Credit Event

An event that has a sudden change in a borrower’s ability to meet payment obligations.

Author: Gilbert Monrouzeau
Gilbert Monrouzeau
Gilbert Monrouzeau
I have a BS in Mathematics and an MBA in Finance. I am currently teaching as an adjunct professor at Lourdes University.
Reviewed By: Manu Lakshmanan
Manu Lakshmanan
Manu Lakshmanan
Management Consulting | Strategy & Operations

Prior to accepting a position as the Director of Operations Strategy at DJO Global, Manu was a management consultant with McKinsey & Company in Houston. He served clients, including presenting directly to C-level executives, in digital, strategy, M&A, and operations projects.

Manu holds a PHD in Biomedical Engineering from Duke University and a BA in Physics from Cornell University.

Last Updated:October 29, 2023

What Is a Credit Event?

A credit event is a sudden change in a borrower’s ability to meet payment obligations. This event is a trigger that causes a credit default swap (CDS) contract to be settled. These events are agreed upon when the CDS is purchased as part of the CDS contract.

A credit default swap (CDS) is a derivative used to hedge against default risk. In other words, it's a type of insurance. In this case, a CDS exchanges a coupon against the payment of a loss caused by the defaulted security.

Credit default swaps are usually publicly known products. CDS themselves can be bought, sold, and traded. For example, The Depository Trust and Clearing Corporation (DTCC) has a central electronic registry for credit default swaps.

To hedge against a risk means to invest in a position to offset potential losses that the accompanied investment could incur.

A CDS is a contract in which one party, the buyer, pays the other party, the seller, a series of payments over the term of the agreement. A simpler way of understanding a CDS is to imagine it as a type of insurance against default risk.

However, defaulting isn’t the only type of credit event. 

Types of Credit Events

The more common credit events are typically referenced in CDS contracts. This is important because they determine when the contract will be called. While some of these are standard, others can be very specific.

While some situations are expected depending on the CDS contract, sometimes the buyer can request that some events be specified before purchase.

The most common credit events include but are not limited to:

  1. Bankruptcy
  2. Failure to pay
  3. Restructuring
  4. Repudiation
  5. Moratorium
  6. Obligation acceleration
  7. Obligation default

Bankruptcy

Bankruptcy is a legal process initiated when an individual or business cannot repay outstanding debts or obligations. When a business or individual declares bankruptcy, all debts they cannot pay are forgiven.

However, when filing for bankruptcy, the debtor's assets are measured and evaluated. Some of those assets may be used to repay some or all of the debt. This gives creditors an opportunity for some repayment during the process.

All bankruptcy cases in the United States go through federal courts as outlined in the U.S. Bankruptcy Code. A bankruptcy judge decides whether a debtor can file for bankruptcy and whether they should be cleared of their debts.

There are different types of bankruptcies per the U.S. Bankruptcy Code.

  • Depending on the situation, individuals may file bankruptcy under Chapter 7 or Chapter 13.
  • Municipalities and school districts may file bankruptcy under Chapter 9.
  • Businesses may file bankruptcy under Chapter 7 or Chapter 11, depending on the situation.
  • Family farmers and fishermen may file for bankruptcy under Chapter 12.
  • Parties from more than one country must file bankruptcy under Chapter 15.

A firm might purchase a CDS to protect against bankruptcy because the individual or business might not have to repay the outstanding debt if they file for bankruptcy. Even if the court liquidates assets to cover some of the debt, it won’t cover all of it.

The seller must then pay the remainder of the debt to the buyer of the CDS per the contract if bankruptcy was one of the credit events specified in it.

Failure to pay

A failure to pay event is triggered following any applicable grace period in which a payment obligation is missed. Interest and principal payments not made when due are considered a default. Defaults can lead to bankruptcy if they occur too frequently.

As previously explained, bankruptcy can also trigger resolving the CDS contract. However, failure to pay can be triggered before it gets to the bankruptcy stage. This must be specified within the CDS contract since it is a default type.

This provides a situation of triggering the CDS payout before waiting until bankruptcy since that trigger can take much longer.

Restructuring

Restructuring is a situation where a lending contract has become problematic due to the actions of one of the parties. These actions lead the other party to grant concessions that it normally wouldn't consider. In some contexts, restructuring might be referred to as forbearance.

By forbearance, the lender delays their right to exercise foreclosure if the borrower makes up their payments on time or agrees to extend their loan term. A foreclosure occurs when the property owner can no longer make the required mortgage payments.

This restructuring may involve reductions on the interest rate or principal, deferral of interest rate or principal, change in priority ranking, or change in currency or payment composition. These changes would impact the issuer of the loan.

If the restructuring affects how much the issuer would receive, it might trigger the CDS. The CDS will be paid out if the contract includes restructuring as a credit event and the restructuring terms satisfy those circumstances.

Repudiation

Repudiation occurs when either the validity of a contract is refuted or one of the parties refuses to honor its terms. If the borrower reneges on the contract, unless the investors can take recourse against the borrower, they may lose their entire investment.

Repudiation is determined by the court. It requires a clear indication that one of the parties is unwilling to honor the contract. However, it can also occur before the breach of contract. In this case, it is referred to as an anticipatory breach.

Note

The anticipatory breach is the intention of breaking a contract before actually breaking it. However, this intention is enough for the affected party to potentially begin taking legal action against any actual breach of contract.

The courts recognize three types of repudiation:

  1. Transfer of the contract’s purpose (such as land or other property)
  2. Unconditionally refusing to honor the contract
  3. One party is taking an action that makes the other party unable to honor the contract.

It should be noted that repudiation does not terminate a contract. It just allows the affected party to determine how to proceed. For example, terminating the contract is one way to deal with repudiation.

A common instance of repudiation is in real estate. Suppose someone wants to buy a house, and the seller agrees. However, after a home inspection, the seller decides not to sell the house. The contract is breached, and the seller must pay any related costs.

Moratorium

Moratorium refers to the suspension of a contract until pertinent issues are solved. For example, if a business has exceeded its budget, it might put a moratorium on new hiring until the following fiscal year.

Another example is the delay of legal obligations or payments. A payment delay due to extenuating circumstances might render one party incapable of paying the other.

Suppose a municipality in the construction of public works hires a construction company to build it. Then, the budget is changed when the mayor isn’t reelected. This affects the contract with the construction company by suspending it.

If the construction company had any loans or other contracts with a financial firm, it would not be able to pay them. However, the company anticipated the municipality potentially changing the budget after the elections and purchased a CDS with a moratorium clause beforehand.

The construction company can then pay the financial firm with the payout from the CDS contract due to the credit event triggering it.

Obligation acceleration

Obligation acceleration refers to moving contract obligations, usually when the issuer needs to pay earlier than expected. This credit event is not considered a “failure to pay.”

Some contracts contain an acceleration clause that allows lenders to require borrowers to repay all outstanding loans if specific conditions are not met. This might trigger an obligation acceleration credit event.

For example, the terms of a contract are changed, and specified payments need to be made earlier than previously established. The paying party might not have been able to make the payment earlier, which doesn’t indicate a failure to pay or default on the payment.

Another example: suppose a borrower with a 10-year mortgage loan fails to pay in the 7th year. If the loan contract contains an acceleration clause, the borrower must repay the remaining balance if one payment is missed.

In this case, the relevant sum must be above a minimum threshold stipulated in the contract for a credit event to occur.

Obligation default

Defaulting is the most common type of credit event. This can happen with any entity, whether individuals, companies, or even governments. For example, the government of Puerto Rico defaulted on its bonds by being unable to prove it could pay its debt.

If investors held Puerto Rican government bonds, they might have hedged against that risk by purchasing CDS contracts with a default credit event. If not, they would’ve lost a significant percentage of their investment.

However, defaulting is most common with individuals and companies. It is rare for US bonds - municipal, state, or federal - to default.

This credit event is common in CDS contracts, “insuring” bonds of foreign countries as well. The more volatile the country or foreign market, the higher the default risk. This can also mean the CDS would require higher upfront and yearly premiums.

Credit Event Market

As previously mentioned, CDS contracts can be bought, sold, and traded on the open marketJPMorgan Chase & Co created this type of derivative in 1994 to fill the need for more liquid and flexible risk-management products for creditors.

The benefit to these early CDSs was that the risk did not count against the banks' regulatory capital requirements. In addition, these CDS were starting to be sold for corporate and municipal bonds.

However, in the mid-2000s, CDS began being issued for structured investment vehicles (SIV) such as asset-backed securities (ABS), mortgage-backed securities (MBS), and collateralized debt obligations (CDO).

A structured investment vehicle (SIV) is a collection of investments that seek to profit from credit spreads between short-term debt and long-term structured financial products.

Asset-backed security (ABS) is a financial security backed by income-generating assets. For example, credit card receivables and loans such as home equity loans, student loans, car loans, etc. Mortgage-backed securities (MBS) are specific to mortgages.

Collateralized debt obligations (CDOs) are more general and bundle multiple types of debt obligations, such as bonds and other loans and assets.

An SIV profits from the spread between incoming cash flows and the high-rated commercial paper it issues. For example, if an SIV borrows money at 2.1% and invests in a finance product with a 3.4% return, it will earn a 1.3% profit from that spread (difference).

However, the market quickly became saturated with all kinds of CDS, and they were bought, sold, and traded to multiple entities to the point where the current holder of a CDS could be the 12th in the line of ownership.

Most famously, the 2008 credit crisis was caused by CDS. Since the CDS seller experienced a default credit event simultaneously with the CDS borrower, CDS sellers defaulted on their CDS obligations.

This means that the buyer of the CDS experienced a default, which triggered its CDS contract. However, the seller was simultaneously experiencing a default. Since the seller was considering assets it didn’t possess, it couldn’t uphold its CDS contract.

Thus, the buyer of the CDS lost its investment, and the issuer went bankrupt. This level of financial irresponsibility caused the US government to intervene and develop the Dodd-Frank Act (2010) to regulate the swaps marketplace.

Credit Event FAQs

Researched and authored by Gilberto Morales | LinkedIn 

Reviewed and edited by Parul Gupta | LinkedIn

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