Credit Event

A Credit Event is the thing that will trigger a change in cashflows on a Credit Derivative.

There are typically 6 things that can trigger a Credit Event:

• Bankruptcy
• Obligation Acceleration
• Obligation Default
• Payment Default (Failure to Pay)
• Repudiation/Moratorium
• Restructuring

These all have very specific terminology as defined by ISDA

When someone believes that a Credit Event has occurred they will post a question to the Credit Derivatives Determinations Committee who will review the evidence and if a Credit Event has indeed occurred they will publish the results and also the exact date of this event which is called the Event Determination Date.

After a Credit Event has been confirmed this will then start in place a timeline leading to the Auction process to determine the final Recovery price(s).

Originally most contracts were drafted including all Credit Events, with Sovereigns trading with "5CE" - all of the above except Bankruptcy, slowly though the market realised that Repudiation was fairly specific to Sovereigns and Obligation Acceleration would be usually covered by Restructuring and Obligation Default would be covered by Failure to Pay, so only "3CE" were used for Corporates and Financials - Bankruptcy, Failure to Pay and Restructuring. See below for more information about Restructuring amendments.

Bankruptcy

This is the catastrophic failure of a corporate (or financial) firm, this sort of Credit Event doesn't apply to Sovereigns/Countries since there's no concept of a Country going Bankrupt.

This is also one quite a rare Credit Event, usually seen in Asia and Europe because in the US companies will more likely file for Bankruptcy Protection, also known as Chapter 11 and go through a restructuring, but it's not unheard of for a Bankruptcy event to happen.

Obligation Acceleration

This is where a bond, for example, becomes due before it's normal maturity, for example your 30 year bond suddenly becomes a 2 year bond. There's a specific threshold amount that is required to be exceeded before this triggers and obviously any call or put provisions that are already in the bond's structure don't count.

In a lot of cases, shortening a bond will result in a worse position for the investor - think of negative convexity in the mortgage bond market, but if a company has money to pay the amount outstanding it's unlikely to be a low Recovery event. This is one of the less common Credit Events.

Obligation Default

Much like Obligation Acceleration there is a minimum threshold that must be exceeded but for this Credit Event to trigger a bond which is due to be paid is not paid and therefore is in Default.

It is unlikely that an Obligation Default will not be accompanied by a Failure to Pay or in fact preceded by a Failure to Pay.

Failure to Pay

The Failure to Pay Credit Event, also known as Payment Default, does pretty much what it says on the tin. It's where a payment is due under a contract and has not been paid. This contract could be the payment of coupons or principal on a bond, it could be on a bank loan or just any financial contract where payments are due. There are a couple of requirements, firstly there is a threshold amount, you couldn't trigger a Credit Event off the back of a $10 lunch reimbursement for example, and also there is a grace period whereby the company is given an amount of time to remedy the situation, to make sure that a Credit Event can't be triggered just because of a clerical error, or a Bank Holiday preventing settlement.

Repudiation Moratorium

Repudiation and Moratorium are usually lumped together and are generally most applicable to Sovereign credits, this is a situation whereby the Government will just Repudiate the debt ("Nah that doesn't belong to me, never seen it before, could be someone else's but it's definitely not mine... Have you tried lost and found?") or they declare a Debt Moratorium. ("Yeah it's definitely mine but the cupboards are bare, you ain't getting anything, sorry")

Along with Restructuring these are the most common Sovereign Credit Events.

Restructuring

When companies start struggling but it's an orderly event (read: NOT LEHMAN) then there is usually time for either a Chapter 11 Bankruptcy protection or something similar in Europe and Asia, the end result is that the Debt gets restructured, maybe your 5 year bond becomes a 25 year bond. Maybe your claim for 100 USD becomes a claim for 20 USD or maybe someone jumps ahead of you in the seniority capital structure.

The bottom line is that the bond you had is different to the one you used to have.

Credit Derivatives have a number of different Restructuring clauses which can be used in different scenarios - initially we started with "Full Restructuring" (FR) which was hoped to be all that the market needed.

Unfortunately this didn't really capture some of the nuances of the US Investment Grade market and a modification was introduced back around 2001 and you had US names trading with "Modified Restructuring" (Mod-R or MR)

It was then noted that European and UK legislation didn't fit into the Mod-R landscape but also FR wasn't doing the job so "Modified Modified Restructuring" (Mod-Mod-R, MMR or MM) was introduced in 2003 and then implemented very broadly via the Small Bang Protocol in 2009.

Finally the market worked out that even Mod-R didn't really work for the US High Yield market so most US High Yield names trade with "No Restructuring" (NR) - this seemed to work best for these companies as they were less likely to be restructured anyway.

The BIS has a paper in their Quarterly review of 2005 by Frank Packer and Haibin Zhu on this.