract to resell the protection did not meet the conditions of the initial CDS contract precisely.
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