What Is a Credit Event?
A credit event is a sudden and tangible (negative) change in a borrower's capacity to meet its payment obligations, which triggers a settlement under a credit default swap (CDS) contract. 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 for protection against credit events like default. In this case, the default is the event that would trigger settlement of the CDS contract.
You may think of a CDS as insurance aimed at protecting the buyer by transferring the risk of a credit event to a third party. Credit default swaps are not regulated and are sold through brokered arrangements.
Since the 2008 credit crisis, there has been much talk of revamping and regulating the CDS market. This may finally come to pass with the ISDA's 2019 proposed amendments to its 2014 Credit Derivatives Definitions, which address issues relating to "narrowly tailored credit events."
Types of Credit Events
The three most common credit events, as defined by the International Swaps and Derivatives Association (ISDA), are 1) filing for bankruptcy, 2) defaulting on payment, and 3) restructuring debt. Less common credit events are obligation default, obligation acceleration, and repudiation/ moratorium.
- Bankruptcy is a legal process and refers to the inability of an individual or organization to repay their outstanding debts. Generally, the debtor (or, less commonly, the creditor) files for bankruptcy. A company that is bankrupt is also insolvent.
- Payment default is a specific event and refers to the inability of an individual or organization to pay their debts in a timely manner. Continual payment defaults could be a precursor to bankruptcy. Payment default and bankruptcy are often confused with one another: A bankruptcy tells your creditors that you will not be able to pay them in full; a payment default tells your creditors that you will not be able to pay when it is due.
- Debt restructuring refers to a change in the terms of the debt, which causes the debt to be less favorable to debtholders. Common examples of debt restructuring include a decrease in the principal amount to be paid, a decline in the coupon rate, a postponement of payment obligations, a longer maturity time, or a change in the priority ranking of payment.
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. In essence, the buyer is taking out a form of insurance on the possibility that a debtor will experience a credit event that would jeopardize its ability to meet its payment obligations.
Although CDSs appear similar to insurance, they are not a type of insurance. Rather, they are more like options because they bet on whether a credit event will or will not occur. Moreover, CDSs 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).
Purchasing a CDS can be a hedge if the buyer is exposed to the underlying debt of the borrower; but because CDS contracts are traded, a third party could be betting that
- the chances of a credit event would increase, in which case the value of the CDS would rise; or
- a credit event will actually occur, which would lead to a profitable cash settlement.
If no credit event arises during the contract's term, the seller who receives the premium payments from the buyer would not need to settle the contract, and instead would benefit from receiving the premiums.
- A credit event is a negative change in a borrower's capacity to meet its payments, which triggers settlement of a credit default swap.
- The three most common credit events are 1) filing for bankruptcy, 2) defaulting on payment, and 3) restructuring debt.
Credit Default Swaps: Brief Background
In the 1980s, the need for more liquid, flexible, and sophisticated risk-management products for creditors laid the foundation for the eventual emergence of credit default swaps.
The Mid-to-Late 1990s
In 1994, investment banking company JPMorgan Chase (NYSE: JPM) created the credit default swap as a way to transfer credit exposure for commercial loans and to free up regulatory capital in commercial banks. By entering into a CDS contract, a commercial bank shifted the risk of default to a third-party; the risk did not count against the banks' regulatory capital requirements.
The Early 2000s
By 2000, the CDS market was approximately $900 billion and was working in a reliable manner—including, for example, CDS payments related to some of the Enron and Worldcom bonds. There were a limited number of parties in the early CDS transactions, so these investors were well-acquainted with each other and understood the terms of the CDS product. Further, in most cases, the buyer of the protection also held the underlying credit asset.
In the Mid-2000s, the CDS Market Changed in Three Significant Ways:
- Many new parties became involved in trading CDSs via a secondary market for both the sellers and buyers of protection. Because of the sheer number of players in the CDS market, it was hard enough to keep track of the actual owners of protection, let alone which of them was financially strong.
- CDS began to be issued for structured investment vehicles (SIVs), for example, asset-backed securities (ABSs), mortgage-backed securities (MBSs), and collateralized debt obligations (CDOs); and these investments no longer had a known entity to follow to determine the strength of a particular underlying asset.
- Speculation became rampant in the market such that sellers and buyer of CDSs were no longer owners of the underlying asset, but were just betting 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 grew 10,000%—credit default swaps were the most rapidly adopted investment product in history.
By 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 that a credit event would occur on a specific asset not owned by either party to the CDS contract. In fact, some CDS contracts were passed through 10-to-12 different parties.
With CDS investments, the risk is not eliminated; rather it is shifted to the CDS seller. The risk, then, is that the CDS seller would experience a default credit event at the same time as the CDS borrower. This was one of the primary causes of the 2008 credit crisis: CDS sellers like Lehman Brothers, Bear Stearns, and AIG all defaulted on their CDS obligations.
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 the seller of protection. AON resold its interest to another company. The underlying bond defaulted and AON paid the $10 million due as a result of the default.
AON then sought to recover the $10 million from the downstream buyer but was not successful in litigation. So, AON was stuck with the $10 million loss even though they 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.