The credit derivatives market and Shakespeare's Juliet have something in common this week: splitting hairs over what's in a name. In this most recent case, dealers, and synthetic CDO originators are contending with "restructuring," a credit event apparently falling under many names.
The new 2003 "Credit Derivative Definitions" from the International Swaps and Derivatives Association (ISDA) took effect June 20. As the industry association for the credit derivatives market, ISDA, since first publishing Definitions in 1999, has been contending with redefining items that relate to certain credit events.
Largely due to the Conseco Inc. bankruptcy filing in September 2000, the attention of the credit default swaps (CDS) market has been directed at restructuring; i.e. what constitutes a credit event and gets delivered after a restructuring event? And as all too many CDO investors know, Conseco was a reference entity in several synthetic portfolios.
The Conseco story brought to light the gray areas of restructuring as defined by the 1999 version of the ISDA definitions - today called "Old R."
After Conseco's loan repayments, and a restructured loan facility, protection sellers received unsecured Conseco bonds instead of the restructured bonds, which became known as the "cheapest-to-deliver" option because it allowed protection buyers to deliver lesser valued securities to sellers of protection. In short, the economic value of the unsecured bonds was much lower than that of the restructured bonds.
"Old R" did not contemplate the economic outcome that Conseco triggered. Investors, in this case, were essentially compensated for a restructuring event that wound up extending maturity of reference obligations. Market participants then asked how to prevent such an outcome from happening again.
Whereas the U.S. market is largely bond-driven, Europe remains very focused on loans, and holding or selling loans varies widely country to country. So when ISDA debuted "Modified Restructuring" or "Mod R" in 2001, Europe did not embrace it.
"Restructuring is one of the credit events that can trigger or cause a credit default swap to go into settlement," said Louise Marshall, policy director and head of communications for ISDA. "(Conseco) raised problems that no one had anticipated at that point."
Last week, the entire international market began working with the new "Mod Mod R" option, or "modified modified restructuring." The only exception, sources say, is Tokyo, which has embraced
"Mod Mod R," but will need few more days to get up to speed, one source said.
"Mod Mod R" is now one of four options available under the ISDA definitions of restructuring. According to ISDA, under "Mod Mod R,"the maturity of the restructured bond or loan may be up to 60 months after the restructuring date. For all other deliverable obligations, the maturity may also be only up to 30 months. Additionally, the deliverable obligation must be conditionally transferable, a big nod to the European market. Consent can't be unreasonably withheld.
"European loans require consent in order to be transferable," explained Kimberly Summe, ISDA's general counsel. "The loan markets work differently in various European locations." For example, France and Germany have greater restrictions on who can hold types of loans. "Mod Mod R" is the newest option to addresses the consent issue.
During this timeframe, rating agencies differed in some instances as to what was considered to be a default compared to what was considered a default in the marketplace. As a result, there was some divergence in the data involving credit events. And historical default data is crucial in determining underlying ratings for CDO vehicles.
"There was a potential mismatch between what we had historically captured in our default database and what the credit event definitions defined as default," said Deepali Advani, an associate vice president and analyst for Moody's Investors Service.
During the years of "Old R" and "Mod R," Advani explained, Moody's artificially increased its default rate, adding stress, in order to compensate for the events its database and the CDS market weren't exactly agreeing on. Currently that stress is still being applied, but by a much smaller amount than what was applied under "Old R," Advani said.
In the end, sources state that deal documents will shed light on which restructuring option a synthetic CDO is structurally designed under, Old R, Mod R or Mod Mod R.
However, investors are reminded there is a fourth: the option to trade without restructuring. According to sources, JPMorgan Securities has ceased to trade with restructuring on its own portfolio.