Cross Default - ISDA Provision
2002 ISDA Master Agreement
Section 5(a)(vi) in full
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The 2002 ISDA updates the 1992 ISDA’s Cross Default so that if the combined amount outstanding under the two limbs of Cross Default exceed the Threshold Amount, then it will be an Event of Default. Normally, under the 1992 ISDA, Cross Default requires one or the other limbs to be satisfied — you can’t add them together. This was a bit of a snafu. The two limbs are:
- a default under a financial agreement that would allow a creditor to accelerate any indebtedness that party owes it;
- a failure to pay on the due date under such agreements after the expiry of a grace period.
Cross Default is intended to cover off the unique risks associated with lending money to counterparties who have also borrowed heavily from other people. If you try to apply it to contractual relationships which aren’t debtor/creditor in nature — as starry-eyed young credit officers in the thrall of the moment like to — it will give you trouble.
Under the ISDA Master Agreement, default by a swap counterparty on “Specified Indebtedness” with a third party in an amount above the “Threshold Amount” is an Event of Default under the ISDA Master Agreement — even though the counterparty might be fully up to date with all covenants under the ISDA Master Agreement itself. Cross Default thus imports the default rights from some contract the counterparty has given away to some third party random — in fact all default rights it has given away to any randoms — into your ISDA Master Agreement. For example, if you breach a financial covenant in your revolving credit facility with some other bank, an entirely different swap counterparty could close you out even if your bank lender didn’t.
This might seem like a groovy thing until you realise that, like most ISDA provisions, Cross Default is bilateral. It can bite on you just as brutally as it can bite on the other guy. In the loan market, where the Cross Default concept was born, contracts are not bilateral. There is a lender and a borrower, and the borrower gets null points in the cross default department against the lender.
So, if you are a regulated financial institution, the boon of having a 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 Cross Default against yourself. Because you have a ton of public indebtedness.
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 Failure to Pay or 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 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.
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.
The Threshold Amount 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. It should be big: like, life-threateningly big — because the consequences of triggering a Cross Default are dire. Expect to see 2-3% of shareholder funds, or (for banks) sums in the order of hundreds of millions of dollars. For fund counterparties the number could be a lot lower — like, ten million dollars or so — and, of course, will key off NAV, not shareholder funds.
For those noble, fearless and brave folk who think 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 Cross Default altogether — a day I swear is coming, even if it is not yet here — one can quickly convert a dangerous 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 Specified Indebtedness, not just become able to accelerate it, with some fairly simple edits, which are discussed in tedious detail here.
Specified Indebtedness is a simple and innocuous enough provision. Almost redundant, you’d think — why go to the trouble of defining “borrowed money” as another term? (Answer: because many firms, in their wisdom, will wish to change the definition in the Schedule to include derivatives, other trading exposures, things owed to their affiliates, or even any payment obligations of any kind, and for those people, “Specified Indebtedness” is a (somewhat) less loaded term.
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.
Stock loans and repo as Specified Indebtedness
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).
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 Specified Indebtedness that failure contributes to the Threshold Amount might be nil, or even negative. This, your risk people will say, is why one should widen Specified Indebtedness to include all payment obligations, but that, for a host of reasons you can find here — is whopping great canard a l’orange in this old contrarian’s opinion.
Measure of 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.
- It can be triggered by any event of default, not just a payment default (i.e. the 1992 ISDA requirement for “an Event of Default ... in an amount equal to...” impliedly limits the clause to payment defaults only since other defaults aren’t “in an amount”...);
- It captures the whole value of the Specified Indebtedness, not just the value of the default (if it even is a payment capable of being valued) itself.
For example: if you defaulted on a small interest payment on your Specified Indebtedness which made your whole loan repayable, under the 1992 ISDA you could only count the value of that missed interest payment to your Threshold Amount. But the whole loan is at risk of being accelerated — so this is a much more significant credit deterioration than is implied by the missed payment.
It is innocuous, that is, unless you are cavalier enough to include derivatives or other payments which are not debt-like in your Specified Indebtedness. But if you do that, you’ve bought yourself a wild old ride anyway.
Don’t say you weren’t warned.
For details freaks
Differences between cross default and DUST
Ideally, cross default and DUST should be mutually exclusive. They are meant to dovetail with each other, not cross over. This will not stop mission creep from over-zealous credit departments, who will try to expand the scope of each, leading to all kinds of cognitive dissonances and righteous indignation from the counterparty’s negotiator. As ammunition for your fruitless attempts to persuade the credit department to live in the real world for once, try these:
- Cross default generally references indebtedness where the exercising counterparty has significant loan-type exposure to the defaulter; DUST references bilateral derivative and trading transactions which tend not to be in the nature of indebtedness (it is true to say that the line between these can be gray, especially in the case of uncollateralised derivative relationships;
- Cross default is only triggered once a certain threshold amount of indebtedness is defaulted upon; DUST is triggered upon any breach;
- Cross default references your Counterparty owes to a third party outside your control; DUST references other obligations your counterparty owes you or an affiliate you can reasonably be expected to be in league with. (ie you can't generally trigger if your counterparty defaults on Specified Transactions it has on with third parties)
- DUST only comes about if the Specified Transaction in question has been actually accelerated, whereas cross default is available whether the primary creditor has accelerated or not. (A cross default which requires acceleration is called “cross acceleration”.)
- Cross default in general
- Cross acceleration — cross default gone runny at the edges
- Capital structure
- That is to say, it is practically useless.
- Ahhh, sometimes literally.
- I am indebted to my good friend Mr. V.C.S., who writes to point out that some of us still listen to that kind of music. All About Eve were misunderstood geniuses I tell you.
- Your correspondent is one of them; the author of that terrible FT book about derivatives is not.
- And, to be candid, rightful.