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The purpose of credit derivatives is to make sure that the interests of the buyers of protection are secured if any adverse credit event takes place. Now, since contracts worth billions of dollars are dependent upon adverse credit events, it is essential to clearly define what a credit event is. In general, a credit event is any event wherein the ability of the borrower to pay back the loan that they have taken comes into question. However, there are more than one causes that can lead to this negative situation. These are known as the different types of credit events.
There are many organizations that have defined what a credit event is and what types of credit events there are. The International Swaps and Derivatives Association definition is used widely in different parts of the world. In this article, we will explain the different types of credit events as well as how they impact the discipline of credit risk management.
The most commonly known and understood credit event is bankruptcy. Bankruptcy is a legal procedure that is filed by the creditors when the borrower is not able to pay back the loans.
It is important to note that bankruptcy is a declaration that the firm has gone under and therefore would not be able to pay the creditors in full. Any bankruptcy announcement creates a lot of buzz in the media. This is the reason that this is the most well-known credit event as far as the layperson is concerned. However, this is not the only credit event that can take place.
Debt contracts often have covenants that allow the creditor to demand their outstanding loans immediately. This is defined in some of the covenants. For instance, if the firm misses a monthly payment, then a certain part of its loan may become due immediately.
Instead of paying the loan over several years, the company may have to pay on their obligation in an accelerated manner. Now, if a company has missed on their monthly payment, it generally means that they are facing cash flow problems. On top of that, if they are asked to pay their full debt immediately, this could exacerbate their problems. This is the reason why it is listed as a credit event and can possibly trigger the conditions which ultimately lead to credit derivatives coming into play.
The concept of obligation default is very similar to obligation acceleration. This is also based on the situation wherein a debt that should have ideally been paid at a later date becomes payable immediately because of a different default. The difference between obligation default and obligation acceleration is related to the amount.
There is generally an amount specified in the contract. If the obligation which becomes due is bigger than that amount, it is called an obligation acceleration. On the other hand, if the default is smaller, then it is called an obligation default. Obligation acceleration is actually a subset of obligation default.
A payment default is one of the most common credit events. A payment default simply means that a borrower has not been able to pay one of their installments on time. This does not lead to bankruptcy immediately. Usually, borrowers do pay the missed installment along with fees and penalties for not paying on time. However, a payment default is considered to be a symptom of mismanagement as well as a precursor for default. This is the reason that many derivative contracts get triggered by a payment default.
Companies may often decide not to file bankruptcy against delinquent borrowers. This may be based on the fact that they may get very little of the proceeds. In such cases, they may be willing to work with the borrowers by offering them a moratorium.
A moratorium is a temporary waiver given by either the lenders or by a legal authority. The end result is that the borrower does not have to make payments for some time. They will not be considered to be in default even in the absence of these payments. Once again, this impacts the ability of the borrower to repay and ends up triggering derivative contracts.
A payment default may not necessarily lead to bankruptcy. Many times, the lenders may realize that it is not financially prudent to take the company to bankruptcy courts. Instead, they would be better off compromising with the borrower.
In such cases, debt restructuring is performed. The end result of debt restructuring is that the debt becomes less valuable to the lenders. Sometimes, the coupon rate is reduced. At other times, the principal to be repaid is reduced and the lender is asked to take a haircut. It is also possible for the tenure of the loan to be increased. All of the events mentioned above call the credibility of the borrower into question. Hence, they are often considered to be trigger points for credit derivative contracts.
The bottom line is that there are various types of credit events. Some of them are as simple as a missed payment whereas others are as complex as a bankruptcy. There are different types of derivatives triggered by some or all of these events.
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