Cross Default - ISDA Provision
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2002 ISDA Master Agreement A Jolly Contrarian owner’s manual™ 5(a)(vi) in all its glory
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Overview
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.
Summary
General
Cross Default is intended to cover off 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 like to — you apply this thinking to contractual relationships which aren’t “term loany” in nature — that is, having long spells where one party is deeply in the hole to the other, and there is not so much as an incoming interest payment due over a period of months to trigger any acceleration — 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.
But ISDA Master Agreement is not 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 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:[1] 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[2] 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[3] — listened to.
Specified Indebtedness
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.
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 Cross Default is a bit gauche; a bit passé in these enlightened times of zero-threshold VM CSAs[4] 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.
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- The JC’s famous Nutshell™ summary of this clause
See also
- Cross default in general
- Cross acceleration — cross default gone runny at the edges
- Indebtedness
- Capital structure
References
- ↑ 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.