Credit Events: When the Effects of Weak Markets Leak into Operations

While credit derivatives provide a valued hedge during downturns, the heavy lifting involved with defaults and bankruptcies requires an automated solution.

Jawann Swislow, Instrument Engineering Analyst

During economic downturns, there are a number of consequences felt by various market participants. Individual investors may see a dip in the value of their retirement funds, while investment managers or asset owners will likely have to rebalance portfolios or consider more sweeping reallocations into vehicles or asset classes that carry less downside risk. Although derivatives investors may appear more protected through certain hedged positions, they aren’t immune either as many are affected by a lesser-known phenomenon, known as credit events.

For the uninitiated, a credit event occurs when an organization is unable to meet its financing obligations. This is most often due to a bankruptcy filing, payment default, or debt restructuring, which can trigger payments on credit derivatives linked to that organization. To fully understand credit events and their potentially sweeping implications, it’s helpful to consider the economic climate roughly a decade before the financial crisis of 2008.

The first credit default swap (CDS) was created in 1994 by Blythe Masters of JP Morgan. The instrument provided a means for investors to take a position on the credit worthiness of almost any organization in the market that carried debt. The CDS is based on a specially designated debt obligation, or a reference obligation, provided by the issuer of the financing arrangement.

In a CDS there is a protection buyer, who takes a negative (or short) view on the reference obligation’s credit worthiness, and a protection seller, who takes a positive (or long) view. The buyer pays a quarterly coupon to the seller in exchange for protection against any credit events. In the event of a default, bankruptcy, or other kind of credit event, the deal is terminated and the protection seller must pay the buyer a fee based on the size of the trade’s notional value and the amount of capital that can be recovered through a restructuring. A similar and newer derivative, the credit default index swap (CDX), tracks a basket of 100 reference obligations and trades on a factor after a credit event instead of being terminated.

Credit events are rare during strong economic times. Corporate performance is generally robust, liquidity is more available to even distressed borrowers, and the popularity of covenant-lite loans lowers the likelihood of defaults. In economic downturns, however, the options are much more limited, particularly as liquidity in the capital markets dries up.

But even amid an upcycle, credit events can occur. Sears Holdings, for example, filed for Chapter 11 bankruptcy protection last October. Despite multiple attempts, the company was unable to secure funding from outside investors and was ultimately sold back to its previous investor, the Eddie Lampert-run hedge fund ESL Investments. This bankruptcy triggered credit events in all CDS and CDX linked to Sears Holdings’ reference obligations. Each credit event triggers an auction in which the price, or recovery rate, is set based on the perceived value of the reference obligation’s debt. In this case, the price was set at a bullish 79.875, which means that for every dollar of notional value in each credit event, the protection seller paid $0.20125 to the protection buyer. Though it may seem insignificant, this represents a huge amount of money across all the CDS and CDX linked to Sears Holdings.

Beyond the rise of cleared credit derivatives, which have changed the mechanics of credit event settlements, the fundamentals of CDS and CDX instruments remain unchanged. They still result in payments based on the same formula, and accrued interest is still rebated back to the event determination date. Instead of a direct cash payment from the protection seller to the buyer, that amount is now factored into the security’s valuation for the day, and thus included in the daily variation margin (VM) process. Credit event cash is settled in the same transaction as the typical VM movement that accounts for change in price and daily accrued interest.

While the details of credit event processing are not overly complex, their cyclical nature creates distinct challenges for operations teams. Many accounting systems, for instance, do not support credit events for either CDS and CDX instruments, whether they be bilateral or cleared. Meanwhile, the workarounds to accommodate these scenarios can be very time consuming to execute depending on an organization’s trading volume. Like any manual “fix,” they’re also wrought with opportunities for mistakes, particularly for CDX securities in which the contracts trade on a factor after a credit event. In addition to executing the payment and adjusting the position, organizations also need to maintain a record of original versus current notional values for trading purposes. CDX are traded based on original notional in the market. Moreover, it can be months or years between occurrences, in which case the institutional knowledge to execute the workaround effectively may be lost.

Eagle Investment Systems’ Accounting solution has functionality to support automated credit event handling for CDS and CDX, both bilateral and cleared. They are processed as corporate actions, much like a traditional cash dividend or stock split, to allow one-time execution for all affected positions. A single credit-event corporate-action record is set up at the security level using the dates, factor, and price from the auction. When triggered, all eligible positions against that security are adjusted proportionately to the factor, accrued interest rebates are calculated back to the event-determination date, and payments are calculated based on the auction price. All of this processing takes place at the lot level to maintain maximum granularity for full multi-lot reporting and lot-relief methods.

These capabilities were created to meet the needs of our clients who are significantly invested in CDS/CDX and did not have an automated process in place to handle credit events. The impact, beyond more rigor and accuracy in accounting for credit events, is found in the efficiency afforded to operations. And while institutional memory around how much work goes into credit events ten years into an upcycle may be fading, as the default rate ticks up, so too do the headaches of manual workarounds.

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