Talk:Cross Default - 1992 ISDA Provision

Cross Default generally

As a standard term in master trading agreements

For specific provisions see:

• Cross Default (ISDA)
• Cross Default (FBF)
• Stock lending and repo have no cross default: Neither the 2010 GMSLA nor the Global Master Repurchase Agreement have, as standard, either a cross default or a default under specified transaction provision. Unless some bright spark thinks it is a good idea to negotiate one in.

Compare and contrast

• Default under specified transaction: DUST is like cross default, but just between you and me, on derivative transactions and without a Threshold Amount;
• Cross acceleration: like cross default, only for a kinder, gentler world where people wait for indebtedness to be actually accelerated before closing out their exposures.

History

Cross default in the loan market

Cross default developed in the loan market. If a lender advanced a large sum to a borrower with only periodic interest or principal repayments, there would be long periods — months; quarters; even years — where the borrower was not scheduled to make any payments to the lender at all.

Now a borrower that is not due to pay anything, can hardly fail to pay.

This presented our lender with a risk: if, in the meantime, the borrower failed to pay under a loan from another lender, our lender would be in a difficult spot: it has good reason to think the borrower is in trouble, but the borrower hasn’t missed any payments. (How could it? None were due.) Waiting for the next payment to see if the borrower will pay won’t do. Our borrower wants to accelerate its loan now — while the going is still tolerably good.

Whence came the notion of a cross default: If you default under a loan you have borrowed from someone else, you default under your loan with me.

But this is a drastic measure. It means the borrower and its various lenders are in a Mexican stand-off: The lenders will all tend to be trigger happy: they will want to accelerate before some other blighter does. Therefore some thresholds were put around it: The size of the loan being defaulted on would need to be material enough to threaten the borrower’s very solvency.

Note the key vulnerabilities that cross default clause is designed to protect against:

• Material indebtedness: Our lender has significant credit exposure to the borrower;
• Infrequent payments: Our lender is owed infrequent payment obligations and cannot necessarily rely on a failure to pay.
• Material default: The borrower has taken on other indebtedness in a size big enough to threaten its own viability.

Cross default in the ISDA Master Agreement

In their infinite wisdom (or jest), the framers of the 1987 ISDA Interest Rate and Currency Exchange Agreement (cro-magnon man to the 2002 ISDA’s metropolitan hipster) thought it wise to include a cross default, perhaps because, in those pioneering days, credit support annexes weren’t run-of-the-mill, and may not even have been invented.

Subsequent generations of derivative lawyers, being the creatures of habit they are, especially when sequestered into an ISDA working group, never thought to take it out, and even our artisanal coffee-swilling 2002 ISDA boasts a tedious Cross Default provision, an embarrassing relic of its bogan parentage. It’s like that tattoo you got when you were a drunk, but physically attractive, 19 year-old.

You see the thing is, for a derivative master agreement, cross default is a complete nonsense.

A counterparty to an ISDA Master Agreement, particularly one with a zero-threshold daily CSA and many transactions under it, suffers none of those weaknesses it is designed for:

• Little indebtedness: An ISDA Master Agreement is not a contract of indebtedness, and any mark-to-market exposure that may resemble indebtedness is zeroed daily by means of a collateral call;
• Frequent payments: particularly where there are many transactions, or where the net mark-to-market position is shifting, there are payment obligations flowing every day, and if there are not that means there is no net indebtedness at all to the counterparty.

Additionally, regulated credit institutions have (or should have) enormous concerns about giving away cross default, because it can affect their liquidity buffer calculations.

Yet still we persist in our sophistry.

Then the lawyers and credit officers start fiddling with things

Cross default is a bad enough idea in a derivatives master agreement in the first place, before risk managers start having a go at it. Misguided things they can do include the following:

• Widening it to include default under agreements which aren’t in the nature of indebtedness: for example, derivatives, or even “any payment obligation”.

• This is problematic because of the accretive nature of the threshold: A single technical or operational failure may mean one is technically in default on payments which, if aggregated, could quickly exceed even a large threshold (especially in a heavily traded derivative master agreement).

• Not, in the case of banks, excluding retail deposits, where operational failure or even governmental action (like a moratorium or currency controls) could lead to technical default on a large amount of indebtedness. (Bank deposits are a form of indebtedness, and will almost certainly be a significant source of indebtedness for any trading bank).
• Adding in grace periods or other preconditions, excuses, permission to skip PE class and so on, before a party may invoke a cross default;
• Arguing the toss about threshold amounts (should it be shareholders funds or cash? or both? lower or higher of? Is my threshold higher than yours? Is it too big? Is it too small? Does my Threshold Amount look big in this? Honestly it is so tedious).

Introduction

A cross default provision in an agreement allows a non-defaulting party, on a default by the other party under any separate contract it may have entered for borrowed money, to close out the agreement containing the cross default provision. Compare this with:

• a cross acceleration provision, where the lender of the borrowed money must actually have taken steps to accelerate the borrowed money as a result of the default before the default becomes available as a termination right under the first agreement; and
• default under specified transaction which references default under financial contracts which do not represent indebtedness, but only as between the two counterparties to the present contract.

Cross default is potentially a very damaging clause, as this picture to the right amply illustrates. Or would do, if there were a picture to the right. To the extent it doesn’t:

Cross default

A cross default right effectively imports into the ISDA all the default termination rights under any Specified Indebtedness owed by a party:

• It dramatically (and indeterminately) widens the definition of Event of Default.
• It entitles a Counterparty to accelerate the [[ISDA}} whether or not the {{isdaprov|Specified Indebtedness]] itself has been accelerated.
• Depending on the market value of the transactions under the ISDA it may cause an immediate capital outflow (though is less likely to in these days of compulsory variation margin).

Specified Indebtedness

Specified Indebtedness means, generally, any borrowings that, in aggregate, exceed a designated Threshold Amount. Because of the aggregation right, even comparatively trivial agreements can trigger the provision where they are relatively homogenous and affected by the same local circumstances (for example, retail deposits). A low Threshold Amount, therefore, presents three challenges:

• It allows a more varied (and difficult to monitor) range of potential termination rights, because a greater number of agreements will qualify as Specified Indebtedness.
• It “lowers the bar” so failures to comply with comparatively trivial financial commitments could be aggregated to trigger the Cross Default.
• By not excluding bank deposits, it raises the possibility of being triggered by localised events unrelated to a bank counterparty’s creditworthiness (for example, political action in a single jurisdiction which affects the bank's ability to pay on its local deposits)
• Note that repo is not considered Specified Indebtedness: see borrowed money. But don’t let your inner anal retentive amending the definition in your Schedule so that it is (even though repo is more properly dealt with by DUST).

Derivatives as Specified Indebtedness

Be wary of including derivatives or other non-debt-like money payment obligations in the definition of Specified Indebtedness, no matter how high a Threshold Amount. We would say never do it, but the wise minds of the credit department may well be beyond your calming influence, so you may not have a choice. But if you have a choice, don’t do it.

In its unadulterated formulation, Cross Default aggregates up all Transaction-level defaults, so even though a single ISDA Master Agreement would be unlikely to have a net out-of-the-money MTM of anywhere near the Threshold Amount, a large number of individual Transaction MTMs, if aggregated, may — particularly if you’re selective about which Transactions you’re counting — which Cross Default entitles you to be.

Thus, where you have a large number of small failures, you can still have a big problem. (This is why banks should also carve out deposits: operational failure or regulatory action can create an immediate problem).

Now it is true that you can require the Specified Indebtedness of a master trading agreement to be calculated by reference to its net close-out amount, but this only really points up the imbalance between buy-side and sell-side. Sure, fund managers may have fifty or even a hundred ISDA Master Agreements, but they will be split across dozens of different funds., each a different entity with its own Threshold Amount. Broker-dealers, on the other hand, will have literally hundreds of thousands of master agreements, all facing the same legal entity. Credit dudes: you are the wrong side of this risk, fellas.

Now seeing as most master trading agreements are fully collateralised, and so don’t represent material indebtedness on a netted basis anyway, it may be that even with hundreds of thousands of the blighters, no-one’s Threshold Amount will ever be seriously threatened. But if no Threshold Amount is ever at risk from an ISDA Master Agreement, then why are you including the ISDA Master Agreement in Specified Indebtedness in the first place?

O tempora. O paradox.

Credit Mitigation

Cross Default is intended to be a tool for mitigating credit exposure. It should be set at a level which reflects a material credit concern in the context of the entire enterprise. By convention, the market generally imposes a Threshold Amount equating to between 2 and 3 percent of shareholders’ funds.

Credit Support Annex

There are other ways of mitigating credit exposure (such as a zero threshold 1995 CSA). If a Counterparty's positive exposure to [Counterparty] will be fully collateralised on a daily basis, meaning its overall exposure to [Counterparty] at any time will be intra-day movement in the net derivatives positions (a failure to post collateral itself is grounds for immediate termination).

Contagion risk

It is important to maintain minimum standards which are reflective of genuine credit concerns against the bank so as to limit a “snowball” effect: were we to allow a £50mm Threshold Amount, we would potentially be open to a large number of derivative counterparties simultaneously (and opportunistically) closing out out-of-the-money derivatives positions, which in itself could have massive liquidity and capital implications.

Cross Acceleration

“Cross acceleration” is not an actual ISDA Event of Default, but it is what happens to an actual ISDA Event of Default — namely, the much-negotiated, seldom-used Section 5(a)(vi), Cross Default, if you can persuade your credit department to water it down to something sensible.

How to change Cross Default to cross acceleration

You can amend Cross Default to Cross Acceleration by adding the language in the panel: Seems so easy, doesn’t it?

Cross Default is triggered by two kinds of default:

1. General default: a general event of default of any kind at any time during the tenor of any Specified Indebtedness — this could be anything: the borrower’s bankruptcy, a breach of its reps and warranties, a non-payment of interest, any repudiatory breach of the contract of indebtedness, really; or
2. Repayment default: a borrower’s failure to fulfil, in full, final repayment of the debt itself when due.

Why distinguish between them, seeing as both are cataclysmic?

There is an answer, but it is fussy, word-smithy stuff: because a general default entitles the lender to accelerate the debt requiring the borrower to repay it at once, before its scheduled maturity date; a repayment default, logically, falls on that scheduled maturity date, and so can’t be “accelerated” as such. There is nothing to “accelerate”: our destination, the repayment date, is already here.

Therefore to convert a cross default to a cross acceleration, you only need to require general defaults to have been accelerated. Repayment defaults can’t be accelerated.

Cross acceleration also avoids the need to muck around waiting for grace periods to expire, granting indulgences for administrative and operational error and all that dreck: if the counterparty has actually accelerated the loan, the grace periods and operational errors no longer matter. It is too late. The game is up.

Now, to be sure, legal eagles might start hopping up and down, flapping their wings and squawking restively at this point.

“But,” they will say, “what about grace periods and operational errors on that final payment? We must be allowed those before you can close out!”

The short answer is that ordinary grace periods are factored in — the event isn’t triggered until they have all expired. As for affordances that don’t quite count as grace periods (for example, concessions allowing a borrower to provide evidence of operational error, giving it some more time to pay) — well, on a fair, large and liberal view these count as grace periods anyway.

Is “downgrading” to cross acceleration wise?

There are two schools of thought:
Yes: The sensible, pragmatic, wise, noble, fearless and brave one you will find in these pages: “Yes. Cross default is misplaced in a modern daily-collateralised ISDA. Anything you can do either to restrict its scope, or simply to avoid being dragged into a tedious argument about its scope, is worth doing.”
No: The learned one, from the learned author of that terrible FT book about derivatives: “All other things being equal, no. One should only soften cross default reluctantly. Because other counterparts might not be so weak.”

A brief critique of the FT Book about derivatives

This, in our view, rather mischaracterises what is going on.

“With cross acceleration the innocent third party actually has to start proceedings against the defaulting counterparty before you can trigger your transaction termination rights ...”

But it doesn’t have to sue your counterparty; just call its debt in.

“The downgrading [of cross-default to cross acceleration] therefore affects the timing of your right to terminate, It is no longer automatic but deferred.”

We don’t know what the learned author means by “automatic”: either way, the termination right is optional, not automatic, but in either case, it is contingent on a different independent event: in one case, the more nebulous “default”; in the other, a lender’s quite hard-edged acceleration following the default.

“If the third party is your counterparty’s main relationship bank it may take some time to review its position...”

Indeed it may, and probably will. But while it is doing that it is not accelerating its claim against your counterparty. It is granting its customer, and your counterparty, an indulgence. Your position is, therefore, not worsened in the meantime.

“... and may propose a compromise which does not suit you.”

You, bear in mind, are the owner of a fully collateralised ISDA Master Agreement which the counterparty has, in the meantime, continued faithfully to perform. If one of your co-creditors has granted an indulgence on outstanding indebtedness — even in return for some other surety or compromise — which avoid that debt being accelerated in full, how can that by itself make your position worse?

“I believe such downgrade requests should only be considered favourably if specific foreseeable circumstances justify them [...] or if your counterparty gives written confirmation that cross acceleration applies to all its agreements and will do so in the future. This is because if even one counterparty has Cross Default it would be in pole position to trigger its termination rights.”

On this last point, the learned author is, technically, correct: you are marginally worse off if you have conceded cross acceleration and other swap counterparties have not. They can beat you, and your counterparty’s main relationship bank, to the punch, assuming they are cowboys who view a relationship contract like an ISDA Master Agreement as something that it should be a race to close out. Brokers that the JC knows don’t tend to think that way. They have compliance officers who will quail at the thought of not treating their customers fairly. In any case, the fact that this could happen just illustrates how stupid the concept of cross-default is. Especially in our enlightened age of zero-threshold, daily margined non-exotic swap contracts. Especially given the extreme conceptual difficulty of even gathering enough information to work out whether you even can exercise your stupid cross default right.

Just how a third party would ever be able to assess the value of defaulted Specified Indebtedness has never been explained to this old goat.

So this is angel-on-the-head-of-a-pin stuff indeed.

Basic

{{{{{1}}}|Cross Default}} is intended to cover the unique risks associated with lending money to counterparties who have also borrowed heavily from other people.

Now, if — as starry-eyed young credit officers in the thrall of the moment are apt to — you apply this thinking to contractual relationships which aren’t “term loany” in nature — that is, that don’t have long spells where one party is deeply in the hole to the other, with not so much as interest payment due for months whose failure could trigger any acceleration — it will give you trouble. We go into this more in the premium JC.

Specified Indebtedness

{{ISDA Master Agreement {{{2}}} Specified Indebtedness}}

{{{{{1}}}|Specified Indebtedness}} is generally any money borrowed from any third party (e.g. bank debt; deposits, loan facilities etc.). Some parties will try to widen this: do your best to resist the temptation. Again, more details on why in the premium section.

Threshold Amount

The Threshold Amount is a key feature of the Cross Default Event of Default in the ISDA Master Agreement. It is the level over which accumulated indebtedness defaults comprise an Event of Default. It is usually defined 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 snowball effect that a cross default clause can have on a party’s insolvency it should be big: like, life-threateningly big — because the consequences of triggering a Cross Default are dire, and it may create its own chain reaction beyond the ISDA itself. So expect to see, against a swap dealer, 2-3% of shareholder funds, or sums in the order of hundreds of millions of dollars. For end users the number may well be a lot lower (especially for thinly capitalised investment vehicles like funds — like, ten million dollars or so — and, of course, will key off NAV, not shareholder funds.

Cross acceleration

For those noble, fearless and brave folk who think {{{{{1}}}|Cross Default}} is a bit gauche; a bit passé in these enlightened times of zero-threshold VM CSAs but can’t quite persuade their credit department to abandon {{{{{1}}}|Cross Default}} altogether — a day I swear is coming, even if it is not yet here — one can quickly convert a dangerous {{{{{1}}}|Cross Default}} clause into a less nocuous (but still fairly nocuous, if you ask me — nocuous, and yet strangely pointless) cross acceleration clause — meaning your close-out right that is only available where the lender in question has actually accelerated its {{{{{1}}}|Specified Indebtedness}}, not just become able to accelerate it, with some fairly simple edits, which are discussed in tedious detail here.

Premium

On the danger to dealers of Cross Default

Under the ISDA Master Agreement, default by a swap counterparty on “{{{{{1}}}|Specified Indebtedness}}” — we will come to that, but generally it refers to “borrowed money” — owed to a third party in an amount above the “{{{{{1}}}|Threshold Amount}}” is an {{{{{1}}}|Event of Default}} under the ISDA Master Agreement, even though the {{{{{1}}}|Defaulting Party}} might be fully up to date with all its covenants under the ISDA Master Agreement itself.

{{{{{1}}}|Cross Default}} thus imports the default rights from some contract the counterparty has agreed with some third party random — in fact all default rights it has given away to any third party randoms, as long as they add up to the {{{{{1}}}|Threshold Amount}} — into the present ISDA Master Agreement. For example, if you breach a financial covenant in your revolving credit facility with your bank, an entirely unrelated swap dealer could close you out, even though you weren’t otherwise in default under the dealer’s ISDA, and even though your bank lender didn’t accelerate your RCF.

This ought to strike a fair-minded person as pretty startling. For reasons the JC has not yet been able to fathom, it typically does not strike credit officers as pretty startling. They tend to think it is pretty groovy.

It might, indeed, seem quite groovy at first glance. Especially to a swap dealer’s credit officer. But this is to overlook the fact that, unlike the covenants in a revolving credit facility, which all point, like an arsenal of warheads, in one direction only — the customer’s — {{{{{1}}}|Cross Default}} in an ISDA is a bilateral obligation. It can bite the dealer just as brutally as it can the customer.

The cross-default concept grew out of ordinary bank lending. There is a lender and a borrower, and the borrower gets null points in the cross-default department against the lender. The First Men, framers of the pioneering swap market, borrowed it, at the time not really knowing any better, but presuming that — since swap contracts are bilateral, right? — the cross default event should cut both ways. But the ISDA Master Agreement is not, from a customers’ perspective, a lending contract. Especially not now everything is, by regulation, daily margined to a zero threshold. There is no material indebtedness.

So, if you are a swap dealer, the boon of having a {{{{{1}}}|Cross Default}} against your counterparty — which might not have a lot of public indebtedness — may be a lot smaller than the bane of having given away a {{{{{1}}}|Cross Default}} against yourself. Because you have a ton of public indebtedness.

{{{{{1}}}|Cross Default}} is, therefore, theoretically at least, a very dangerous provision. Financial reporting dudes — some more than others, in the JC’s experience — get quite worked up about it. Yet, it is very rarely triggered: it is inherently nebulous. Credit officers disdain nebulosity and, rightly, will always prefer to act on a clean {{{{{1}}}|Failure to Pay}} or {{{{{1}}}|Bankruptcy}}. Generally, if you have a daily-margined ISDA Master Agreement, one of those will be along soon enough. And if it isn’t — well, what are you worrying about?

“Okay, so why even is there a {{{{{1}}}|Cross Default}} in the ISDA Master Agreement?” Great question. Go ask ISDA’s crack drafting squad™. The best I can figure is that, when the Children of the Forest first invented the eye-ess-dee-aye back in those primordial times, back in the 1980s, swaps were new, they hadn’t really thought them through, no-one realised how the market would explode and in any case, folks back then held lots of opinions we would now regard as quaint. I mean, just look at the music they — okay, we — listened to.

The Threshold Amount

1992 ISDA

This contemplates default “in an aggregate amount” exceeding the Threshold Amount which would justify early termination of the Specified Indebtedness: that is to say, the value of the failed payment, and not the whole principal amount of the Specified Indebtedness it was owed under, contributes to the Threshold Amount.

2002 ISDA

This contemplates an event of default under agreements whose “aggregate principal amount” is greater than the Threshold Amount: that is to say it is the whole principal amount of the agreement which is picked up, not just the amount of the payment. This change, we speculate, is meant to fix a howler of a drafting lapse from ISDA’s crack drafting squad™. 2002’s Cross Default can be triggered by any event of default, not just a payment default, whereas the 1992 ISDA’s requirement for “an Event of Default ... in an amount equal to...” impliedly limited the clause to payment defaults only since other defaults — failure to provide annual reports and so on — would not be “in an amount” of anything). Lastly, it captures the whole value of the {{{{{1}}}|Specified Indebtedness}} that has been defaulted on, not just the value of the payment default itself (allowing for a moment that it even is a payment capable of being valued — see above).

Example: if you defaulted on a small interest payment on your loan that nonetheless entitled the lender to accelerate the whole loan, under the 1992 ISDA you could only count the value of the actually missed payment to your {{{{{1}}}|Threshold Amount}}, even though the whole loan was at risk of being accelerated. That is to say, a failed interest payment, even in a small amount, can be a much more significant credit deterioration than is implied by the value of the missed payment.

Specified Indebtedness

Derivatives

This is all presuming you leave the definition of Specified Indebtedness to capture things that resemble actual borrowings. If you are cavalier enough to include non-debt-like payments — things like, for example, swaps — you've bought yourself a wild old ride anyway. AS WE SHALL EXPLAIN.

For reasons best known to themselves, credit officers from perennially accident-prone continental banks are especially prone to this sort of thing. The JC once tried to warn them. He was told, not for the first time, to “mind his own jolly business”. So he did. You are reading the result.

In any case, be wary of including derivatives or other non-debt-like money payment obligations in the definition of Specified Indebtedness, no matter how high a {{{{{1}}}|Threshold Amount}}. We would say never do it, but the wise minds of the credit department may well be beyond your calming influence, so you may not have a choice. But if you have a choice, don’t do it.

In its unadulterated formulation, {{{{{1}}}|Cross Default}} aggregates up all {{{{{1}}}|Transaction}}-level defaults, so even though a single ISDA Master Agreement would be unlikely to have a net out-of-the-money MTM of anywhere near the {{{{{1}}}|Threshold Amount}}, a large number of individual {{{{{1}}}|Transaction}} MTMs, if aggregated, may — particularly if you’re selective about which {{{{{1}}}|Transaction}}s you’re counting — which {{{{{1}}}|Cross Default}} entitles you to be.

Thus, where you have a large number of small failures, you can still have a big problem. (This is why banks should also carve out deposits: operational failure or regulatory action can create an immediate problem).

Now it is true that you can require the Specified Indebtedness of a master trading agreement to be calculated by reference to its net close-out amount, but this only really points up the imbalance between buy-side and sell-side. Sure, fund managers may have fifty or even a hundred ISDA Master Agreements, but they will be split across dozens of different funds., each a different entity with its own {{{{{1}}}|Threshold Amount}}. Broker-dealers, on the other hand, will have literally hundreds of thousands of master agreements, all facing the same legal entity. Credit dudes: you are the wrong side of this risk, fellas.

Now, seeing as most master trading agreements are fully collateralised, and so don’t represent material indebtedness on a netted basis anyway, it may be that even with hundreds of thousands of the blighters, no-one’s {{{{{1}}}|Threshold Amount}} will ever be seriously threatened.

But if no {{{{{1}}}|Threshold Amount}} is ever at risk, then why are you including the ISDA in Specified Indebtedness in the first place?

O Tempora. O Paradox.

Stock loans and repo

In any case, what should one make of “borrowed money”? Could it include repo and stock loan obligations under securities financing transactions? Amounts owed to trade creditors? (In each case no, according to Simon Firth - see here).

Initial margin

What of a failure to pay an Independent Amount? Technically this is not a payment of indebtedness, and if the IM payer is up-to-date on variation margin payments, there may not be any indebtedness at all. Indeed, once the IM payer has paid required IM, the IM receiver becomes indebted to the payer for the return of the initial margin — so while it certainly comprises a failure to pay when due, the value of the {{{{{1}}}|Specified Indebtedness}} that failure contributes to the {{{{{1}}}|Threshold Amount}} might be nil, or even negative. This, your risk people will say, is why one should widen {{{{{1}}}|Specified Indebtedness}} to include all payment obligations, but that, for a host of reasons just explained, is whopping great canard a l’orange in this old contrarian’s opinion.

DUST v Cross Default

A cut-out-and-keep guide to the difference between {{{{{1}}}|Default Under Specified Transaction}} and {{{{{1}}}|Cross Default}} at the {{{{{1}}}|DUST}} page,