What is a credit event?
A credit event is a sudden, tangible (negative) change in a borrower’s ability to meet their payment obligations, which triggers a settlement under a credit default swap (CDS). A CDS is a credit derivative investment product with a contract between two parties. In a credit default swap, the buyer makes periodic payments to a seller to protect against credit events such as default. In this case, the default is the event that would trigger the unwinding of the CDS contract.
You can think of a CDS as insurance to protect the buyer by transferring the risk of a credit event to a third party. Credit default swaps are unregulated and are sold through brokerage arrangements.
Since the 2008 credit crisis, there has been a lot of talk about overhauling and regulating the CDS market. It could finally happen with the Changes proposed by ISDA in 2019 to its 2014 Definitions of Credit Derivatives, which address issues relating to “closely matched credit events”.
Types of credit events
The three most common credit events, as defined by the International Swaps and Derivatives Association (ISDA), are 1) bankruptcy, 2) default, and 3) debt restructuring. Less common credit events are breach of obligation, acceleration of obligation, and repudiation / moratorium.
- Bankruptcy is a legal process and refers to the inability of an individual or organization to repay its unpaid debts. Usually, the debtor (or, more rarely, the creditor) files for bankruptcy. A bankrupt business is also insolvent.
- Default is a specific event and refers to the inability of an individual or organization to pay debts on a timely basis. Continued defaults could be a precursor to bankruptcy. Default of payment and bankruptcy are often confused: bankruptcy tells your creditors that you will not be able to pay them in full; a default tells your creditors that you will not be able to pay when due.
- Debt restructuring refers to a change in the terms of the debt, which makes the debt less favorable to the debt holders. Common examples of debt restructuring include a decrease in the principal amount payable, a decrease in the coupon rate, a postponement of payment obligations, a longer maturity or a change in the priority ranking of payments.
Understanding Credit Events and Credit Default Swaps
A credit default swap is a transaction in which one party, the “protection buyer”, pays the other party, the “protection seller”, a series of payments over the term of the agreement. Essentially, the buyer takes out some form of insurance against the possibility that a debtor will experience a credit event that would jeopardize their ability to meet their payment obligations.
Although CDS looks like insurance, they are not a type of insurance. On the contrary, they are more like options because they bet on whether or not a credit event will occur. In addition, CDS do not have the underwriting and actuarial analysis of a typical insurance product; rather, they are based on the financial strength of the entity issuing the underlying asset (loan or bond).
Buying a CDS can be a hedge if the buyer is exposed to the borrower’s underlying debt; but because CDS contracts are traded, a third party could bet that
- the chances of a credit event would increase, in which case the value of the CDS would increase; or
- a credit event will indeed occur which would lead to a profitable cash settlement.
If no credit event occurs during the term of the contract, the seller who receives the buyer’s premium payments would not need to settle the contract and would instead benefit from the receipt of the premiums.
Key points to remember
- A credit event is a negative change in a borrower’s ability to meet their payments, which triggers the settlement of a credit default swap.
- The three most common credit events are 1) bankruptcy, 2) default, and 3) debt restructuring.
Credit Default Swaps: A Brief History
In the 1980s, the need for more liquid, flexible and sophisticated risk management products for creditors laid the groundwork for the eventual emergence of credit default swaps.
Mid to late 90s
In 1994, investment banking firm JPMorgan Chase (NYSE: JPM) created the credit default swap as a means of shifting credit exposure for commercial loans and freeing up regulatory capital in commercial banks. By entering into a CDS contract, a commercial bank transferred the risk of default to a third party; the risk was not taken into account in the banks’ regulatory capital requirements.
In the late 1990s, CDSs began to be sold against corporate and municipal bonds.
The early 2000s
In 2000, the CDS market was around $ 900 billion and functioning reliably, including, for example, CDS payments tied to some of the Enron and Worldcom bonds. There were a limited number of parties to early CDS transactions, so these investors knew each other well and understood the terms of the CDS product. In addition, in most cases the buyer of protection also held the underlying credit asset.
In the mid-2000s, the CDS market evolved in three significant ways:
- Many new parties have become involved in CDS trading through a secondary market for both sellers and buyers of protection. Due to the large number of players in the CDS market, it was hard enough to keep track of the actual owners of the protection, let alone those who were financially strong.
- CDSs have started to be issued for structured investment vehicles (SIVs), for example, asset-backed securities (ABS), mortgage-backed securities (MBS) and secured debt securities (CDOs) ; and those investments no longer had a known entity to track in determining the strength of a particular underlying asset.
- Speculation became widespread in the market, so that sellers and buyers of CDSs no longer owned the underlying asset, but simply wagered on the possibility of a credit event of a specific asset. .
The role of credit events during the 2007-2008 financial crisis
Arguably, between 2000 and 2007 – when the CDS market rose 10,000% – credit default swaps were the fastest adopted investment product in history.
At the end of 2007, the CDS market had a notional value of $ 45 trillion, but the corporate bond, municipal bond and SIV market totaled less than $ 25 trillion. Therefore, a minimum of $ 20 trillion was comprised of speculative bets on the possibility of a credit event occurring on a specific asset not owned by either party to the CDS contract. In fact, some CDS contracts have been made by 10 to 12 different parties.
With CDS investments, risk is not eliminated; instead, it is transferred to the CDS seller. The risk then is that the CDS seller will experience a credit default event at the same time as the CDS borrower. This was one of the main causes of the 2008 credit crunch: CDS vendors like Lehman Brothers, Bear Stearns and AIG all defaulted on their CDS bonds.
Finally, a credit event that triggers the initial CDS payment may not trigger a downstream payment. For example, professional services firm AON PLC (NYSE: AON) entered into a CDS as a seller of protection. AON sold its stake to another company. The underlying bond defaulted and AON paid the $ 10 million owed due to the default.
AON then sought to recover the $ 10 million from the downstream buyer, but was unsuccessful in the dispute. Thus, AON was stuck with the loss of $ 10 million even though he had sold the protection to another party. The legal problem was that the downstream contract to resell the protection did not exactly match the terms of the original CDS contract.