Template:M summ 2002 ISDA 5(a)(vi)

Cross Default covers the unique risks that come from lending money to people who have also borrowed heavily from others, likely on better terms than you. The basic vibe is:

If any of your other loans become payable, I want mine to be payable too.

In the ISDA Master Agreement that means I get an Event of Default. Sounds simple? Well: ride with me a while.

Origins in the loan market

Cross default grew out of the traditional loan market, and was transplanted into derivatives at the dawn of the Age of Swaps. Consider a traditional unsecured loan. Its characteristics are as follows:

Firstly, there is an identifiable lender — usually a bank — and borrower — usually a business — in a formalised relationship of dominance and subservience. Their roles in this power structure cannot change. The lender is, always, the lender: it gives away its money against the borrower’s bare promise to later give it back. The borrower does not have risk to the lender.

Secondly, a loan is an outright allocation of capital from lender to borrower. There, intrinsically, credit risk. The lender’s main concern is that the borrower can give the money back. It will want the right to force it to if the borrower’s creditworthiness takes a turn for the worse. The bank therefore wants its “weapons” pointed at the borrower. The borrower, in contrast, has no need to point any weapons at the bank.

Thirdly, the borrower has few payment obligations: usually, only periodic interest and final repayment. Most of the borrower’s obligations come at the end of the contract.

Fourthly, unless the borrower defaults, the bank cannot get its money back before expiry of the term. All it is entitled to is periodic interest on the amount loaned.

Because the borrower has infrequent payment obligations, and they are large, the bank will want to be able to call a default as soon as it thinks the customer will not be able to repay. It will not want to wait and see.

But what default events can it look to? “Failure to pay” or “breach of agreement” won’t do, because there might not be any payment obligations due under the loan. If the borrower has loans with other banks, it may owe interest on them before it owes anything under this loan.

This will make all bank lenders nervous: if the borrower becomes distressed, everyone will want to use their weapons as soon as possible: there is an advantage to being the first lender to pull the trigger. If one lender shoots — if it even becomes entitled to shoot — then the other banks will want to be able to shoot, too.

Hence, the concept of “cross default”: should a borrower be in material default under a third-party loan, cross default permits the bank to call in its loan, too, even though the borrower has not missed any payments directly. Even if none were even due.

This puts the borrower’s lenders into a standoff: all will have “twitchy trigger fingers”. All will want to accelerate their loans as soon as anybody else is entitled to.

There is a curious “systemantic” effect here: though Cross Default is designed as a credit mitigant, its very existence makes a credit default more likely.

The loan market therefore developed some “thresholds” around the cross-default concept: firstly, you could only invoke Cross Default if the borrower’s default exceeded a certain monetary value. Cross Default should only apply to events material enough to threaten the borrower’s solvency.

Recap: Cross Default is meant to protect against the risk of material uncollateralised indebtedness, on terms containing infrequent payment obligations, where the borrower also has significant indebtedness to other lenders in the market. It is a one-way right. A borrower has no cross-default right against a lender.

The ISDA evolved from the loan market

We have seen that the ISDA Master Agreement developed out of the loan market. Early swaps were offsetting loans. They were documented by lawyers who were banking specialists: they were used to thinking about the world in terms of lending.

It was only natural that early versions of the ISDA Master Agreement included the usual set of banker’s “weapons” to manage the risk of default. That included Cross Default.

Swaps are different

But swaps are not very much like outright loans. They are financing, not lending arrangements: The swap dealer does not allocate capital outright to the customer, as a lender does. Financing and lending are fundamentally different activities. They present different risks.

Swaps, also, are by their nature fully bi-directional. There is no fixed lender and borrower. (In theory, there’s no lender or borrower at all). Under a swap, either party can “owe money”. Who is “in-the-money” can change suddenly, without warning and it has nothing to do with the parties’ relative creditworthiness.

This means the Events of Default under the ISDA Master Agreement must be symmetrical and bi-directional: if there is to be a Cross Default right, it must point in both directions. Therefore, unlike in a traditional loan the Cross Default in the ISDA Master Agreement applies equally to the bank as it does to the customer.

This presents some rather curly conceptual challenges, as we will see.

Cross default is not needed in a swap

In any case, the risks of loans that Cross Default address, broadly, do not hold for swaps:

Firstly, swaps are not primarily instruments of uncollateralised indebtedness.

Secondly, there tend to be multiple small Transactions rather than a single big one: therefore payments under the ISDA architecture are frequent and flow in both directions, especially under an ISDA Master Agreement with multiple Transactions. You don’t have the “no coupon due for six months” problem.

Thirdly, ISDA Master Agreements are typically margined, so even though it is conceptually possible for uncollateralised exposure to arise under an ISDA, in practice, it there won’t be much and it will be quickly reset.

Lastly, the majority of swap end users will not have significant unmargined third-party debt: investment funds tend to invest on margin. They do not borrow under uncollateralised loans. So there are few instances of specified indebtedness that they are likely to trigger. It is far more likely that a bank counterparty or swap dealer will have material specified indebtedness. This is a bit of a self-own.

You would not expect Cross Default to often arise as a sole means of closing out an ISDA Master Agreement. Usually, there would long since have been a Failure to Pay or Deliver or Bankruptcy, and both of those events are a much more deterministic, identifiable and therefore safe means of bringing an ISDA arrangement to an end.

How does Cross Default work?

Imagine swap counterparty N who, alongside its ISDA Master Agreement with you, has significant Specified Indebtedness to lenders A, B and C.

Should N default under any of that indebtedness — that is, should any of those lenders become entitled to call in their loans, whether or not they actually do — in a total sum greater than your agreed “Threshold Amount”, you would be entitled to close out your ISDA, even though N had not defaulted in any way directly to you.

“Specified Indebtedness”

What counts as “Specified Indebtedness”? The ISDA itself defines it as “borrowed money” without further elaborating on what that means. Generally speaking, it means loans.

Financing arrangements

“Borrowed money” excludes margined financing arrangements. “Financing arrangements” include a wide selection of capital markets transactions including margin loans, synthetic prime brokerage, swaps, stock loans and repos.

These are “asset transformations” rather than borrowings and do not involve uncollateralised “indebtedness” as such: at inception, the party raising money gives title to an asset of greater value to the financer, and is subsequently margined to that asset value. Therefore net, the financing beneficiary is not a debtor at all, but a creditor.

This does not stop excitable credit officers expanding “Specified Indebtedness” to bring financing arrangements into scope. A favourite tweak is to include derivatives and securities financing arrangements without stopping to clarify how the “borrowed money” under them (hint, under a margined ISDA, there will not be any) is to be measured. Notional? Mark-to-market exposure? Outstanding payment obligations? Present value of all future payments?

Bank deposits

Bank deposits plainly are “borrowed money”, and they mightily add up: as we will see, aggregation is important when calculating the Threshold Amount.

Bank deposits illustrate the problem of having cross-default in a financing contract like an ISDA. In the traditional loan market, bank deposits tend not to trigger cross default obligations, because the sort of parties having cross default obligations do not have deposits. Only banks accept deposits. Since they are usually the lender in a commercial loan they, and their deposits, are not subject to cross default.

But ISDAs are bilateral, so a bank dealer’s deposits will be in scope and could trigger a Cross Default against a bank. It is not out of the question that a bank could be prevented from honouring deposits through operational error, IT outage or geopolitical incident. This would put it in technical default on a large number of its deposits at once.

Therefore, banks exclude retail deposits from the ambit of Specified Indebtedness. They will not lightly resile from this position, so buy-side legal eagles looking for a ditch to die in are advised to avoid this one.

Public indebtedness

With the honourable exception of public bond issuances, most Specified Indebtedness arises under private arrangements about which the market will have no reliable real-time information. No one will know how much a given borrower owes, much less whether it has defaulted and when.

This makes practical policing and enforcement of Cross Default fraught, where it is even possible.

“Default”

“Default” is described widely and (at least in the 2002 ISDA) is not restricted to payment defaults. A technical breach of representations as long as it entitles the lender to accelerate would count towards an actionable Cross Default.

Vitally, the lender need not actually accelerate the loan. The cross-default right arises as soon as it is entitled to accelerate. This makes the Cross Default event a powerful and sensitive tool. Too powerful. Too sensitive.

There is now an entirely different page dedicated to cross acceleration — a weakened version of Cross Default that requires the loan to be actually called in.

“Threshold Amount”

The Threshold Amount is the level over which accumulated defaults in Specified Indebtedness trigger Cross Default. It is usually expressed as a cash amount or a percentage of shareholder funds, or both, in which case — schoolboy error hazard alert — be careful to say whether it is the greater or lesser of the two.

Because of the extreme risk Cross Default presents, the Threshold Amount should represent an existential threat to the counterparty’s solvency. For a bank counterparty, that is typically two or three per cent of its shareholders’ equity or the cash equivalent.

A cash equivalent runs the risk of “decoupling” from the value of shareholders’ equity — especially in times of great market stress — so while it is easier to measure and monitor, it presents a greater systemic risk, and you may find it more prudent to stick with an equity-linked threshold.

Snowball risk

This “accumulation” feature means relatively trivial amounts of indebtedness can be problematic. This is particularly so where there are a lot of them — see bank deposits and swap transactions — or where the default is technical, systemic or operational. Should a system outage prevent a counterparty from honouring a class of contracts it might instantly trigger a catastrophic cross-default right across all ISDA Master Agreements.

For buy-side parties (especially for thinly capitalised investment vehicles) the Threshold Amount may be a lot lower than that — like, ten million dollars or so — and, of course, for fund entities will key off NAV, not shareholder funds.

Problematic derivatives

Bear in mind, too, that if even one of your ISDA contracts has a lower Threshold Amount, that can create a chain reaction: because the exposure under that ISDA, once it has been triggered by a Cross Default, then contributes to the total amount of defaulted Specified Indebtedness and may itself lead to Threshold Amounts being triggered in other ISDAs. And each of those then contributes … you get the idea.

The obvious solution is to exclude derivatives and similar financing arrangements from the definition of Specified Indebtedness. That is, to revert to the ISDA standard.

Cherry-picking

One last problem with including swaps: how do you measure the “indebtedness” under a Transaction?

You could, in theory, cherry-pick all out-of-the-money Transactions, total them up and cross a Threshold Amount fairly easily.

Nothing requires you to apply a Single Agreement concept or cross-transactional netting to those exposures. (Why would it? ISDA contracts are meant to be out of scope for Cross Default).

Even if you calculate Specified Indebtedness by reference to a net close-out amount, this only really highlights the imbalance between dealers and their customers. Sure, big fund managers may have ten, twenty or even fifty ISDA Master Agreements, but they will be split across dozens of different funds, each a different entity with its own Threshold Amount. Swap dealers, on the other hand, will have literally hundreds of thousands of master agreements, all facing the same legal entity. Dealers are the wrong side of this risk.

Now, you could manage this by careful negotiation — but there is a better way: excluding financing transactions altogether, for the perfectly sensible reason that they are not “borrowed money”.

Cross default as a “most favoured nation” clause

While the ISDA Events of Default are standardised, bilaterally-negotiated default events under private loans will be highly customised.

Especially since Section 5(a)(vi) is pretty loose about what counts as a qualifying default:

“a default, event of default or other similar condition or event (however described) in respect of such party”.

This could include potential events of default (those which will become an event of default on expiry of a grace period). In any case, it would haul into the ISDA’s ambit any weird or sensitive default triggers in that loan documentation that deal with peculiarities of the lending arrangement and have no real bearing on the general credit position of the borrower as a derivatives counterparty.

In other words Cross Default functions as a gated “most favoured nation” clause. This is a wide, swingeing term and is likely to be much more severe against bank and dealer counterparties than end-users, since banks will have a lot more indebtedness.