Friday, June 17, 2011

Restructuring Credit Event and Repudiation

Restructuring Credit Event and Repudiation
There has been so much market chatter about what would constitute a Credit Event for a Greek restructuring, but so few details.  Here is our attempt to shed some light on the issue and hopefully get some feedback.  I’m not a lawyer, but for better or worse have been involved in many of the documentation issues over time.  Vitaly at least has the decency to have a Yale Law degree though he is not a practicing lawyer.  As further disclosure I did not pay the $350 to ISDA to get the 2003 definitions.  Partly because I’m too cheap, and partly because I’m sure Dodd/Frank meant to ensure that something that is such a crucial part of the world’s financial markets should be open domain.  I feel almost as bad as I do when I DVR a football game without the express written consent of the NFL.  As far as I know, these are the current definitions and would be applicable to Hellenic Republic CDS.
Our interpretation is that any voluntary restructuring would NOT constitute a Credit Event.  We will walk you through how we get there.
Section 4.7. Restructuring.
(a) "Restructuring" means that, with respect to one or more Obligations and in relation to an aggregate amount of not less than the Default Requirement, any one or more of the following events occurs in a form that binds all holders of such Obligation, is agreed between the Reference Entity or a Governmental Authority and a sufficient number of holders of such Obligation to bind all holders of the Obligation or is announced (or otherwise decreed) by a Reference Entity or a Governmental Authority in a form that binds all holders of such Obligation, and such event is not expressly provided for under the terms of such Obligation in effect as of the later of (i) the Credit Event Backstop Date and (ii) the date as of which such Obligation is issued or incurred:
(i) a reduction in the rate or amount of interest payable or the amount of scheduled interest accruals;
(ii) a reduction in the amount of principal or premium payable at maturity or at scheduled redemption dates;
(iii) a postponement or other deferral of a date or dates for either (A) the payment or accrual of interest or (B) the payment of principal or premium;
(iv) a change in the ranking in priority of payment of any Obligation, causing the Subordination of such Obligation to any other Obligation; or
(v) any change in the currency or composition of any payment of interest or principal to any currency which is not a Permitted Currency.
The Restructuring Credit Event requires two conditions to be met.
Any restructuring would trigger one of the 5 clauses, so would satisfy that condition
One of i, ii, iii, iv, or v, must be agreed to by bondholders. 
Since all the talk is about maturity extension it seems pretty easy to see condition iii being met.  Condition i may also be met as there is pressure to reduce the current debt burden.  Neither of these conditions seem particularly controversial as even banks who hold existing debt in non mark to market accounts would likely be able to keep the restructured bonds at par since the hold to maturity accounting doesn’t focus on maturity or interest rate. 
Since the bulk of the bonds are unsecured, condition iv is unlikely to trigger, as even if Greece issued senior secured debt, it would not trigger iv as bonds were not secured and technically were not subordinated by the definitions of CDS.
Clause v would occur if Greece tried to change the denomination of the existing bonds.  If they tried to change them to new Drachma’s or something, this would be triggered, but it seems pretty far fetched at this stage as nothing I read indicates Greece is anywhere close to being prepared to launch a new currency. 
Clause ii would be the most problematic for lenders regardless of its impact on CDS.  Reducing the notional that is due would not only satisfy the first condition to being a Restructuring Credit Event, but banks would have to realize the loss on the principal written down.  Even if the second condition to trigger a Restructuring Credit Event wasn’t met, banks would have to take a write down as this would be a permanent reduction in the amount they expect to receive.  I highly doubt this clause will be triggered because it would force the writedowns that the banks (or their regulators, or their governments) are desperately trying to avoid.
Voluntary Restructuring would NOT satisfy the first condition
This is the confusing part of the definition and at least in my opinion, could have been drafted much better.
A lot of ISDA members place weight on what the ‘intention’ of the language was.  Many people who participated in the development of the documentation over time, myself included, believed that a basis package should be protected.  You should be able to hold a bond and buy CDS to the bond maturity and over the life of the trade, either the bond will mature and the CDS will expire, or that the bond will experience a default and the CDS would trigger.  These documents were often drafted with corporate credit in mind.  Many corporate bonds have ‘clean-up’ provisions, where if the amount outstanding is reduced to a certain point, the bond would go away.  Some corporate bonds have voting provisions that state if X% of bondholders agree to something, all bondholders would be subject to that agreement.  That is what the language here is trying to pick up.  Say there was a provision that said if 90% of holders agreed to a maturity extension the bond would have its maturity extended.  If 95% voted in agreement, then 100% of the bondholders would have to accept the new terms.  This condition of the Restructuring Credit Event was meant to pick this up and protect investors from having bond terms changed against their will without being able to trigger CDS.
With that as the intention, you can make more sense of the terms used.
 occurs in a form that binds all holders of such Obligation, is agreed between the Reference Entity or a Governmental Authority and a sufficient number of holders of such Obligation to bind all holders of the Obligation or …”
The language talks about binding all holders and that a sufficient number agrees such that all holders (even those that didn’t agree) would be bound by the agreement.  That is consistent with what I believe the intention was, but it is a bit sloppy to the extent that 100% of bondholders agree.
I have only reviewed a couple of the Hellenic Republic Bond offering circulars.  I did not see any evidence of a cramdown provision, so basically any debt that doesn’t agree to a restructuring should remain outstanding with its original terms.
For example, if there was a bond and 90% of the holders agreed to amend the maturity by extending it for 5 years, you would meet condition iii, but would not have a Credit Event as not all holders were forced into the amended terms.  Those who agreed to the change would, exchange their existing bonds for the new bonds.  The amount outstanding of the original bonds would be reduced by 90%, but the 10% who didn’t agree to the changes, would keep their existing bonds.  Greece would still owe them principal and interest on the original terms.  Since not all bondholders were bound by the actions of those who agreed, there would NOT be a Restructuring Credit Event.
Where I get confused, is what happens if 100% of the bondholders agree to extend the maturity?  I believe the intention of the document was for that NOT to be a Credit Event, but it might be in someone’s interest to challenge that interpretation.  If every holder voted to make a change, would that then bind all holders to the change? If you agreed to something, you are bound to it, so someone might argue that 100% of people agreeing to something meets the requirement that (after the agreement) sufficient number agreed such that all bondholders are subject to the terms.  It seems like it is a little bit of a stretch, and is against the intention of the document, and creates a strange scenario where 99.9% of the bondholders could accept amended terms without causing a Credit Event, but 100% would cause trigger a Credit Event.  Those arguing against it being a Credit Event when 100% of people vote, would fight about what ‘bind’ means and what ‘sufficient bind’ means.  They would argue that it was meant to pick up only cases where some bondholders did not agree to a change but are subject to it. 
Maybe they should have specifically stated that a 100% vote was explicitly not a enough to trigger a Credit Event.  You might wonder why this language is as confusing as it is.  Part of the reason is that a restructuring is a bit like pornography, it is hard to define but you know it when you see it.  That might be good enough for government work, but for a financial contract with an explicit maturity we really should have defined it better.  The other reason is that the U.S. in particular was already moving to a modified restructuring world (where the consequences of a Restructuring Credit Event were muted by maturity limitations placed on Deliverable Obligations) and has ultimately moved to a No Restructuring world with the implementation of the SNAC protocol.  Full Restructuring actually applies to a very limited universe of outstanding CDS trades, but sovereign debt, and Greece in particular, is one area where it still applies.  With so few people having a vested interest in Restructuring, it is easy to see how it has evolved less over time than other areas of credit derivative trading.
In no way is this meant to be legal advice, it is merely our interpretation of the rule, but we remain of the opinion that voluntary amendments to original bond terms would not trigger a Restructuring Credit Event for CDS, although if any bond does get 100% participation, I would expect some owners of CDS to push hard to trigger and they have a more legitimate case, than if 95% of some issue agrees, but the other 5% remains outstanding.
Repudiation/Moratorium Event
Well, if you have made it this far without shaking your head and mumbling something about what a ‘bizarre’ product CDS is, this should put you over the top.
Section 4.6. Repudiation/Moratorium.

(a) "Repudiation/Moratorium" means the occurrence of both of the following events: (i) an authorized officer of a Reference Entity or a Governmental Authority (x) disaffirms, disclaims, repudiates or rejects, in whole or in part, or challenges the validity of, one or more Obligations in an aggregate amount of not less than the Default Requirement or (y) declares or imposes a moratorium, standstill, rollover or deferral, whether de facto or de jure, with respect to one or more Obligations in an aggregate amount of not less than the Default Requirement and (ii) a Failure to Pay, determined without regard to the Payment Requirement, or a Restructuring, determined without regard to the Default Requirement, with respect to any such Obligation occurs on or prior to the
Repudiation/Moratorium Evaluation Date.

(c)Potential Repudiation/Moratorium. "Potential Repudiation/Moratorium" means the occurrence of an event described in clause (i) of the definition of Repudiation/Moratorium.

(d) Repudiation/Moratorium Extension Condition. The "Repudiation/Moratorium Extension
Condition" is satisfied (i) if ISDA publicly …

So Greece needs to be very careful about saying anything about not being willing to pay all of their debt.  Saying they won’t pay their debt is not enough to trigger an actual Credit Event, because it has to be followed up by a Failure to Pay or Restructuring, or some other Credit Event, though the conditions are slightly easier to satisfy if the Potential Repudiation/Moratorium has occurred, but that is not the messy part here.  The messy part is that the Potential Repudiation/Moratorium event affects the scheduled Termination Date of the CDS contracts.  The details are quite complicated, and for some reason Japan and Japanese corporates have their own specific supplement, but the main impact, as far as we can tell, is that the CDS contracts are extended for at least 60 days.  I doubt Greece does or says anything that would trigger this extension, but it is another wild card.  CDS ending maturing June 20th seems safe from this, given how aggressively Greece has been saying it wants to pay, but if I had sold short dated protection for later this year, or early next year, I would examine this seldom/rarely used provision in the CDS contract and figure out whether the potential impact fits my strategy.
Repudiation/Moratorium is archaic, even by credit derivative standards, but could affect the maturities of CDS contracts in the unlikely event a Potential Repudiation/Moratorium event is triggered.