Moody's Investors Service has taken issue with recent guidelines put forth by the International Swaps and Derivatives Association, which broaden the definition of credit events. The rating agency believes these will expose investors to unintended risks.
Moody's has rated a considerable number of deals - mostly synthetic collateralized debt obligations and credit-linked notes - featuring a credit default swap. In these types of swaps, losses experienced by investors are based on credit events that happen in a reference portfolio. The risk taken by investors, therefore, largely depends on how a credit event is defined. Thus the broader the definition of a credit event, the larger the risk that investors take on.
The ISDA defines "defaults" in a broader sense, thus transferring losses to investors from events that don't fall under what is generally considered a default.
"When investors buy these transactions, they assume that the risk they are exposed to is the risk of default on a reference portfolio and they also assume that the risk of default can be measured by a Moody's rating of the reference portfolio," said Jeffrey Tolk, author of the report. "The problem is that the ISDA definitions include events that are not defaults and those are events that would not be captured by a Moody's rating, so investors are actually subject to more risk than they intend."
For the rating to reflect the risk to investors, the "credit events" should be consistent with the way Moody's defines defaults, which are based on three things: failure to pay, bankruptcy, and certain forms of restructuring.
"Those are the events that we have tracked for more than 80 years," said Tolk. "So based on that data we are able to predict the likelihood of default for any given rating category."
ISDA, however, has defined certain credit events - certain forms of restructuring, bankruptcy, obligation acceleration and obligation default - in a broader way, thus not falling under the Moody's definition of default .
And for these cases, "We can't really assign a hard probability the way we can for actual defaults," said Tolk.
The differing definitions of what a credit event has affected past and recent transactions.
Moody's mentioned the case of Conseco's restructuring of its debt in August 2000. While the maturity of the loan was extended to three months, it also carried an increased coupon, a new corporate guarantee as well as more covenants, thus compensating lenders for the extended maturity of the loan. However under ISDA's definition of restructuring, the loan extension was seen as a credit event, triggering loss payments under the credit default swaps written on Conseco.
According to an earlier story in ASR 3/19/01, the restructuring of Crown Cork & Seal company has sent ripples in the CDO market. On the swap front, it has caused confusion as to whether the restructuring could be considered a credit event.