CVA's cousin: Dealers try to value early termination clauses

Much of the talk about counterparty risk has concentrated on tweaks due to default expectations – credit and debit value adjustments – but there are other legal loopholes that allow counterparties to terminate trades. One in particular – using credit downgrades as a trigger – is now animating modellers, and is potentially the most complex adjustment yet. By Laurie Carver

Since the collapse of Lehman Brothers three years ago this month, banks, regulators and accountants have been struggling to ensure default risk is priced, reported and capitalised accurately through the use of credit value adjustment (CVA) and its more controversial twin, debit value adjustment (DVA).

Now, the implications of another type of counterparty risk are beginning to occupy quants and dealers. It’s a new creature that doesn’t even have a proper name yet. All anyone knows is that it belongs to the value adjustment family and could be incredibly difficult to capture. “It’s one of the most complicated things around,” says a quant who has been working on the problem at one large bank. “Basically, you make some assumptions and hope not to be too wrong.”

The risk arises from a clause in derivatives contracts that allows one party to terminate if the other is downgraded below an agreed threshold, prompting close-out of the trade at its current market value and typically also requiring the downgraded firm to pay for the cost of a replacement for its erstwhile counterparty. Working out that replacement cost is the challenge – in part because dealers don’t know whether they need to take into account credit and funding costs associated with putting on the new trade. Clearing that up requires industry consensus, dealers say, and the International Swaps and Derivatives Association says it is reviewing the issue, following requests from some members.

The clause is part of a general category of alternative termination events (ATEs) – including, for example, options to settle at fixed dates in a contract’s life – which has existed for some time, but the downgrade-triggered ATE has rarely been considered important. Prior to the crisis, banks had been dismissive about the possibility of their own downgrade and were loath to risk damaging client relationships by turning away their business. So, clauses were signed – and are being signed today at the request of increasingly wary clients – without any thought being given to the value of the option being granted. The clauses vary in detail, often depending on the relative strengths of the counterparties, but have some common themes.

“Typically it says that if the long-term unsecured credit rating of your counterparty is downgraded below a certain level, then it constitutes an ATE and allows you to terminate all contracts with the downgraded counterparty, and settle the costs involved in replacing them,” says Andrew Cross, a partner at law firm Reed Smith in Pittsburgh. “The trigger level can be as shallow as one notch, but often it’s set at the unsecured junk rating. The mechanics of it are quite similar to what people did when Lehman filed for bankruptcy.”

After Lehmans, people realised the terms in the documents all matter. We wouldn't be talking about this five years ago. The difference is significant

Downgrade-triggered termination clauses are becoming more common, says David Kelly, New Jersey-based head of credit products at risk management software provider Quantifi and a seasoned CVA trader who has worked at various banks: “People used to be reluctant to bring downgrade clauses up, for fear of hurting the client relationship. Now we’re seeing much freer discussion – it’s no longer taboo.”

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CVA's cousin: Dealers try to value early termination clauses