Isda’s CDS fix draws murmurs of dissent

Proposed changes don’t go far enough for some; others say it will block legitimate activity

An industry-led effort to clamp down on manufactured credit defaults is running into criticism.

Some credit default swap (CDS) users say the changes proposed by the International Swaps and Derivatives Association don’t go far enough to fix the problem; others want more clarity on how the new creditworthiness test will work in practice. And there are growing calls for the comment period – which expires on April 10 – to be extended until the end of the month.

“This proposal goes a long way to solving the egregious cases like Hovnanian where you see manufactured triggers,” says a credit analyst at a US bank. “But there’s a little more work to do.”   

An Isda spokesperson tells Risk.net there are no plans to extend the comment period, which has already been pushed back from an earlier deadline of March 27. However, other changes have not been ruled out. “The working group may come out with further proposals, but we’re not able to say what they might be at this stage,” the spokesperson says.

Under Isda’s proposals, released on March 6, a missed coupon payment would no longer be enough to trigger CDS payouts. Instead, a failure to pay would need to be accompanied by an observable deterioration in creditworthiness.

The test is designed to ward off manufactured defaults – or narrowly tailored credit events, to use Isda’s preferred terminology – which have threatened to undermine the credibility of CDSs. 

In 2013, Blackstone’s GSO unit agreed to fund Codere if the Spanish gaming company delayed a coupon payment on certain debts by two days, engineering a default. In December 2017, it did something similar with US builder Hovnanian. GSO revisited the deal four months later, convincing the builder to enter into a debt exchange that would have shifted the settlement value of CDSs in GSO’s favour. Hovnanian’s creditors ultimately rejected the debt swap. 

Critics of Isda’s proposal argue that while it may deter manufactured defaults, it doesn’t prevent companies and their lenders from inflating CDS payouts by issuing deeply discounted debt.

If you have a legitimate trigger there’s nothing to stop the creation of some sort of inflated notional

Credit analyst at a US bank

CDS payouts are determined by an auction of the defaulting company’s debt, with holders paid an amount equal to par less the auction value of the cheapest-to-deliver securities. GSO sought to exploit this by convincing Hovnanian to issue long-dated bonds that were expected to trade at no more than 30 cents on the dollar, ensuring that GSO would collect 70 cents on its CDS contracts.

Isda had been working on a dual fix for both the default and deliverables issues – a belt-and-braces approach intended to prevent a repeat of the Hovnanian case. But in early 2019, the decision was made to propose the causation test as a standalone, with the aim of rallying the industry around a one-step change.

“The proposal aims to prevent manufactured defaults, but if you have a legitimate trigger there’s nothing to stop the creation of some sort of inflated notional, which all of a sudden means recoveries are much lower than you would expect,” says the credit analyst at the US bank. “You need to deal with both the trigger and the amount of deliverable that goes in.”

He expects to see a separate proposal on the securities that can be delivered into auction in the coming weeks, which could then be combined with the creditworthiness test in a single protocol.

Call for clarity

Others are calling for the guidance on the creditworthiness test to be tweaked.

Isda’s proposed fix is subjective by design. The working group that suggested the changes advised against adopting prescriptive rules, which could be easily gamed.

“The proposal is a balance between discretion and definitional precision,” says John Williams, a partner at law firm Milbank, who represents a group of nine fund managers that helped Isda develop the proposal. “It explicitly leans into the sort of DC discretion that the market has traditionally been uncomfortable with, but it does so with pretty detailed guidance about how this is going to be handled. It’s a good balance.”

Isda hopes the inherent subjectivity of the causation test will serve as a catch-all deterrent, but the drift away from certainty of outcomes is a big change for traders and the determinations committee (DC) – the panel of 15 sell-side and buy-side firms who currently rely on strict legal “bright-line” tests to decide whether CDSs will pay out.

Some have raised concerns about what they consider to be ambiguous wording in the four-page guidance note accompanying the proposal. For example, section 2.7 of the guidance states that the DC “may presume that the credit deterioration requirement is satisfied in the absence of any eligible information to suggest the contrary.”

This suggests the committee could rule either way if the information necessary to gauge whether a deterioration in creditworthiness has occurred is not available. To provide more certainty, some firms are requesting that the word “may” be changed to “will”. Such a shift would create a presumption of credit deterioration in the event of a missed payment, absent any evidence to the contrary.

Another group wants the guidance note to address the practice of missing payments to deal with basis traders, who hold both the bonds and CDSs and may be standing in the way of a restructuring. According to lawyers, this is a legitimate activity that should not be blocked.  

Distinguishing between breaking a basis trade versus enabling certain market participants to inappropriately profit from artificial defaults may prove difficult

Fabien Carruzzo, Kramer Levin

“Distinguishing between breaking a basis trade versus enabling certain market participants to inappropriately profit from artificial defaults may prove difficult,” says Fabien Carruzzo, a partner at law firm Kramer Levin. 

Questions are also being raised about whether causation tests would have prevented all past cases of manufactured defaults. Analysis by Kramer Levin, which applied Isda’s guidance to historical scenarios, shows that the credit event determination for Codere’s intentional default in 2013 could have gone either way. 

The Spanish gaming firm was two days late on a $10 million coupon payment, which triggered CDSs under a failure-to-pay credit event. The delay, which was agreed with bondholders in advance, was tied to a clause in a €60 million ($68 million) rescue credit facility. The lenders, led by GSO, ruled that the loan must be repaid in full if the bond payment was made within the grace period.

“Codere is one of those where there’s some uncertainty as to what the outcome would be. I think the working group intended for the new rules to exclude Codere resulting in a failure-to-pay credit event determination, but if you look at the indicators used in the guidance and the facts as I understand them in Codere, you can very well see it landing exactly on the line,” says Carruzzo.

Others believe Codere’s “technical default” would have been nullified by the proposed changes. The credit analyst at the US bank points to section 2.10(e) of the rules, which states that the credit deterioration requirement is not satisfied if the non-payment “was promptly cured following the expiry of the relevant grace period”.

Milbank’s Williams believes the proposed changes would have prevented a credit event on Codere. But perhaps more importantly, the lack of certainty may have prevented the situation from arising in the first place. “[Under the proposed rules] the Codere event that actually occurred probably would not be a credit event, though of course its lenders may have behaved differently had this rule been in place. In all likelihood there would eventually have been some form of CDS payout because the company was in bad shape; it just wouldn’t have been triggered by lenders telling the company to pay immediately after the grace period,” he says.

Some say the new rules would not have prevented Spanish gaming company Codere’s intentional default

The Spanish gaming company eventually filed for bankruptcy protection the following year – an event that would ultimately have triggered a credit event.

Still, Isda’s proposal has plenty of backing. Williams says the nine buy-side firms he represents expect to adopt the changes in new and legacy contracts. “To the extent that anyone has comments, those should be assessed and dealt with, but I would expect those won’t lead to any major revisions,” he says.

A survey conducted by JP Morgan also found widespread support for Isda’s proposal, with 57% of the bank’s CDS clients saying it would have a positive impact on their trading activity. An additional 37% said the issue has no material impact on the way they trade, while 6% said the proposals would have a negative impact.

Whatever the final fix, market participants believe that CDS definitions will continue to evolve to match rapid developments in the notoriously litigious credit markets.

“The history of credit derivatives has been plagued by good faith rules being put in place and an unforeseen eventuality, whether a certain style of default, a change of reference obligations or a change of subsidiaries, unearthing possible flaws. I think it makes a lot of sense that there would be more discretion in determining credit events, as there are no hard-and-fast rules to avoid this,” says a former credit derivatives trading head based in New York.