By Nabeel Naqui, principal, Global Structured Products, Banc of America Securities

Without boring the reader with the statistics, it is sufficient to say that growth in the credit derivatives market has been dramatic, surpassing even the most optimistic assumptions. However, this growth is hardly surprising considering the overall benefits of the product, which transfers, mitigates and diversifies credit risk efficiently.

Interestingly, the CDS market emerged and evolved during a period of general creditworthiness, when defaults and tests of the market's integrity were few and far between. The global slowdown, however, has led to massive credit deterioration and a spate of corporate defaults, particularly in the investment-grade sector (the most highly traded sector in the CDS market). The next growth phase of the CDS market will involve more vigorous assessments, while the market will need to demonstrate its ability to meet the challenges of more frequent and more diverse types of credit events.

Though the tests so far have been successfully endured, they have highlighted inadequacies in the documentation and differences in interpretation among participants themselves, based largely on sporadic experiences over the last four years. The International Swaps and Derivatives Association (ISDA), along with the dealer community, has to a large extent remedied the various shortfalls in the 1999 ISDA Credit Derivative Definitions (1999 Definitions) through a number of supplements. ISDA has just recently released the 2003 ISDA Credit Derivative Definitions (2003 Definitions).

The changes to the documentation and the publication of the 2003 Definitions have come a long way in appeasing the diverse universe of participants, correcting deficiencies and providing greater clarity. They have, however, led to a trail of legacy contracts and created a divergence between the U.S. and Europe/Asia on the standard definition of "restructuring." While this presents a potential headache for risk managers, dealers and synthetic CDO originators, it can be overcome, and indicative of the challenges in the advancement of any new product or market. Credit markets represent by far the most esoteric asset class and in order for credit derivative markets to function smoothly, standard derivative documentation needs to be forward-looking to cater to the plethora of potential market scenarios, as well as the diverse universe of participants.

The most significant challenge over the last three years has revolved around agreeing to a suitable definition for a restructuring event. The original definition of restructuring introduced by ISDA required only that the terms of an obligation become materially less favorable to its holders. Naturally this was considered too subjective. Considerable refinements were made in 1999, with the definition evolving toward objectivity by listing specific occurrences that would trigger a restructuring credit event.

While the 1999 definition introduced objectivity into the text, it did not distinguish between different types of restructuring - namely distressed debt exchanges and other forms of restructuring often termed "soft credit events." The market's contemplation of restructuring when the 1999 Definitions were formulated extended only to distressed debt exchanges, although the 1999 Definitions were sufficiently broadly drafted to allow the possibility of triggering under "soft" restructurings. Soft restructurings are generally events that are not necessarily defaults or pre-emptive defaults and not necessarily pre-cursive to other more terminal credit events such as failure-to-pay or bankruptcy. That said, it is difficult to describe a distressed debt exchange, as this would involve some measure of subjective analysis. For instance, if an event that qualified as a restructuring for the purposes of the 1999 Definitions were combined with other modifications then it could amount to more than a "soft restructuring." For example, an obligation that has been restructured to defer principal payments may not represent a distressed exchange if the lender has been compensated for this deferral by revision of another term of the obligation, such as an increase in the rate of interest payable. One party may feel that the increase in the rate of interest is adequate compensation while another party may not share the same opinion and therefore the decision of whether the obligation has been diminished in such cases requires subjective assessment.

The debate over the 1999 Restructuring Definition was initiated after Conseco paid back in full its $450 million loan and extended the maturity of the remaining bank debt (approximately $900 million) by about 15 months. The interest rate on the loan was simultaneously increased from 50 basis points to 250 basis points and collateral was provided against the restructured loan facility. The restructured loan facility traded at 92% of its outstanding principal amount and protection buyers therefore chose instead to deliver long-dated senior bonds trading at 68%. Protection sellers were naturally displeased, as losses on CDSs and synthetic CDOs did not mimic the actual loss that would have been borne by holding the restructured loan. Due to the Conseco restructuring in 2000, ISDA focused on two issues:

(I) Whether a restructuring that extended the maturity of the reference obligations where the lender is compensated for this deferral should constitute a credit event; and

(II) Whether protection buyers could satisfy their delivery obligations under physical settlement provisions by delivering long-dated bonds trading at distressed levels and unrelated to the restructured asset.

This deliberation resulted in the Restructuring Supplement (also referred to as Modified Restructuring) in May 2001. The supplement did not solve the first issue, as it proved difficult to describe whether a restructuring was indeed material without introducing subjective considerations as mentioned above. The supplement did, however, address the second issue by allowing protection sellers to specify the maximum maturity of the deliverable obligations that could be delivered under physically settled contracts in the event the buyer triggered a restructuring credit event. ( )

This satisfied the majority of the sellers of protection - for the time being at least - as it meant that while the contract could be triggered for events that were arguably soft, the "cheapest to deliver" option had been tempered to prevent large losses being sustained by sellers of protection. While the "cheapest to deliver" option is a natural ingredient in CDS contracts and should be preserved, the reality is that, following a credit event other than a restructuring event, the price of obligations fitting the obligation characteristics designated in the standard contract are not too dissimilar, barring structural subordination. While the supplement solved some of the critical issues surrounding the definition of restructuring, it by no means concluded the debate and has led to a bifurcated market on the definition of restructuring. The U.S. adopted the supplement while Europe and Asia continued to transact on the old 1999 Definition, now termed Old Restructuring.

The 2003 Definitions, which were recently released, attempt to bring together a bifurcated market and provide users with four choices on restructuring. In addition to old, modified and no restructuring, they introduced Modified Modified Restructuring (or Mod Mod R). In general, Mod Mod R was a compromise and designed to be more palatable for the European and Asian market as it allowed longer dated obligations to be delivered. It also circumvented another issue, that most European loans required consent. It did not, however, deal with the issue that most of the loans in the Asian market are bilateral loans, which cannot be the cause of a restructuring credit event in Modified Restructuring or Mod Mod R. In addition, there was still a regulatory concern of many banks (protection buyers) in Europe whether a CDS without restructuring would still lead to a perfect hedge and therefore provide better risk weighting. While this has not been overcome and a standard still needs to be established, ISDA at the request of end users has undertaken to make further enhancements to the definition of restructuring so that the market can be harmonized further between buyers and sellers in different regions and jurisdictions.

The concerns over a suitable restructuring definition represents only one of the issues that has come to light from the credit events experienced by market to date. Other events, such as the de-merger of National Power in the U.K., forced the market to re-evaluate the 1999 Definition of Successor and highlighted the impracticalities of resolving disputes under Section 10.2 of the 1999 Definitions. More recently, the de-merger of Six Continents has shown the Successor Supplement (introduced after National Power) to be lacking once more, as it is not able to correctly track the correct Reference Entity.

It should, however, be realized that the majority of credit events, including some of the largest such as Enron Corp. and WorldCom, have been settled without any complications or revisions to the structure of the contracts. In addition, matters of interpretation are a feature of any maturing market and are justified considering the relative level of complexity associated with the transfer of credit risk. The more important issue is that harmonization is gradually achieved. It is important that, as the market matures, disagreements over the nature and design of the contract do not persist, which would hinder further standardization and growth. The development and growth of the market over the last five years has been dramatic, and the fact that these issues have been successfully dealt with provides a considerable improvement in the overall understanding of the market.

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