Credit Downgrade Triggers 2.0

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Segregated pension schemes transacting OTC derivatives have often sought credit downgrade triggers against the counterparty banks with whom they are transacting.  Banks are increasingly reluctant to offer these downgrade triggers. How should pension schemes respond?



1. What is a credit downgrade trigger?
An asymmetrical credit downgrade trigger typically allows pension fund trustees to move their OTC derivative positions transacted with one bank, to another counterparty bank on favourable terms. It may also specify that additional collateral (an Independent Amount) should be posted by the (downgraded) bank to the pension scheme. The improved terms for moving positions means that the scheme can, in theory,  move its positions away from the downgraded counterparty to a more secure counterparty without incurring the bid-offer spreads that would typically arise from such a transaction (See below for a more detailed explanation of how this has been documented in the ISDA). Alternatively, the posting of an Independent Amount is a means of mitigating the additional risk from facing a weaker counterparty bank.

In practice, novation, is really only desirable if there is in fact a more secure counterparty available in the market. Transitioning bid-offer spreads are borne by the downgraded bank. The asymmetrical nature of the clause means that this only applies to a deterioration in the credit quality of the bank (specifically to a downgrade below a specified rating by either Moody's or S&P). Historically, the rating trigger has been set to take effect following a downgrade below A- (S&P) or A3 (Moody's).

Pension schemes themselves have no credit rating** that can be referenced, although other events, which point to a deterioration in the credit worthiness of the pension scheme, can be (and are) referenced as events which would allow the bank to terminate the contracts it has in place on terms that are favourable to the bank.

It is worthwhile noting that while such downgrade triggers are common place in ISDAs, they are not present in GMRA (Global Master Repurchase Agreement) documentation under which repo transactions are executed. There are a number of reasons why this is the case:
- GMRA and gilt repo is a more recent addition to the pension fund toolkit
- if the repo market is the one "funding market" that can be expected to stay open in a stressed market environment then, arguably, it is sensible to negotiate market standard GMRAs, which would not include downgrade triggers. This is so as to ensure continued access to funding markets in stressed environments; under stressed market conditions, repo counterparties may be reluctant to offer funding lines to those counterparties who hold a downgrade trigger over them.


2. Why have credit downgrade triggers been important to pension schemes?
It is a benefit to have what was (is?) considered to be an option to either "upgrade" to a higher quality counterparty at no additional cost to the scheme or call for an Independent Amount from the downgraded bank. Especially if that option is exercisable under what is likely to be a stressed market environment. Pension schemes have typically viewed themselves as a high quality counterparty for the banks and have used this to manouvre a favourable position for themselves and secure these triggers.  There are many reasons why pension schemes may regard themselves as a high quality counterparty:
- the bank has recourse to the scheme's assets ahead of the scheme's liabilities
- typically the extent of hedging has not been large enough to envisage a situation where the scheme's assets would not be sufficient to meet the scheme's obligations under the derivatives being entered in to.

3. What has changed?
3.1. Reality bites
Firstly, there has been a general decline in credit ratings in the banking sector such that trigger levels which were once thought to be something that would never materialise have actually now been breached. The two most recent and notable occurrences were the "jump-to-default" of Lehman and the downgrading of Merrill Lynch. Banks are therefore very sensitised to the issue and are concerned, rightly so, about the financial impact of offering these downgrade triggers.

3.2. Systemic risk
Regulators are becoming increasingly concerned about the systemic risk to the banking sector from these triggers creating further liabilities for banks, potentially in an already stressed market environment.

For example this extract from the FSB's paper titled "Principles for reducing reliance on CRAs": "Firms should ensure that they have appropriate expertise and sufficient resources to manage the credit risk that they are exposed to. They may use CRA ratings as an input to their risk managements, but should not mechanistically rely on CRA ratings. Market participants and central counterparties should not use changes in CRA ratings of counterparties or of collateral assets as automatic triggers for large, discrete collateral calls in margin agreements on derivatives and securities financing transactions."

3.3. Central clearing

The advent of central clearing means that credit downgrade triggers will only be relevant in the future for trades which will still be bilaterally cleared. For UK pension schemes, this is likely to include inflation swaps - most clearing exchanges have been quite explicit that, at least initially,  inflation swaps are not a product they will offer. As the table below shows this is not an unreasonable stance since not only are inflation swaps a small proportion of the total OTC market (1.2%), they are also generally less central clearing friendly in that they are less likely (only between 0-10% of all trades) to exhibit the required properties of standardisation.

4. How have pension schemes and their advisers responded so far?

Pension schemes have continued to argue in favour of including credit downgrade triggers but are now prepared to accept that these will be at lower rating levels. It is now more common to see pension schemes pushing for a credit downgrade trigger to take effect below BBB flat or BBB  minus.

Pension schemes are also trying to negotiate a two stage process of calling for an Independent Amount to be posted following the downgrade below a first (higher) rating with the ability to close-out and novate on favourable terms following a downgrade below a second (lower) credit rating. Most banks have shown themselves to be amenable to both of these.

A minority of pension schemes have sought to restrict the amount of business they choose to transact with banks not willing to offer a credit downgrade trigger.

5. How are banks responding?

Banks are pressurising pension schemes and their advisers to eliminate all references to downgrade triggers. In general the actual actions taken have been to either offer the terms outlined in 4. above but a small number of banks have refused to sign up to ISDAs which include a credit downgrade trigger.

6. Are these responses appropriate and sufficient?

The responses we are witnessing are incremental in nature - evolutionary rather than revolutionary. This is approprite as an initial response, however a more comprehensive review and response is required. The current approach would appear to be:

1. Tweak the current credit downgrade trigger wording to either have a lower ratings triggers and/or an independent amount.

2. Rely on a combination of initial and ongoing due-diligence, counterparty diversification limits and collateral to provide the necessary protection.

So, what could we do differently?

It is instructive to look at the Additional Termination Events which banks currently specify against the scheme. What has been specified are events which may act as an early warning signal of imminent financial difficulties for the pension scheme, for example the Pensions Regulator ordering a wind up of the scheme.

Extrapolating from this, then one option may be to consider whether the current credit rating downgrade trigger could be replaced with a trigger linked to a capital adequency measure proposed under Basel 3. For example, Basel 3 has introduced a minimum capital conservation buffer which is intended to be available to be drawn down during periods of stress. If the buffer falls below the minimum then there are constraints on a bank's ability to distribute earnings. Similarly, pension schemes may link the posting of an Independent Amount or indeed the novation of swaps on favourable terms to a higher rated counterparty to a failure to meet the minimum capital conservation buffer.

7. Conclusion

My purpose here was to describe the issues around credit downgrade triggers and how pension schemes are responding to these issues. In doing so, I hope to stimulate a discussion about the continued appropriateness of these triggers. It is not the intention to argue for the abandonment of triggers to protect against a deterioration in the credit quality of the counterparty bank. Rather, the aim is to question the relevance of the current measures and suggest how one might go about deriving replacement measures.

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8. Other useful background reading

Allen & Overy, An Introduction to the documentation of OTC derivatives

Slaughter and May summary of the 2002 ISDA Master Agreement: http://www.slaughterandmay.com/media/38944/2002_isda_master_agreement_-_guide_to_principal_changes.pdf

Bank of England, Whither the credit ratings industry? Whither the credit ratings industry? Financial Stability Board, Principles for Reducing Reliance on CRA Ratings

 http://www.financialstabilityboard.org/publications/r_101027.pdf

* How are these determinations of "cost" arrived at?

Under the 1992 ISDA MasterAgreement there was a choice of early termination payment measures - either Market Quotation or Loss. However the financial crisis of 1997-98 showed these measures to be unstable during times of market stress and so work began on a new method, Close-out Amount.

Market Quotation
On an event of default or termination event applying to a party or transactions between the parties, the Non-defaulting Party or the party who was not the Affected Party (in the 2002 Agreement, referred to as the Determining Party) i.e. the pension scheme, could value the termination amount payable as a result of the event of default or termination event by asking market makers in the transactions in question what price they would pay (or would be willing to accept) to assume the rights and obligations of the defaulting party under the transactions in question. It provided a straightforward, non-subjective method for determining a termination payment. For that reason, the choice of Market Quotation was popular.

Loss
The Determining Party would simply calculate its total losses and costs in connection with the ISDA Master Agreement as at the relevant date. Certain guidelines were provided for this calculation but it was essentially a subjective test.

Close-out Amount

During the 1997-1998 financial crisis the strict methodology of Market Quotation was shown to be less than robust due to the inability to source market quotes. Also the lack of discipline or high degree of subjectivity in the Loss method was also exposed.  Post this crisis the Close-Out Amount methodoology was developed. This methodology was incorporated into the 2002 ISDA Master Agreement and on 27 February 2009 ISDA issued the Close-out Amount Protocol. According to ISDA "in launching the Close-Out Amount Protocol, ISDA is facilitating amendment of existing 1992 ISDA Master Agreements by replacing Market Quotation and, if elected, Loss with the Close-Out Amount approach".

Accordingly, in calculating its Close-out Amount, the non-defaulting party is required to calculate the amount of its losses and costs that are, or would be, incurred (similar to the 1992 Loss measure) in replacing or providing the economic equivalent of the payments and deliveries under the terminated transactions that would have been required but for the early termination (similar to the 1992 Market Quotation measure).

The definition of Close-out Amount goes on to provide a number of factors that the Determining Party may consider in assessing its losses and costs. Again, these provide a balance between the methods used in assessing Market Quotation and Loss in the 1992 Agreement. For example:

1. quotations from third parties, such quotations being permitted to take into account the creditworthiness of the Determining Party;
2. relevant market data provided by third parties; and
3. information of the type referred to in (a) and (b) from internal sources.

However, there is an important over-riding determination in assessing the Close-out Amount. The determining party must always use commercially reasonable procedures to produce a commercially reasonable result. (Source: Allens Arthur Robinson)

The following link will take you to the full text of the Close-out Amount Protocol.
http://www.isda.org/isdacloseoutamtprot/docs/isdacloseoutprot-text.pdf

** Bank credit departments will typically have their own internal methodology for ascribing a credit rating to entities which don't have any formal rating from a recognised ratings agency.