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ISDA Issues Q&A On What Happens To US CDS In Case Of A Default

Tyler Durden's picture




 

ISDA is getting nervous, or rather the same contingent of clueless "asset managers" who listen to ISDA as religiously as they listen to the rating agencies, is getting nervous. The boilerplate: "The following are responses to the most frequently-asked questions that ISDA has received in connection with a potential CDS Credit Event on US sovereign debt. The following does not constitute legal advice, and is subject in all respects to any determination that the ISDA Americas Credit Derivatives Determinations Committee may make in relation to CDS referencing the United States.  ISDA makes no comment on the likelihood of the events described in this Q&A." True - for the likelihood of any event happening, your best bet is to ask Turbo Tax Tim, and then multiply the answer by -1.

How are Credit Default Swaps documented?

The vast majority of Credit Default Swaps (CDS) are documented using the 2003 ISDA Credit Derivatives Definitions, as supplemented by the July 2009 Supplement. The Definitions can be obtained from ISDA’s Bookstore.

What triggers CDS?

The CDS contract contains a number of elections that parties can make (for example, which events from a menu of potential Credit Events will apply, what obligations are relevant for triggering a Credit Event, what kind of obligation will be deliverable if a Credit Event occurs).

Of course, parties are free to agree to make whichever elections they wish, but standard elections are generally used for particular transaction types (so, for example, some of the elections for North American corporates, will be different from those for, say, Western European Sovereigns).

A CDS is triggered when a Credit Event occurs. There are three Credit Events that are typically used for Sovereigns such as the United States. They are: Failure to Pay; Repudiation/Moratorium and Restructuring. We will focus on Failure to Pay for these purposes.

The Failure to Pay credit event is defined as follows: “Failure to Pay means, after the expiration of any applicable Grace Period (after the satisfaction of any conditions precedent to the commencement of such Grace Period), the failure by a Reference Entity to make, when and where due, any payments in an aggregate amount of not less that the Payment requirement under one or more Obligations, in accordance with the terms of such Obligation at the time of such failure.”

What is the Grace Period for CDS on US Sovereign Debt?

There is a three business day grace period for Failure to Pay specified in the Definitions. This grace period would apply if there is no grace period or if the grace period is less than 3 business days under the terms of the reference entity’s debt obligations. What this means is that if the debt specifies payment on a certain day, the reference entity has 3 business days to make the payment before a credit event could be triggered.

Are CDS triggered by a declaration by a rating agency that the Reference Entity has been downgraded or is in “default”?

No. There is no link between a rating agency declaration and a CDS Credit Event. It is possible that the same set of facts might give rise to both, but it is also possible that one might occur but not the other.

What is the process for determining a Credit Event?

All firms entering into CDS transactions using the standard ISDA documentation (described above) have agreed to be bound by the decisions reached through the process for determining a Credit Event set out in the CDS Definitions. This process is fair, transparent and well tested, and was developed working closely with global regulators.

Credit Events are determined by one of five regional ISDA Credit Derivatives Determinations Committees (DCs). An event with respect to the US would be dealt with by the Americas DC. The composition of the DCs is explained below.

The process begins when a market participant puts a question to the DC for the relevant region. Any market participant (who need not be an ISDA member) with one or more CDS transactions can raise a question. A question is raised by submitting it, along with publicly-available information evidencing the event, using an online form on the ISDA website. 

After a question is submitted, it must be accepted by one of the members of the appropriate DC. This step is included in order to filter out frivolous questions. Once a question is accepted, the DC will meet within a defined timeframe to consider it. The DC will weigh the publicly-available evidence and vote on whether a Credit Event has occurred within the terms of the CDS Definitions. It should be noted that the DC simply applies the Definitions to the public facts; it is not empowered to decide whether, as a matter of policy, a Credit Event should or should not occur in particular circumstances.

As soon as a vote has occurred, the determination is posted on the ISDA website. Each DC member’s vote is made public.

Requests to the DCs and updates following meetings of the DCs are posted immediately on the ISDA website on the Credit Derivatives page at http://www.isda.org/credit. In order to stay up to date on requests to any of the 5 DCs and the status of the requests the DCs are considering, you can subscribe to our RSS feed, which allows you to receive updates by e-mail or through a news aggregator. To subscribe to our RSS feed click here: http://www.isda.org/dc/rssform.asp. Details on how RSS feeds work are available here: http://www.isda.org/dc/aboutrss.html. 

Further details of the operation of the DCs are available at www.isda.org/dc/dc_info.asp.

Who are the members of the DCs?

Each DC consists of ten voting dealers and five voting non-dealers, plus two consultative (non-voting) dealers and one consultative non-dealer. The dealers are selected annually according to (and only to) their CDS trading volume over the past year and their compliance with certain requirements, notably to participate in CDS auctions, whilst the non-dealers are selected annually at random from a pool of buyside market participants meeting certain specified size criteria. Non-dealer members’ one-year terms are staggered so that they do not all finish their terms at once. A list of the firms that are members of the DCs is available at: http://www.isda.org/dc/committees.html.

Would a Credit Event on the US lead to massive payments by protection sellers?

No. According to the Depository Trust & Clearing Corporation’s CDS data warehouse, the total net exposure of market participants who have sold CDS credit protection on US sovereign debt is approximately $4.8bn as of July 15, 2011. This figure is calculated by summing the net exposures of the protection sellers, and so it is impossible for any one firm selling protection to have more than $4.8bn in exposure and, of course, given that there are many net sellers, any one seller’s exposure is likely to be far less.

Also, firms’ net exposures are partially offset by the recovery value of underlying obligations. For example, if the CDS auction showed the recovery value of debt to be (hypothetically) 90%, the maximum aggregate amount payable would, in the US's case, be 10% of $4.8bn: $.48bn.

Furthermore, statistics indicate that, on average, 70% of derivatives exposure is collateralized and the level of CDS collateralization is likely to be even higher as over 90% of CDS transactions (by numbers of trades) are collateralized. Thus, in this example, of the $2.4bn payable, at least $2bn has effectively already been paid.

Where can I get data on CDS exposures?

The data regarding CDS exposures on US sovereign debt, and for the top 1,000 reference entities, is publicly available here: www.dtcc.com/products/derivserv/data_table_i.php?tbid=5.  Regulators have access to additional data, including individual firm CDS exposures.

 

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Thu, 07/28/2011 - 09:49 | 1500846 buzzsaw99
buzzsaw99's picture

no way in ufck they are going to trigger an event.

Thu, 07/28/2011 - 09:53 | 1500863 snowball777
snowball777's picture

We may get to the grace period stage though...

http://www.youtube.com/watch?v=Cwnq5BEvRj8

Thu, 07/28/2011 - 09:52 | 1500852 digitlman
digitlman's picture

I don't need to see the HTML in the article, thanks.

Thu, 07/28/2011 - 09:52 | 1500855 Ted K
Ted K's picture

"True - for the likelihood of any event happening, your best bet is to ask Turbo Tax Tim, and then multiply the answer by -1."

 

Funny shit!!! Tyler you got good comedy writers.

Thu, 07/28/2011 - 09:53 | 1500858 SheepDog-One
SheepDog-One's picture

They will trigger an event, thats the plan after all, we just dont know WHEN.

Thu, 07/28/2011 - 09:57 | 1500879 buzzsaw99
buzzsaw99's picture

They will evict and starve granny in the street before the bondholders suffer the loss of one penny.

Thu, 07/28/2011 - 10:12 | 1500926 unununium
unununium's picture

1. Starve granny

2. Ensure bonds passed to new bagholders

3. Allow the loss of many pennies

Thu, 07/28/2011 - 10:14 | 1500949 SheepDog-One
SheepDog-One's picture

Yea, thats the plan, to 3rd world america. All your savings and retirement funds are belong to us.

Thu, 07/28/2011 - 09:56 | 1500871 RobotTrader
RobotTrader's picture

 

 

Gold and silver selling off.  Which means a deal is being cut as we speak.

And notice how the owners of GMCR have absolutely nothing to worry about.  The stock has gone from $10 to $104 in 2 years.

When is Eric King going to interview the CEO?  LOL......

Thu, 07/28/2011 - 09:57 | 1500876 jkruffin
jkruffin's picture

I sold my calls on GMCR right at the open,  time to go SHORT!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!

Thu, 07/28/2011 - 10:01 | 1500889 A Man without Q...
A Man without Qualities's picture

Of course there will be a deal, and of course silver will sell off as a result.  However, they've exposed to the world the fact that i) the elected representatives in Washington are a bunch of lunatics and ii) the US is really fucking broke, with no way out.  Therefore, this is going to be a great buying opportunity and I for one am waiting...

Thu, 07/28/2011 - 10:06 | 1500904 Dr. Engali
Dr. Engali's picture

I hope gold and silver sell off on the news. That will give me a good entry point to add to positions.

Thu, 07/28/2011 - 10:12 | 1500931 Abitdodgie
Abitdodgie's picture

Gold and silver is selling off because the banks always raid the market for the first 2 days after options expire, to try and stop people from rolling over tomorrow we will be going north.

Thu, 07/28/2011 - 09:56 | 1500872 jkruffin
jkruffin's picture

Look at Europe get trashed!!!!!!!!!!!!!! And the pumpers in America think stocks are going higher today in US?  Bwaahhahaaaa!!!  Too funny!  The crooks just keep suckering morons into the scam and they keep buying it letting the terds out at higher prices than they deserve.

Thu, 07/28/2011 - 09:56 | 1500873 Quintus
Quintus's picture

"... the total net exposure of market participants who have sold CDS credit protection on US sovereign debt is approximately $4.8bn as of July 15, 2011"

That's the number I've been interested in finding for the last couple of days, since this whole '3 Days Grace before ARMAGEDDON!!" meme started recently.

As I suspected, there is more net CDS exposure to Greece than the US.  I guess putting pressure on the Debt Ceiling negotiations by holding out the threat of a CDS related disaster is not going to work then.

 

 

Thu, 07/28/2011 - 10:02 | 1500881 Cognitive Dissonance
Cognitive Dissonance's picture

 

 

The following does not constitute legal advice, and is subject in all respects to any determination that the ISDA Americas Credit Derivatives Determinations Committee may make in relation to CDS referencing the United States. 

Sounds like something the IRS tells people when they don't want to stand behind their verbal or written communications.  

"This is what we mean and we aren't responsible for what we say. Oh, and you are guilty until you prove yourself innocent. Have a nice day."

Thu, 07/28/2011 - 10:00 | 1500885 urbanelf
urbanelf's picture

"True - for the likelihood of any event happening, your best bet is to ask Turbo Tax Tim, and then multiply the answer by -1."

Tyler's  comments violate the inclusion-exclusion principle.

 

Thu, 07/28/2011 - 10:00 | 1500888 WALLST8MY8BALL
WALLST8MY8BALL's picture

I dont know if anyone has seen this yet - there was a humongous block trade in UST Futures on the CBOT yesterday

http://etfdailynews.com/2011/07/25/investors-the-1-billion-armageddon-trade-placed-against-the-united-states/

Thu, 07/28/2011 - 10:06 | 1500906 BrianOFlanagan
BrianOFlanagan's picture

I wouldn't be surprised if the US defaulted and was downgraded and bonds rally anyway.  Good luck to the gambler that put on that trade.

Thu, 07/28/2011 - 10:56 | 1501126 Hedgetard55
Hedgetard55's picture

Hahahaha... It was Harry Reid!

Thu, 07/28/2011 - 10:01 | 1500890 BrianOFlanagan
BrianOFlanagan's picture

so CDS gets triggered and the sellers have to pay based on the recovery value of the bonds - that's a big non-event.  The value of the bonds are going to be little changed as any inability to pay would be temporary.  Thus there will be little, if anything, that the CDS sellers would have to pay.

No armageddon here.

 

Thu, 07/28/2011 - 10:13 | 1500912 Coldfire
Coldfire's picture

Meme: it's containable.

Thu, 07/28/2011 - 10:12 | 1500918 Everybodys All ...
Everybodys All American's picture

There will be no trigger ... if Greece did not trigger then no one will.

I said this the other day in so many words. Now a better question is what idiot would buy a credit default swap knowing it will never pay out?

Thu, 07/28/2011 - 10:18 | 1500964 zenmeister
zenmeister's picture

"Are CDS triggered by a declaration by a rating agency that the Reference Entity has been downgraded or is in “default”?

No. There is no link between a rating agency declaration and a CDS Credit Event. It is possible that the same set of facts might give rise to both, but it is also possible that one might occur but not the other."

...well, even if the majority does not have "downgrade" as a trigger event this is hardly without repercussions. All manner of structured notes will have rating (hair)triggers that will go off. Also, plenty of SPVs that have collateral quality stipulations of AAA rated paper are currently stuffed with USTs. When they no longer count folks will probably realise quite quickly that Bunds, OATs and Gilts are not quite as abundant. Watch out for the collateral switch stampede...

Thu, 07/28/2011 - 10:22 | 1500982 mess nonster
mess nonster's picture

Something tells me that "Only 4.8 billion of exposure" and "...firms’ net exposures are partially offset by the recovery value of underlying obligations", is the kind of sanguinary remark only made when one confines one's view to nothing more than the very first domino.

Thu, 07/28/2011 - 10:32 | 1501031 oogs66
oogs66's picture

I think isda just copied and pasted from zh articles. Zh explained all this long ago :)

Thu, 07/28/2011 - 11:39 | 1501239 MobBarley
MobBarley's picture

Irrational Sloppy Default Arbitration

 

Thu, 07/28/2011 - 13:56 | 1501676 Greater Fool
Greater Fool's picture

Treasury yields appear not to care one whit about the soap opera.

I think it would funny for Treasury to announce "to provide a margin of safety" that they were declaring a moratorium on interest payments...but only on notes held by the Fed.

As defined above, that is a credit event and would trigger CDS. Bond markets would likely shrug and go about their business. Protection buyers would get nothing except the privelege of losing their MtM and re-entering the trade at an equal or higher spread if they felt so inclined. 

Fri, 07/29/2011 - 03:47 | 1503658 qing
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removed content (spam)

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