9 00 Rance

Credit Derivatives
Practicing Law Institute: Swaps and other Derivatives 2009
Credit Derivatives:
Usage, Practice and Issues
Don Bendernagel, Citigroup

Amy Kim, Morgan Stanley
Darren Littlejohn, Goldman Sachs
Brian Rance, Freshfields Bruckhaus Deringer
New York City, October 21, 2009
Credit Derivatives
Page 2
Outline of Presentation
• Introduction/General • Variants on Basic CDS
Background
• Big and Small Bang
• Basic Mechanics of a Credit Protocols
Default Swap
• Ongoing Industry Initiatives
• Synthetic CDOs/Basket and
• Interesting Legal and
Managed Trades
Documentation Issues
• Novation; Index
• CDS and the Financial Crisis
Transactions; Master
Confirmations/Matrix • Proposed Legislation
Supplement; NOLs
• Overview of Recent CDS

Documentation
1
Credit Derivatives
Page 3
Introduction/General Background
Credit Derivatives
Page 4
Credit Derivatives—General Background
• Facilitate the trading of credit risk
• Can replicate, in part, long or short cash positions on

an unfunded basis in corporate bonds or loans (or
other financial assets)
• By aggregating credit risk across obligors and

tranching that risk, credit default swaps can be used
to replicate collateralized debt obligation ("CDO")
transactions
2
Credit Derivatives
Page 5
Credit Derivatives—General Background
• Credit derivatives separate out the risk of loss due to default

from all of the risks of funding and owning a bond or loan
Ownership of a financial asset exposes the holder to each of the
following risks:
— Market risk (interest rate risk and currency risk)
— Liquidity risk
— Credit risk
• Credit derivatives allow institutions to acquire or dispose of credit

risk alone (although the market value of a Credit Derivative is
subject to fluctuation)
Credit Derivatives
Page 6
Credit Derivatives—Risks and Participants

• Increased risks of a credit derivative
— Somewhat less liquidity than the related cash market due to
restrictions on termination (although aggregate credit derivatives
market size is larger than the cash market for debt)
— Counterparty default risk under the credit default swap
— Legal Risk (due to application of Definitions)
• Participants
— Commercial banks/investment banks (as portfolio managers and as
dealers)
— Insurers/reinsurers
— Hedge funds
— Collateralized debt obligation and other investment funds
3
Credit Derivatives
Page 7
Credit Derivatives—Market Volume
• According to ISDA survey as of June 30, 2008:
— Aggregate notional amount outstanding of credit derivatives

decreased by 12% in the first six months of 2008 to $54.6
trillion from $62.2 trillion
— The annual growth for credit derivatives was 20% from $45.5
trillion at mid-year 2007
— For the purposes of the survey, credit derivatives comprise

credit default swaps referencing single names, indexes,
baskets, and portfolios
Credit Derivatives
Page 8
Credit Derivatives—Market Volume

• By comparison:
— Aggregate notional amount outstanding of interest rate

derivatives was $464.7 trillion. The annual growth rate for
interest rate derivatives to mid-2008 was 34%.
— Aggregate notional amount outstanding of equity derivatives

grew by 19% to $11.9 trillion from $10.0 trillion. The annual
growth rate for equity derivatives to mid-2008 was 19
percent to $11.9 trillion from $10.0 trillion at mid-year 2007.
• Accordingly, credit derivatives account for approximately 10% of

the total OTC derivatives market
4
Credit Derivatives
Page 9
Basic Mechanics of a
Credit Default Swap
Credit Derivatives
Page 10
Basic Mechanics of a Credit Default Swap
Credit default swap is a:

• Bilateral contract in which one party (the “Buyer”)
• Pays a periodic, fixed rate payment to another party
(the “Seller”)
• In exchange for protection related to the occurrence
of “Credit Events” related to a “Reference Entity” or
“Obligations” of that Reference Entity
5
Credit Derivatives
Page 11
Basic Mechanics of a Credit Default Swap
Fixed
Seller Buyer
Float ing
Synt het ically Synt het ically

" Long" t he " Short " t he
Credit and Credit and
" Short " t he " Long" t he
Prot ect ion Prot ect ion
Credit Derivatives
Page 12
Alternative/Related Form – Structured Note
Pu rch ase Pr ice
Issu er Ho ld er
Repayment
Syn t h et ically Principal + Syn t h et ically
" Sh o rt " t h e Interest* " Lo n g " t h e
Cr ed it an d Cr ed it an d
" Lo n g " t h e " Sh o r t " t h e
Pr o t ect io n Pro t ect io n
* If a Cr ed it Even t o ccu r s, Issu er m ay sat isf y it s

o b lig at io n s eit h er b y (a) if Ph ysical Set t lem en t ap p lies,
d eliver in g Deliver ab le Ob lig at io n s o r (b ) if Cash
Set t lem en t ap p lies, p ayin g less t h an 100% o f p r in cip al
b ased o n t h e Fin al Pr ice
6
Credit Derivatives
Page 13
Alternative/Related Form: Total Return Swap
Appreciat ion
Payment s
Int erest or
Dist ribut ions on
Ref erence
Obligat ions
Seller Buyer
Cost of carry
(t ypically LIBOR +
spread)
Depreciat ion
Payment (s)
Synt het ically Synt het ically
" Short " all " Long" all
economic risks economic risks
Credit Derivatives
Alternative/Related Form: Tranched Synthetic CDO Page 14
(often in Structured Note Form)

Po o l o f
Re f e r e n ce
O b lig at io n s
AAA/
A aa Se l l e r ( s) - A A / A a R i sk
C Se l l e r ( s) - B a a 3 / B B B - R i sk
A A /A a
B
Baa3/
BBB A Se l l e r ( s) - U n r a t e d R i sk
U n rated
Bu yer Se l l e r s
A - C u m u l a t i v e l o sse s u p t o 4 % o f e n t i r e p o r t f o l i o
B - A d d i t i o n a l c u m u l a t i v e l o sse s u p t o 1 2 % o f e n t i r e p o r t f o l i o
C - A d d i o n a l c u m u l a t i v e l o sse s u p t o 4 0 % o f e n t i r e p o r t f o l i o
L o sse s u su a l l y m e a su r e d t h r o u g h c a sh se t t l e m e n t
7
Credit Derivatives
Page 15
Credit Protection: Two Types of Settlement
Physical Settlement
• The right of the Buyer upon occurrence of a Credit Event
to deliver Deliverable Obligations to the Seller and to
receive from the Seller the Notional Amount (usually "par")
Cash Settlement
• The right of the Buyer upon occurrence of a Credit Event
to receive cash in an amount equal to (a) the Notional
Amount minus (b) the current market value of a Reference
Obligation
Credit Derivatives
Page 16
Documentation
• Based on 2003 ISDA Credit Derivatives Definitions published by
the International Swaps and Derivatives Association, Inc.
• Most credit derivatives are documented using ISDA credit

derivatives confirmations (or related language)
• Basic Form of Confirmation, together with May 2003 Supplement

relating to guarantees
• Given that trades are often intermediated by dealers or other

market-makers, it is important to have both:
— Uniformity (which ISDA is attempting to promote through the use of
standardized language in Confirmations)
— Objectivity (particularly because payoffs are binary)
8
Credit Derivatives
Page 17
Binary nature of CDS contracts and issues of

interpretation
• Binary nature of payoffs in credit default swaps create

potential for dispute
• Relative youth of the CDS documentation and market

means that unexpected facts have arisen, and will
continue to arise, that test the ISDA Credit Derivatives
Definitions
Credit Derivatives
Page 18
Documentation
• The Definitions make extensive use of fallback

provisions that will be deemed to apply if the parties
fail to make a specific election in a Confirmation
• The Definitions are intended to operate on a free-
standing basis and therefore, for most transactions,
there is no need to incorporate any other ISDA
definitions (such as the 2000 ISDA Definitions) into
the Confirmation of a Credit Derivative Transaction
9
Credit Derivatives
Page 19
Most Important Elements in any

Credit Default Swap
• Reference Entity
• Reference Obligation(s)
• Credit Events
• Settlement
Credit Derivatives
Like all ISDA Agreements: Page 20
The Confirmation is the Key
10
Credit Derivatives
Page 21
General Terms: Familiar Appearance
Credit Derivatives
Page 22
General Terms—Distinctions
• Same as any other financial derivative, except for

"Calculation Agent City", whose only importance is to
determine on which Business Day a notice may be
effectively given to the Calculation Agent
• Calculation Agent has duties that involve discretionary
determinations that go beyond the scope required by a
typical fixed income financial derivative
• Note that Effective Date and Scheduled Termination Date
are not subject to adjustment in accordance with any
Business Day Convention unless specified in a
Confirmation
11
Credit Derivatives
Page 23
Reference Entity: Simple (or so it seems)
Credit Derivatives
Page 24
Identifying the Correct Reference Entity
• Vitally important to identify the correct Reference

Entity
• Holding company, operating company, etc.

structure requires attention to detail
• Note issue of identification of Armstrong World

Industries in dispute between two major dealers
12
Credit Derivatives
Page 25
Reference Entity and “Successors”
• The 2003 Definitions define the “Reference Entity” as

each entity specified as such in the related
Confirmation and any “Successor”
• In defining “Successor”, the 2003 Definitions

incorporate the provisions of the Supplement
published on November 28, 2001 by ISDA specifying
consequences with respect to Succession Events and
certain Credit Events
Credit Derivatives
Page 26
Succession Events
• “Succession Events” means an event such as a

merger, consolidation, amalgamation, transfer of
assets or liabilities, demerger, spin-off or other similar
event in which one entity succeeds to the obligations
of another entity, whether by operation of law or
pursuant to any agreement
• Does not include an event in which the holders of
obligations of the Reference Entity exchange such
obligations for the obligations of another entity, unless
such exchange occurs in connection with an event
described above
13
Credit Derivatives
Page 27
Successor Issues in Practice

AT&T/Comcast—not a simple transaction:
AT&T will assign and transfer to AT&T Broadband, a newly formed holding company for AT&T's broadband business, all of the
assets of AT&T's broadband business (as reflected in the AT&T Broadband Group balance sheet dated as of December 31, 2000
or as otherwise specified in the separation and distribution agreement between AT&T and AT&T Broadband) that are not at such
time assets of AT&T Broadband or an AT&T Broadband subsidiary.
At the same time, AT&T Broadband will assume all of the liabilities of AT&T's broadband business (as reflected in the AT&T
Broadband Group balance sheet dated as of December 31, 2000 or as otherwise specified in the separation and distribution
agreement between AT&T and AT&T Broadband) that are not at such time liabilities of AT&T Broadband or an AT&T Broadband
subsidiary.
Following the separation, AT&T will spin off AT&T Broadband to its shareholders by distributing one share of AT&T Broadband
common stock to each holder of record of a share of AT&T common stock as of the close of business on the record date for the
AT&T Broadband spin-off, which we refer to as the "AT&T Broadband spin-off".
Immediately following the AT&T Broadband spin-off, AT&T Broadband will merge with AT&T Broadband Acquisition Corp., a newly
formed, wholly owned subsidiary of AT&T Comcast, with AT&T Broadband continuing as the surviving corporation. In the AT&T
Broadband merger, AT&T Broadband shareholders will receive the merger consideration.
At approximately the same time as the AT&T Broadband merger, Comcast will merge with Comcast Acquisition Corp., a newly
formed, wholly owned subsidiary of AT&T Comcast, with Comcast continuing as the surviving corporation. In the Comcast merger,
Comcast shareholders will receive the merger consideration.
After the mergers, Comcast and AT&T Broadband will each be a wholly owned subsidiary of AT&T Comcast and the former
shareholders of Comcast and AT&T Broadband will be shareholders of AT&T Comcast.
Credit Derivatives
Page 28
Successor Issues in Practice
• The various successor entities will have different credit

standings. The outcome is vitally important from an economic
point of view.
• From a legal point of view, obtaining the necessary information

to determine the outcome may be difficult. Access to full text of
various bond indentures is required. They may not always be
publicly available.
• The definitions of “Successor” and “Successor Event” can lead

to unsatisfactory results for both Buyer and Seller.
14
Credit Derivatives
Page 29
Operation of the “Successor” Provisions
• The diagram on the following two slides illustrates the

decision process to follow to determine the “Successor”
• “Relevant Obligations” defined as the Obligations

constituting Bonds and Loans of the Reference Entity
outstanding immediately prior to the effective date of the
Succession Event, excluding any debt obligations
outstanding between the Reference Entity and any of its
Affiliates, as determined by the Calculation Agent
Credit Derivatives
D id th e p a rtie s e le c t Page 30
R e s u lts L e ft to
to h a v e th e No
C o n tra c t L a w
S u p p le m e n t a p p ly ?
Yes
H a s a S u c c e s s io n
No N o C hange
E v e n t O c c u rre d ?
Yes
D id a n E n tity s u c c e e d
T h a t E n tity is th e
to 7 5 % o r m o re o f th e Yes
s o le S u c c e s s o r
R e le v a n t O b lig a tio n s ?
No
D id o n ly o n e E n tity s u c c e e d to
m o re th a n 2 5 % o f th e R e le v a n t
S u c c e e d in g E n tity is
O b lig a tio n s , b u t n o t m o re th a n Yes
th e s o le S u c c e s s o r
2 5 % re m a in s w ith th e o rig in a l
R e fe re n c e E n tity ?
No
D id m o re th a n o n e E n tity
E a c h s u c c e e d in g
s u c c e e d to m o re th a n 2 5 % o f th e
E n tity w ill b e a
R e le v a n t O b lig a tio n s , b u t n o t Yes
S u c c e s s o r (a n d
m o re th a n 2 5 % re m a in s w ith th e
2 .2 (d ) w ill a p p ly )
o rig in a l R e fe re n c e E n tity ?
No
15
Credit Derivatives
Page 31
No
Did one or more Entities succeed Each succeeding
to more than 25% of the Entity and the original
Relevant Obligations, but more Yes Reference Entity will
than 25% remains with the be a Successor (and
original Reference Entity? 2.2(d) will apply)
No
Did one or more Entities succeed
to part of Bonds and Loans, but
no Entity succeeds to more than
Yes No Change
25% of Relevant Obligations, and
the Reference Entity continues to
exist?
No
One or more Entities succeed to

part of Bonds and Loans, but no Entity that succeeds
Entity succeeds to more than to greatest % of
Yes
25% of Relevant Obligations, and Bonds and Loans is
the Reference Entity does not the sole Successor
continue to exist
Credit Derivatives
Page 32
Reference Obligations
16
Credit Derivatives
Page 33
Reference Obligations—Usage
• Reference Obligations help to define "Obligations", which are the

"reference point" for determining whether certain Credit Events
have occurred
• Reference Obligations must be specified for a Credit Default

Swap to which Cash Settlement applies—price quotations are
given with respect to the Reference Obligations
• If the Reference Obligations are redeemed (or certain other

events occur, which could include an event resulting from a
Succession Event), then "Substitute Reference Obligations" will
be identified by the Calculation Agent
Credit Derivatives
Page 34
Reference Obligation—Back End Identification
• Where Cash Settlement is applicable, some Confirmations

provide that the Reference Obligation is identified after the
Event Determination Date (as opposed to on the Trade
Date)
• Preserves, in the context of Cash Settlement, the Buyer's

flexibility to identify the equivalent of the "Deliverable
Obligations" that determine the economic outcome of
Physical Settlement
17
Credit Derivatives
Page 35
Buyer pays Fixed Payments*
*Note that Fixed Payment can be payment of floating amount (e.g., LIBOR)
Credit Derivatives
Page 36
Fixed Payments
• Buyer pays Fixed Payments on
• Each Fixed Rate Payer Payment Date
• (for the related Calculation Period)
• In an amount equal to the product of:
No. Days
Fixed Rate * Fixed Rate Payer Calc Amount *
360
18
Credit Derivatives
Page 37
Floating Payment—Possible Elections
Credit Derivatives
Page 38
Floating Payment—Typical Elections
19
Credit Derivatives
Page 39
Floating Payment
• Upon the occurrence of a Credit Event applicable

to a Credit Default Swap and
• Satisfaction of all of the Conditions to Settlement
• The parties must perform their respective

obligations in accordance with the applicable
Settlement Method
Credit Derivatives
Page 40
Conditions to Settlement—Depends Upon

Settlement Method Chosen
• If Cash Settlement is specified, (1) Credit Event

Notice and (2) if specified as applicable in the related
Confirmation, Notice of Publicly Available Information
• If Physical Settlement is specified, (1) Credit Event

Notice, (2) Notice of Physical Settlement and (3) if
specified as applicable in the related Confirmation,
Notice of Publicly Available Information
20
Credit Derivatives
Page 41
Credit Event Notice
• Delivery of a Credit Event Notice by the Notifying Party

that is effective during the Notice Delivery Period
• Credit Event Notice describes a "Credit Event" that
occurred on or after the Effective Date and on or prior to
the Scheduled Termination Date (subject to extension in
limited circumstances) or, if relevant, the
Repudiation/Moratorium Evaluation Date
• Notifying Party is usually not only Buyer but also Seller
because Seller does not want to wait for exercise to occur
while Reference Entity deteriorates in credit quality
(particularly if Seller has an offsetting hedge)
Credit Derivatives
Page 42
Notice Delivery Period
The period from and including the Effective Date to and including
the date that is 14 calendar days after:
• The Scheduled Termination Date
• The Grace Period Extension Date if (i) Grace Period Extension is
applicable, (ii) the Credit Event that is the subject of the Credit Event Notice is a
Failure to Pay that occurs after the Scheduled Termination Date and (iii) the
Potential Failure to Pay with respect to such Failure to Pay occurs on or prior to
the Scheduled Termination Date
• The Repudiation/Moratorium Evaluation Date if (i) the Credit Event

that is the subject of the Credit Event Notice is a Repudiation/Moratorium that
occurs after the Scheduled Termination Date, (ii) the Potential
Repudiation/Moratorium with respect to such Repudiation/Moratorium occurs on
or prior to the Scheduled Termination Date and (iii) the Repudiation/Moratorium
Extension Condition is satisfied
21
Credit Derivatives
Page 43
Notice of Publicly Available Information
• Irrevocable notice from the party delivering the relevant

Credit Event Notice or Repudiation/Moratorium Extension
Notice (which may be by telephone) to the other party
• E-mail notice given operational challenges in large
corporate defaults
• Citing Publicly Available Information confirming the
occurrence of the Credit Event or Potential
Repudiation/Moratorium, as applicable
• Containing a copy, or a description in reasonable detail, of
the relevant Publicly Available Information
Credit Derivatives
Page 44
Publicly Available Information
Generally speaking:
• Information that reasonably confirms any of the facts

relevant to the determination that the Credit Event or
Potential Repudiation/Moratorium has occurred
• Which has been published in or on not less than the

Specified Number (usually “Two”) of internationally
recognized published or electronically displayed news
sources (usually “Standard Public Sources”) such as The
Wall Street Journal, Bloomberg, Financial Times, etc.
22
Credit Derivatives
Page 45
Publicly Available Information
May Also Be:

• Received from (A) a Reference Entity that is not a party to
the Credit Derivative Transaction or (B) a trustee, fiscal
agent, administrative agent, clearing agent or paying agent
for an Obligation
• Contained in any bankruptcy petition or filing
• Contained in any order, decree or notice, however
described, of a court, tribunal, regulatory authority or
similar administrative or judicial body
Credit Derivatives
Page 46
Notice of Physical Settlement
• Notice from Buyer to Seller that irrevocably confirms that

Buyer will require performance in accordance with the
Physical Settlement Method
• Must contain a detailed description (including CUSIP or
ISIN number, if available) of the Deliverable Obligations
that Buyer will, subject to provisions to be discussed,
Deliver to Seller
• If Notice is not delivered by Buyer on or before the 30th
calendar day (subject to Business Day adjustment) after
the Event Determination Date, the Transaction terminates
(with no further obligation of either party)
23
Credit Derivatives
Page 47
Credit Events: Possible Choices
Credit Derivatives
Page 48
Credit Events: Typical Choices
24
Credit Derivatives
Page 49
Bankruptcy (Tied to Reference Entity Only)
• Uses standard language, with minor

modifications, from Section 5(a)(vii) of the 1992
ISDA Master Agreement
• In structured transactions, rating agencies
sometimes insist on modifications because of
concerns over subjectivity of certain of the
clauses
Credit Derivatives
Page 50
Bankruptcy (cont’d)
• Subjectivity of some aspects of the definition:
— Becomes "insolvent": Bankruptcy Code or state law

insolvency definition? Johns Manville? Tobacco
companies?
— Unable to pay its debts as they become due: Liquidity

crisis?
25
Credit Derivatives
Page 51
“Bankruptcy” means a Reference Entity:

— (a) is dissolved (other than pursuant to a consolidation, amalgamation or
merger);
— (b) becomes insolvent or is unable to pay its debts or fails or admits in writing in
a judicial, regulatory or administrative proceeding or filing its inability generally to
pay its debts as they become due;
— (c) makes a general assignment, arrangement or composition with or for the

benefit of its creditors;
— (d) institutes or has instituted against it a proceeding seeking a judgment of

insolvency or bankruptcy or any other relief under any bankruptcy or insolvency
law or other similar law affecting creditors' rights, or a petition is presented for its
winding-up or liquidation, and, in the case of any such proceeding or petition
instituted or presented against it, such proceeding or petition (i) results in a
judgment of insolvency or bankruptcy or the entry of an order for relief or the
making of an order for its winding-up or liquidation or (ii) is not dismissed,
discharged, stayed or restrained in each case within thirty calendar days of the
institution or presentation thereof;
Credit Derivatives
Page 52
Practical Issues
— (e) has a resolution passed for its winding-up, official management or liquidation
(other than pursuant to a consolidation, amalgamation or merger);
— (f) seeks or becomes subject to the appointment of an administrator, provisional

liquidator, conservator, receiver, trustee, custodian or other similar official for it or
for all or substantially all its assets;
— (g) has a secured party take possession of all or substantially all its assets or has
a distress, execution, attachment, sequestration or other legal process levied,
enforced or sued on or against all or substantially all its assets and such secured
party maintains possession, or any such process is not dismissed, discharged,
stayed or restrained, in each case within thirty calendar days thereafter; or
— (h) causes or is subject to any event with respect to it which, under the
applicable laws of any jurisdiction, has an analogous effect to any of the events
specified in clauses (a) to (g) (inclusive).
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Credit Derivatives
Page 53
Practical Issues
• Bankruptcy Credit Event
— Fannie/Freddie
— Bradford & Bingley
— Tembec
— General Motors
Credit Derivatives
Page 54
Failure to Pay
• After the expiration of any applicable (or deemed) Grace

Period (after the satisfaction of any conditions precedent to
the commencement of such Grace Period)
• The failure by a “Reference Entity” to make, when and
where due
• Any payments in an aggregate amount of not less than the
“Payment Requirement”
• Under one or more “Obligations”
• In accordance with the terms of such Obligations at the
time of such failure
27
Credit Derivatives
Page 55
Failure to Pay (cont’d)
• Grace Period. There is a deemed Grace Period of 3

Business Days for Obligations that, at the later of the
Trade Date and the date as of which they are issued or
incurred, either do not provide for a grace period or
provide for a Grace Period of less than 3 Business Days
• Grace Period Extension may be specified
Credit Derivatives
Page 56
Restructuring
• With respect to one or more “Obligations”

• In relation to an aggregate amount of not less than the
“Default Requirement”
• One or more specified events occurs in a form that binds
all holders of such Obligation(s) and
• Such event is not expressly provided for under the terms
of such Obligation in effect as of the later of the Trade
Date and the date as of which such Obligation is issued or
incurred
28
Credit Derivatives
Page 57
Restructuring (cont’d)—Specified Events
• A reduction in the rate or amount of interest payable or the

amount of scheduled interest accruals
• A reduction in the amount of principal or premium payable at
maturity or at scheduled redemption dates
• A postponement or other deferral of a date or dates for either (A)
the payment or accrual of interest or (B) the payment of principal
or premium
• A change in the ranking in priority of payment of any Obligation,
causing the Subordination of such Obligation
• Any change in the currency or composition of any payment of
interest or principal to any currency that is not a Permitted
Currency
Credit Derivatives
Page 58
Restructuring (cont’d)—Subordination
• “Subordination” defined as a contractual, trust or similar arrangement
providing that (i) upon the liquidation, dissolution, reorganization or
winding up of the Reference Entity, claims of the holders of the Senior
Obligation will be satisfied prior to the claims of the holders of the
Subordinated Obligation or (ii) the holders of the Subordinated
Obligation will not be entitled to receive or retain payments in respect of
their claims against the Reference Entity at any time that the Reference
Entity is in payment arrears or is otherwise in default under the Senior
Obligation. For purposes of determining whether Subordination exists
or whether an obligation is Subordinated with respect to another
obligation, the existence of preferred creditors arising by operation of
law or of collateral, credit support or other credit enhancement
arrangements shall not be taken into account, except that,
notwithstanding the foregoing, priorities arising by operation of law shall
be taken into account where the Reference Entity is a Sovereign.
29
Credit Derivatives
Page 59
Restructuring (cont’d)—Permitted Currency

• “Permitted Currency” defined as (1) the legal tender of any
Group of 7 country (or any country that becomes a member of
the Group of 7 if such Group of 7 expands its membership) or (2)
the legal tender of any country which, as of the date of such
change, is a member of the Organization for Economic
Cooperation and Development and has a local currency long-
term debt rating of either AAA or higher assigned to it by
Standard & Poor's, a division of The McGraw-Hill Companies,
Inc. or any successor to the rating business thereof, Aaa or
higher assigned to it by Moody's Investors Service, Inc. or any
successor to the rating business thereof or AAA or higher
assigned to it by Fitch Ratings or any successor to the rating
business thereof.
Credit Derivatives
Page 60
Restructuring (cont’d)—Key Exceptions

• The occurrence of any of the Restructuring events in
circumstances where such event does not directly or indirectly
result from a deterioration in the creditworthiness or financial
condition of the Reference Entity [SUBJECTIVE]
• The payment in euros of interest or principal in relation to an
Obligation denominated in a currency of a Member State of the
European Union that adopts or has adopted the single currency
in accordance with the Treaty establishing the European
Community, as amended by the Treaty on European Union
• The occurrence of any of the Restructuring events due to an
administrative adjustment, accounting adjustment or tax
adjustment or other technical adjustment occurring in the
ordinary course of business
30
Credit Derivatives
Page 61
Restructuring—Some Examples
• Conseco
• Xerox
• Solutia
Credit Derivatives
Page 62
Conseco
• Background: Conseco’s decline began with the purchase of Greentree
Financial in April 1998 for $6.2 billion. The underperformance of this
subsidiary led, in the spring of 2000, to the resignation of CEO Steven
Hilbert and the June 2000 hiring of Gary Wendt, former CEO of GE
Capital. Wendt began a program of asset sales, but with over a billion
dollars of bank debt due in September, he needed to negotiate an
extension to provide time for the sale of the non-core assets.
• Triggering Event: In September 2000, Conseco announced agreement
providing for repayment of $650 million to banks and 15-month
extension of $571 million of bank debt to be financed by asset sales and
an acceleration of $300 million on $1.5 billon of bank debt due in
September 2003. Bank debt extension was accompanied by an
increase in the loan interest rate from L+50 bp to L+250 bp and receipt
by the lenders of additional collateral resulting in structural
subordination of the bonds.
31
Credit Derivatives
Page 63
Conseco: Actions Taken in Response

• Holders of default protection, which included banks hedging short-term loans to
Conseco, exercised rights. Using the 1999 ISDA Definitions, they took advantage
of the “cheapest to deliver” option by delivering longer maturity deep discount
bonds trading in the 65-80% range. At the same time, shorter dated obligations,
mostly the loans held by banks, traded at higher prices. Protection buyers were
able to make a gain by selling the higher priced loans and purchasing the
cheaper assets to settle the protection.
• Market trading levels after Restructuring:
— Loan Dollar Price: 92 (loss on loans of 8%)
— 30 yr. Bond Price: 68 (gain on hedge of 32%)
• Resulted in the adoption of Modified Restructuring definition in the U.S. in order
to reduce the economic impact of the Cheapest-to-Deliver option.
Credit Derivatives
Page 64
Xerox
• Market participants had long feared the October 2002

maturity of Xerox’s $7 billion revolving credit facility. On 21
June 2002, Xerox announced a renegotiation of the facility,
paying down $2.8 billion and refinancing the remaining
$4.2 billion. The financing consisted of three loans totalling
$2.7 billion (maturing on 15th September 2002 to 30th
April 2005) and a $1.5 billion revolver.
32
Credit Derivatives
Page 65
Solutia
• Solutia announced on 19 July 2002 that it had reached an

agreement with its banks to extend the maturity of a 5-year
maturing revolving loan facility for two years, and to reduce
the facility from $800 million to $600 million. The $200
million paid to the banks came from a bond issued two
weeks earlier.
Credit Derivatives
Page 66
Restructuring Alternatives
• Old-R: The version in the 1999 Definitions prior to the adoption of

the Restructuring Supplement
• Mod-R: When Buyer triggers, maturity of Deliverable Obligations
is limited and Deliverable Obligations must be fully transferable
• Mod-Mod-R: Maturity of Deliverable Obligations is limited and
Deliverable Obligations may be conditionally transferable
• No-R: Removal of Restructuring as a Credit Event
• Sovereign Restructured Deliverable Obligations: only need to
satisfy Deliverable Obligation Characteristics pre-Restructuring
33
Credit Derivatives
Page 67
Restructuring: Old-R
• Restructuring does not include “circumstances where such

event does not directly or indirectly result from a
deterioration in the creditworthiness or financial condition
of the Reference Entity”
• However, even when such circumstances are excluded,

the Buyer still has the ability to use “cheapest to deliver”
option to sell a defaulted obligation at a higher price and
purchaser another obligation at a lower price and then
deliver the lower priced obligation in settlement
Credit Derivatives
Page 68
Restructuring Alternatives: Mod-R (used
primarily for North American credits)
• If Physical Settlement and "Restructuring Maturity

Limitation and Fully Transferable Obligation Applicable"
are specified in a Confirmation and Restructuring is the
only Credit Event specified in a Credit Event Notice
delivered by Buyer
• Then a Deliverable Obligation may be specified in the

Notice of Physical Settlement only if it
— is a “Fully Transferable Obligation” and
— has a final maturity date not later than the “Restructuring

Maturity Limitation Date”
34
Credit Derivatives
Page 69
Restructuring Alternatives: “Fully Transferable

Obligation”
• A Deliverable Obligation that is either
— “Transferable”, in the case of Bonds, or
— capable of being assigned to all “Eligible Transferees” without the
consent of any person being required, in the case of any
Deliverable Obligation other than Bonds
• Any requirement that notification of transfer of a Deliverable

Obligation be provided to a trustee or other agent for a
Deliverable Obligation shall not be considered to be a
requirement for consent
• Determination made as of the Delivery Date for the Deliverable
Obligation, taking into account only the terms of the Deliverable
Obligation and any related transfer or consent documents which
have been obtained by Buyer
Credit Derivatives
Page 70
Restructuring Alternatives: “Restructuring

Maturity Limitation Date”
• Earlier of
— 30 months following the Restructuring Date (legally effective date of
the Restructuring)
— The latest final maturity date of any Restructured Bond or Loan
• PROVIDED that, under no circumstances shall the Restructuring

Maturity Limitation Date be
— earlier than the Scheduled Termination Date (and, if it would be,
then the Restructuring Maturity Limitation Date will be the
Scheduled Termination Date) or
— later than 30 months following the Scheduled Termination Date

(and, if it would be, the Restructuring Maturity Limitation Date will
be 30 months following the Scheduled Termination Date)
35
Credit Derivatives
Page 71
“Transferable”
• An obligation that is transferable to institutional investors without

any contractual, statutory or regulatory restriction
• None of the following shall be considered contractual, statutory
or regulatory restrictions:
— contractual, statutory or regulatory restrictions that provide for
eligibility for resale pursuant to Rule 144A or Regulation S
promulgated under the Securities Act of 1933(and any contractual,
statutory or regulatory restrictions promulgated under the laws of
any jurisdiction having a similar effect in relation to the eligibility for
resale of an obligation) or
— restrictions on permitted investments such as statutory or
regulatory investment restrictions on insurance companies and
pension funds
Credit Derivatives
Page 72
“Eligible Transferee”
• Includes:
— Any bank or other financial institution, an insurance or reinsurance
company, a mutual fund, unit trust or similar collective investment
vehicle or a registered or licensed broker or dealer, in each case,
with total assets of at least $500 million
— An Affiliate of an entity specified above
— Any other entity that is an investment vehicle that (1) has total
assets of at least $100 million or (2) is one of a group of investment
vehicles under common control or management having, in the
aggregate, total assets of at least $100 million
— Any other entity that has total assets of at least $500 million
36
Credit Derivatives
Page 73
Sovereign Restructured Deliverable Obligations
• If a Restructuring occurs in respect of the Obligation of a

Sovereign Reference Entity which was otherwise a
Deliverable Obligation, such “Sovereign Restructured
Deliverable Obligation” will remain Deliverable even if after
(and whether or not as a result of) such Restructuring it no
longer falls within the Deliverable Obligation Category or
no longer satisfies the Deliverable Obligation
Characteristics
Credit Derivatives
Page 74
Restructuring Alternatives: Mod-Mod-R (used

primarily for European credits)
• If Physical Settlement and "Modified Restructuring Maturity
Limitation and Conditionally Transferable Obligation
Applicable" are specified in a Confirmation and
Restructuring is the only Credit Event specified in the
Credit Event Notice
• Then a Deliverable Obligation may be specified in the

Notice of Physical Settlement only if it
— is a “Conditionally Transferable Obligation” and
— has a final maturity date not later than the applicable

“Modified Restructuring Maturity Limitation Date”
37
Credit Derivatives
Page 75
Restructuring Alternatives: “Conditionally

Transferable Obligation”
• Deliverable Obligation that is either
— “Transferable”, in the case of Bonds, or
— capable of being assigned to all “Modified Eligible Transferees”
without the consent of any person being required, in the case of
any Deliverable Obligation other than Bonds
• PROVIDED that a Deliverable Obligation other than Bonds will be a
Conditionally Transferable Obligation notwithstanding that consent is
required for such transfer so long as the terms of such Deliverable
Obligation provide that such consent may not be unreasonably withheld
or delayed
• Any requirement that notification of transfer of a Deliverable Obligation
be provided to a trustee or other agent for a Deliverable Obligation shall
not be considered to be a requirement for consent
Credit Derivatives
Page 76
Restructuring Alternatives: “Modified

Restructuring Maturity Limitation Date”
• Later of
— The Scheduled Termination Date and
— 60 months following the Restructuring Date (in the

case of a Restructured Bond or Loan) or 30
months following the Restructuring Date (in the
case of all other Deliverable Obligations)
38
Credit Derivatives
Page 77
“Modified Eligible Transferee”
• Any bank, financial institution or other entity
• Which is regularly engaged in or established for the

purpose of making, purchasing or investing in loans,
securities and other financial assets
Credit Derivatives
Page 78
Restructuring Alternatives: No-R
• Exclude “Restructuring” as a Credit Event

• Protection using this alternative should be the cheapest to
purchase at the outset
• Query: When does Restructuring provide protection to a
Buyer that is not provided by Failure to Pay and
Bankruptcy?
• Exclusion of “Restructuring” may result in a loss of
regulatory capital benefits of entering into a Credit
Derivative Transaction, although this is under discussion
with the Credit Risk Mitigation Subgroup of the Basel
Committee
39
Credit Derivatives
Page 79
Restructuring: Multiple Holder Obligation

• Exclusion of restructurings in connection with bilateral loans from
the Restructuring Credit Event. In order for the restructuring of
an Obligation to trigger the Restructuring Credit Event, there
must be more than three holders of the Obligation and the
Obligation must require at least 66 2/3% to consent to the event
which would otherwise constitute a Restructuring
• Does not affect deliverability of a bilateral loan; still capable of

being delivered (assuming it meets the definition of "Deliverable
Obligation" and, if applicable, the Restructuring Maturity
Limitation provisions) even though its restructuring cannot trigger
a Restructuring Credit Event
Credit Derivatives
Page 80
Restructuring: Multiple Exercise
• Permits a Notifying Party, when the Credit Event is

“Restructuring”, to deliver a Credit Event Notice with respect to
less than all of the Floating Rate Payer Calculation Amount
(subject to a minimum amount) and to deliver more than one
Credit Event Notice (the “Exercise Amount”)
• If a Credit Event Notice is delivered with respect to less than all

the outstanding Floating Rate Payer Calculation Amount, the
rights and obligations of the parties will be construed as if they
had entered into two Credit Derivative Transactions (one
exercised and the other unexercised)
40
Credit Derivatives
Page 81
Disfavored Credit Events

• Obligation Default (i.e., “cross default”)
— Hair Trigger/Immaterial Defaults May Trip It
• Obligation Acceleration (i.e., “cross acceleration”)

— Sometimes used
— Most believe that “Bankruptcy” and “Failure to Pay” are
adequately protective
• Repudiation/Moratorium (only relevant for Sovereigns)

• In the US, Restructuring
— Considered subjective; less relevant to high yield bond
market
Credit Derivatives
Page 82
Repudiation/Moratorium (for “Sovereigns”)
• The occurrence of both of the following events:

— An authorized officer of a Reference Entity or a Governmental
Authority (x) disaffirms, disclaims, repudiates or rejects, in whole or
in part, or challenges the validity of, one or more Obligations in an
aggregate amount of not less than the Default Requirement or (y)
declares or imposes a moratorium, standstill, roll-over or deferral,
whether de facto or de jure, with respect to one or more Obligations
in an aggregate amount of not less than the Default Requirement
and
— A Failure to Pay, determined without regard to the Payment
Requirement, or a Restructuring, determined without regard to the
Default Requirement, with respect to any such Obligation occurs on
or prior to the Repudiation/Moratorium Evaluation Date
41
Credit Derivatives
Page 83
Credit Events: Reference Obligations vs.

“Obligations”
• Each Credit Event other than the Bankruptcy

Credit Event occurs with respect to “Obligations”
• “Obligations” are typically defined more broadly

than just the “Reference Obligations”
Credit Derivatives
Page 84
Obligations: Possible Elections
42
Credit Derivatives
Page 85
Obligations: Typical Election
Credit Derivatives
Page 86
Market Issues with Other Alternatives
• Payment—Too Broad
• Reference Obligations Only—Too Narrow
• Bond—Too Narrow
• Loan—Too Narrow
• Bond or Loan—Too Narrow
43
Credit Derivatives
Page 87
Guarantees
• “All Guarantees” means that any “Qualifying Guarantee”

will constitute an “Obligation”
• Otherwise, only a “Qualifying Affiliate Guarantee” will
constitute an “Obligation”
• These provisions were modified by the May 2003
Supplement
• Guarantees that are not Qualifying Affiliate Guarantees
may be subject to enforceability issues due to lack of
consideration/fraudulent transfer/Section 548 of the
Bankruptcy Code
Credit Derivatives
Page 88
Qualifying Guarantee
• An arrangement evidenced by a written instrument
• Pursuant to which a Reference Entity irrevocably

agrees (by guarantee of payment or equivalent legal
arrangement)
• To pay all amounts due under an obligation (the

"Underlying Obligation") for which another party is the
obligor (the "Underlying Obligor")
44
Credit Derivatives
Page 89
Qualifying Guarantee (cont’d)
• Qualifying Guarantees do not include any arrangement:

— Structured as a surety bond, financial guarantee insurance policy,
letter of credit or equivalent legal arrangement or
— Pursuant to the terms of which the payment obligations of the
Reference Entity can be discharged, reduced or otherwise altered
or assigned (other than by operation of law) as a result of the
occurrence or non-occurrence of an event or circumstance (other
than payment)
• The benefit of a Qualifying Guarantee must be capable of being

Delivered together with the Delivery of the Underlying Obligation
Credit Derivatives
Page 90
Qualifying Affiliate Guarantee
• A Qualifying Guarantee provided by a Reference Entity in

respect of an Underlying Obligation of a Downstream Affiliate of
that Reference Entity
• A “Downstream Affiliate” is an entity whose outstanding Voting

Shares were, at the date of issuance of the Qualifying
Guarantee, more than 50% owned, directly or indirectly, by the
Reference Entity
• “Voting Shares” are shares or other interests that have the power
to elect the board of directors or similar governing body of an
entity
45
Credit Derivatives
Page 91
Treatment of Qualifying Guarantees
• For purposes of the application of the Obligation

Characteristics (and, to be discussed later, the Deliverable
Obligation Characteristics), both a Qualifying Guarantee
and its Underlying Obligation must satisfy on the relevant
date of the applicable Obligation Characteristics (or
Deliverable Obligation Characteristics), if any, specified in
the related Confirmation from the following list: Not
Subordinated, Specified Currency, Not Sovereign Lender,
Not Domestic Currency and Not Domestic Law
Credit Derivatives
Page 92
Settlement—Physical Settlement
Was Originally Preferred
• Originally, Cash Settlement was seldom used except in structured
transactions such as synthetic CDOs in which Physical Settlement is not
a viable option
• Buyer prefers Physical Settlement because it does not have to risk bad
price determination
• Seller prefers Physical Settlement because (a) it believes it is in a better

position to get "best price" for Deliverable Obligations and (b) it doesn't
have to risk bad price determination
• But difficulties in effecting settlements among multiple counterparties

has led market participants to adopt auction protocols when dealing with
specific Reference Entities that have become the subject of Credit
Events. Discussed in greater detail in a subsequent portion of this
outline.
46
Credit Derivatives
Page 93
Cash Settlement
• The Floating Rate Payer must pay (a) the Floating Rate
Payer Calculation Amount multiplied by (b) the difference
between the Reference Price and the Final Price
• The Final Price is a price determined by a specified

Valuation Method
Credit Derivatives
Page 94
Cash Settlement—Valuation Method
• Final Price is expressed as a percentage and based on

Quotations obtained from at least two Dealers by the
Calculation Agent on one or more Valuation Dates
• Generally, the Quotations are firm Bids and the Highest Bid
obtained on a specified Valuation Date (or, less commonly,
the average of the Highest Bids obtained on each Valuation
Date) will represent the Final Price. Alternatively, the parties
may agree to determine the Final Price on a "Market" basis
where for each Valuation Date the high and low Quotations
are discarded and the remaining Quotations are averaged.
47
Credit Derivatives
Page 95
Cash Settlement—Valuation Method
• If no firm Bids are obtained within specified periods,

the Final Price is deemed to be zero. Indicative
quotes are not used.
• See discussion below under “Recent

Developments" on auction process.
Credit Derivatives
Page 96
Physical Settlement
• Seller pays Floating Rate Payer Calculation

Amount (typically) to Buyer
• Against delivery by Buyer to Seller of Deliverable

Obligations
48
Credit Derivatives
Page 97
Physical Settlement – Bond Buy-in Procedures:

• Under the 2003 Definitions, a new provision was added to
change what occurs when a Buyer fails to deliver the Deliverable
Obligation(s) specified in the Notice of Physical Settlement
• Under the 1999 Definitions, if a Buyer did not make timely
delivery the transaction could terminate with the Buyer not
receiving any payment even though a Credit Event had occurred
• Under the 2003 Definitions, a transaction will not terminate and
the Buyer will continue to have the right to deliver the specified
Deliverable Obligation(s) or the Seller can "buy-in" the
Deliverable Obligation(s)
• The treatment of Loans differs from the treatment of Bonds
Credit Derivatives
Page 98

Specifics
• At any time after the date that is 5 Business Days after the Physical Settlement
Date, if Buyer has not Delivered any Deliverable Obligations that are Bonds,
Seller may, upon no less than 2 Business Days' notice (which may be provided
during the 5 Business Day period), close out all or part of the Transaction by
buying-in such Bonds, unless such failure to Deliver is due to impossibility or
illegality The “Buy-in Notice" must specify the date of the "Buy-in Date", the
“Relevant Bonds” subject to the buy-in and the outstanding principal balance
thereof
• On the Buy-in Date, Seller must attempt to obtain five or more firm quotations
("Buy-in Offers") for the Relevant Bonds. The lowest Buy-in Offer is the "Buy-in
Price". If Seller is unable to obtain at least one Buy-in Offer, Seller must attempt
to obtain Buy-in Offers for all or part of the Relevant Bonds from at least 5
Dealers on each Business Day following the Buy-in Date until the earlier of (i) the
fourth Business Day (inclusive) following such Buy-in Date and (ii) the date Buy-
in Price(s) are determined for all of the Relevant Bonds (such period, the "Buy-in
Period").
49
Credit Derivatives
Page 99

Specifics (continued)
• Buyer's right to Deliver the Relevant Bonds is suspended during the Buy-in
Period. If a Buy-in Price has not been determined during a Buy-in Period with
respect to all the Relevant Bonds, Seller may give another Buy-in Notice at any
time after the sixth Business Day after such Buy-in Period
• On or about the date a Buy-in Price is determined, Seller must provide notice of
the amount of the Relevant Bonds for which Buy-in Prices were determined and
the Buy-in Price(s) therefor. On the third Business Day following such notice,
Buyer will be deemed to have Delivered Deliverable Obligations for which a Buy-
in Price was determined and Seller will pay to Buyer (a) the portion of the
Physical Settlement Amount that corresponds to such portion of the Deliverable
Obligations minus (b)(I) the Buy-in Price multiplied by (ii) the corresponding
outstanding principal balance of the Relevant Bonds for which a Buy-in Price was
determined plus (c) any reasonable brokerage costs incurred by Seller in
connection with the buy-in.
Credit Derivatives
Page 100
Physical Settlement – 60 Business Day Cap

• Buyer and Seller may elect to enter into an ISDA-approved form of Letter
Agreement which provides that if the Termination Date has not occurred within
60 Business Days following the Physical Settlement Date, such 60th Business
Day will be deemed to be the Termination Date except in relation to any
“Affected Portion” of the Transaction in respect of which:
• (1) a valid notice of Buy-in Price has been delivered that is effective fewer
than three Business Days prior to such 60th Business Day, in which case the
Termination Date for that Affected Portion will be the third Business Day
following the effective date of such notice; or
• (2) Buyer has purchased but not Delivered Deliverable Obligations specified
by Seller as an alternative to the Deliverable Obligations specified in the Notice
of Physical Settlement in accordance with the procedure set out in Section
9.10(b) of the 2003 ISDA Credit Derivatives Definitions, in which case the
Termination Date for that Affected Portion will be the 10th Business Day
following the specification date on which Seller specified such alternative
Deliverable Obligations to Buyer
• Generally adopted in Europe but not North America (except CLNs)
50
Credit Derivatives
Page 101
Deliverable Obligations: Possible Elections
Credit Derivatives
Page 102
Deliverable Obligations: Typical Elections
51
Credit Derivatives
Page 103
Deliverable Obligations Provisions
• Buyer wants to ensure that it is not “squeezed” and unable

to obtain Bonds or Loans to Deliver in order to settle
• Seller wants to ensure that it does not receive highly

illiquid Bonds or Loans that are difficult to transfer (Seller
may be using the Bonds or Loans to settle its own hedge)
• Convertible, exchangeable and accreting obligations are

dealt with in 2003 Definitions
Credit Derivatives
Page 104
Convertible, Exchangeable and Accreting

Obligations (cont’d)
• On November 9, 2001, ISDA published a Supplement to specify

consequences with respect to Convertible, Exchangeable and
Accreting Obligations. Supplement incorporated into 2003
Definitions.
• Under 2003 Definitions, "Not Contingent" means any obligation
(A) the payment or repayment of principal in respect of which is
not in an amount determined by reference to any formula or
index, or which is not subject to any contingency, and (B) which
bears interest at either a fixed or floating rate that is paid on a
periodic basis and computed on a benchmark interest rate plus
or minus a spread, if any
52
Credit Derivatives
Page 105

Obligations (cont’d)
• "Not Contingent" is intended to prevent obligations from
constituting Deliverable Obligations if the repayment of principal
may not occur due to events either unrelated to the credit of the
issuer or not within the control of the holder or a trustee or similar
agent acting for the benefit only of holders
• Provisions draw a distinction between obligations that are
convertible or exchangeable into equity securities solely at the
option of holders or a trustee or similar agent acting for the
benefit only of holders ("Convertible Obligations") and
obligations that are convertible or exchangeable in any other
circumstances
Credit Derivatives
Page 106

Obligations
• Accreting Obligations (such as zero coupon bonds) are

Deliverable Obligations even if the "Not Contingent"
characteristic is specified as being applicable
• “Outstanding Principal Balance” of an Accreting Obligation to

mean (a) the sum of (i) the original issue price of the obligation
and (ii) the portion of the amount payable at maturity that has
accreted in accordance with the terms of the obligation, less (b)
any cash payments made by the obligor thereunder that, under
the terms of the obligation, reduce the amount payable at
maturity (unless already accounted for)
53
Credit Derivatives
Page 107
Practical Issues
• What are Deliverable Obligations?

— Borrowed Money—Treatment of principal strips under
Fannie and Freddie bonds and definition of Accreting
Obligations
— "Borrowed Money" means any obligation (excluding an

obligation under a revolving credit arrangement for which
there are no outstanding, unpaid drawings in respect of
principal) for the payment or repayment of borrowed money
(which term shall include, without limitation, deposits and
reimbursement obligations arising from drawings pursuant to
letters of credit)
Credit Derivatives
Page 108
Practical Issues
• "Accreting Obligation" means any obligation, the terms of

which expressly provide for an amount payable upon
acceleration equal to the original issue price (whether or
not equal to the face amount thereof) plus an additional
amount or amounts (on account of original issue discount
or other accruals of interest or principal not payable on a
periodic basis) that will or may accrete, whether or not (A)
payment of such additional amounts is subject to a
contingency or determined by reference to a formula or
index, or (B) periodic cash interest is also payable
54
Credit Derivatives
Page 109
Practical Issues
• What are Deliverable Obligations?

— Consent Required Loan—What if there are conditions to
transfer that cannot be waived by the borrower?
— "Consent Required Loan" means a Loan that is capable of

being assigned or novated with the consent of the relevant
Reference Entity or the guarantor, if any, of such Loan (or
the consent of the relevant borrower if a Reference Entity is
guaranteeing such Loan) or any agent
Credit Derivatives
Page 110
Synthetic CDOs/Basket and

Managed Trades
55
Credit Derivatives
Page 111
Synthetic CDOs/Basket and Managed Trades
• Rather than being based on the credit risk

characteristics of a single debtor, a credit
derivative can be written on a portfolio or “basket”
of reference entities or reference obligations,
such as a portfolio of project finance loans
• The simplest form of such derivatives is called a
basket swap
Credit Derivatives
Page 112

• A common example of a basket swap is a first-to-
default basket
• In such a contract, the payment by the protection
seller is triggered by a default event by any of the
reference entities included in the portfolio
• Effectively, if the protection buyer is long the portfolio,
the buyer limits its exposure to credit risk by
transferring some of that risk to the protection seller
• Second- and third-to-default baskets are similarly
defined
56
Credit Derivatives
Page 113

• Alternatively, a multi-name credit derivative may be set up
as a portfolio default swap, whereby the transfer of risk is
specified not in terms of defaults by individual reference
entities represented in the portfolio but rather in terms of
the size of the default-related loss in the overall portfolio
• For instance, in a portfolio default swap with a “first-loss
tranche” of, say, 4%, investors in that tranche (first-loss
protection sellers) are exposed to however many individual
defaults are necessary to lead to a 4% loss in the overall
portfolio
• Second- and third-loss portfolio default swaps are defined
similarly
Credit Derivatives
Page 114

• Portfolio default swaps can be thought of as the building blocks for
synthetic collateralized debt obligations (“CDOs”)
• While a simple credit default swap allows a protection buyer to

synthesize the sale of a financial asset, by using a synthetic CDO a
protection buyer can transfer part of the credit risk in an entire portfolio
of financial assets without having to incur the costs of transferring the
assets themselves from its balance sheet
• As in a conventional CDO, the cashflow of a synthetic CDO is directed

to various tranches to suit the risk appetites of different investors. Thus,
while investors in the most senior tranches face very low default risk,
those in the first-loss (equity) tranche will be the first to absorb any
default-related losses in the portfolio.
57
Credit Derivatives
Page 115

Po o l o f
Re f e r e n ce
O b lig at io n s
AAA/
A aa Se l l e r ( s) - A A / A a R i sk
C Se l l e r ( s) - B a a 3 / B B B - R i sk
A A /A a
B
Baa3/
BBB A Se l l e r ( s) - U n r a t e d R i sk
U n rated
Bu yer Se l l e r s
A - C u m u l a t i v e l o sse s u p t o 4 % o f e n t i r e p o r t f o l i o
B - A d d i t i o n a l c u m u l a t i v e l o sse s u p t o 1 2 % o f e n t i r e p o r t f o l i o
C - A d d i o n a l c u m u l a t i v e l o sse s u p t o 4 0 % o f e n t i r e p o r t f o l i o
L o sse s u su a l l y m e a su r e d t h r o u g h c a sh se t t l e m e n t
Credit Derivatives
Novation
58
Credit Derivatives
Page 117
Novation
• Article X of the 2003 ISDA Credit Derivatives Definitions

established a procedure for novating Transactions
• Entry by the Transferee and Remaining Party into a “Novation
Confirmation” with respect to any Transaction constitutes
deemed entry by each of them into (a) an ISDA Master
Agreement (without any Schedule) until the finalized ISDA
Master Agreement is entered into and (b) an ISDA-approved
form of “Novation Agreement”
• In the event of a partial novation, the old Transaction
automatically remains in full force and effect except to the extent
of the portion novated
Credit Derivatives
Page 118
Novation—ISDA Protocol
• ISDA Novation Protocol published.
• Scope of Protocol: Credit Derivative or Interest

Rate Derivative Transactions
• Effective Date of Protocol: October 24, 2005 or

such later date as a party adheres to the Protocol
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Novation
• All Sales and Trading personnel transacting in products subject

to the Protocol whose institutions have adhered to the Protocol
should apply the Best Practices outlined below with respect to a
Novation with a Transferor who is an adhering party.
• If a Transferor has not adhered to the Protocol, all Sales and
Trading personnel should act in accordance with Section 7 of the
ISDA Master Agreement in place between the Transferor and
Remaining Party, and accordingly must receive prior written
consent from the Remaining Party before firm pricing is given.
Credit Derivatives
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Novation: Best Practices under the Protocol
• Negotiating a proposed Novation: The Transferor will

contact the Transferee to agree a price for the Novation.
The Transferor will explicitly advise the price is for a
Novation and not a new deal.
• Once the price has been agreed the Transferor will now
obtain consent from the Remaining Party as follows:
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• The Transferor’s obligations:
— The Transferor should promptly after agreement of the Novation price request the Remaining Party’s consent in writing (email,
electronic messaging or any other communications system).
— The Transferor should provide sufficient detail to permit the Remaining Party to identify the trade being novated equivalent to that
outlined in Exhibits A and B attached to ISDA Novation Protocol Guidelines available on ISDA website.
— The Transferor should either copy the Transferee on the request for consent to the Remaining Party, or include the contact
details of the Transferee in the request for consent. This will allow the Remaining Party to include the Transferee on the returned
consent message.
— The Transferor should send the request for consent in sufficient time to allow the Remaining Party to respond prior to the time
the Transferee has designated.
— As and when the Remaining Party’s consent has been received, the Transferor should send this onto the Transferee, unless it is
evident from the Remaining Party’s response that the Transferee has received a copy directly from the Remaining Party.
— The Transferor should then remove the novated trade from their booking system.
— If evidence of the consent of the Remaining Party is not received by the time the Transferee has designated, or if the Remaining
Party indicates to the Transferor and Transferee that it does not consent, the Transferor and the Transferee shall be deemed not
to have entered into a novation, and a new trade will be booked against the Transferee.
— This new trade will be subject to any CSA or margining arrangement in place between the Transferor and Transferee.
— The effective date of the new trade shall be the effective date of the proposed novated trade. All other terms and conditions of
the proposed novated trade will be replicated in the new trade. The new trade should be documented as any other new trade.
— The new trade will include an upfront Fee between the Transferor and the Transferee equivalent to the Fee which would have
been settled on the Novation.
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• The Remaining Party’s obligations:

— The Remaining Party should respond promptly to any request for
consent made by a Transferor but at the latest by the cut-off time
designated by the Transferee.
— The Remaining Party should ensure the response back to the
Transferor includes full trade details of the trade they consent to be
novated equivalent to that outlined in Exhibits C and D attached to
the ISDA Protocol guidelines available on ISDA website.
— The Remaining Party should copy all parties on the original
request. If the Transferee was not included on the original request
the Remaining Party should ensure they are copied on the
response to the Transferor.
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• The Transferee’s obligations:

— After it receives evidence of the consent of the Remaining Party, the Transferee should promptly advise the Remaining
Party as to the details of the trade that the Transferee originally agreed with the Transferor and which is now being
transferred.
— The Transferee will then book the novated trade against the Remaining Party.
— There is no requirement for the Transferee to respond to the Remaining Party in order for the novation to be valid.
— If evidence of the consent of the Remaining Party is not received by the time designated by the Transferee, or if the
Remaining Party indicates to the Transferee and Transferor that it does not consent, the Transferee and the Transferor
shall be deemed not to have entered into a novation, and a new trade will be booked against the Transferor.
— This new trade will be subject to any CSA or margining arrangement in place between the Transferee and Transferor.
— The effective date of the new trade shall be the effective date of the proposed novated trade. All other terms and
conditions of the proposed novated trade will be replicated in the new trade. The new trade should be documented as any
other new trade.
— The new trade will include an upfront Fee between the Transferee and the Transferor equivalent to the Fee which would
have been settled on the Novation.
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• Novation Communication Mechanism

— Each organization will notify both ISDA and all market participants
of their preferred method of communication by product and region,
for use by the Transferor when requesting consent from the
Remaining Party.
• Novation Confirmations
— The Remaining Party agrees to dispatch the Novation Confirmation
as soon as practical after the Remaining Party’s consent has been
given.
— All adhering parties agree to sign the Novation Confirmation
promptly after receiving the Remaining Party’s Novation
Confirmation, taking due note of any agreed industry targets.
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• Transferor and Transferee are legally bound by the terms

of a transfer by novation from the moment they agree to
those terms (whether orally or otherwise), subject only to
the condition that evidence of the consent of the
Remaining Party to such transfer is received by the
Transferee not later than 6:00 p.m. in the location of the
Transferee on the day such transfer is agreed to.
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• If consent of Remaining Party to transfer is not received by

Transferee by such 6:00 p.m. deadline or if Remaining Party
does not consent to such transfer:
— The Transferor and the Transferee shall be deemed not to have
entered into a transfer by novation of the Covered Transaction.
— The Transferor and the Transferee shall be deemed instead to
have entered into a Transaction identical to the Covered
Transaction in which Transferor is in the position taken by the
Remaining Party in such Covered Transaction and Transferee is in
the position taken by the Transferor in such Covered Transaction.
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Index Transactions
Credit Derivatives
Page 128
Index Transactions
• In order to meet investor demand for greater liquidity,

transparency and broader acceptance in a highly
diversified credit product, Dow Jones iTraxx CDS (now
“CDX”) indices were launched in 2004, in conjunction with
a consortium of leading global investment banks
• The new rules-based indices are a result of the merger of

the iBoxx and Dow Jones TRAC-X credit derivative index
products
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CDX Family of Indices
• CDX.NA.IG (North American Investment Grade)

• CDX.NA.HY (North American High Yield)
• CDX.EM (Emerging Markets)
• Other more specialized indices
— Europe
— Asia
— ABX: Liquid subprime RMBS
— CMBX: 10 year AAA tranches
Credit Derivatives
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Index Transactions
Market-makers in US CDX Indices
ABN AMRO, Bank of America, Barclays Capital, BNP

Paribas, Citigroup, Credit Suisse First Boston, Deutsche
Bank, Goldman Sachs, HSBC, JPMorgan, Lehman
Brothers, Merrill Lynch, Morgan Stanley, UBS and
Wachovia
65
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Index Transactions
Licensed market makers for European indices:
ABN AMRO, Bank of America, Barclays Capital, BBVA,

BNP Paribas, CALYON, Citigroup, Commerzbank, CSFB,
Deutsche Bank, Dresdner Kleinwort Wasserstein,
Goldman Sachs, HSBC, HypoVereinsbank, JP Morgan,
Lehman Brothers, Merrill Lynch, Morgan Stanley, Nomura,
Royal Bank of Scotland, Société Générale and UBS
Credit Derivatives
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Index Transactions
Licensed market makers for Asian indices:
ABN AMRO, Barclays Capital, BNP Paribas, CALYON,

Citigroup, Deutsche Bank, Goldman Sachs, HSBC, JP
Morgan, Lehman Brothers, Merrill Lynch, Mitsubishi
Securities, Mizuho, Morgan Stanley, nikkoCitigroup and
UBS
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Index Transactions—CDX Europe
• The CDX Europe index started trading on Eurex, Europe’s

largest derivatives exchange, on
September 20, 2005.
• The composition of the indices is changed every

six months to ensure they reflect the most actively traded
names and the companies whose credit rating status has
changed.
• The ex-Japan Asia index will also be expanded from

30 names to 50 names.
Credit Derivatives
Page 134
Index Transactions—ISDA Protocols
• When Collins and Aikman, the US auto parts supplier, filed for
bankruptcy, one of the tricky issues was settlement because
Collins was a part of the Dow Jones credit derivatives indexes
being traded in the market.
• Physical settlement would have been chaotic due to a limited
supply of Collins deliverable securities in the market.
• To resolve the problem, ISDA developed a new protocol, the
2005 CDS Index Protocol.
• Under the Protocol, the specific Collins Reference Obligation is
valued by an Auction Procedure
67
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Index Transactions—ISDA Protocols
• Protocol adopted with respect to Northwest and Delta

• Consideration of expanding principles of the Index
Protocols (i.e., auction mechanics) to single name trades
— Short squeeze risk taken by dealers as buyers and sellers
differentially elect cash vs. physical settlement
— Basis risk of single name trades with different settlement
basis than the auction rate mechanism
— Concern, however, that auction mechanism will distort the
valuation process
Credit Derivatives
Page 136
Master Confirmations; ISDA

Publication of Matrix Supplement
68
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Master Confirmations
• In 2003/4, ISDA published Master Confirmations for

— North America/Europe
— Asia Pacific
— Sovereigns
• Master Confirmations are intended to streamline the confirmation
process.
• They incorporate the 2003 ISDA Credit Derivatives Definitions
and the May 2003 Supplement. A General Terms Confirmation
and Transaction Supplement is also offered.
Credit Derivatives
Page 138
ISDA Publication of Matrix Supplement

• 2005 Matrix Supplement amends the 2003 Definitions by
the incorporating a new Credit Derivatives Physical
Settlement Matrix
• Matrix sets out certain elections that apply to certain

Reference Entities under Credit Derivatives Transactions
for which Physical Settlement applies as the relevant
Settlement Method
• Parties may elect that Matrix apply to a Credit Derivative

Transaction by referencing the 2005 Matrix Supplement in
their Confirmation and including and identifying a
Transaction Type in the Confirmation
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ISDA Publication of Matrix Supplement
• Matrix is updated from time to time
• Most recently updated in September 2009
• When incorporated into Confirmation, the relevant Matrix is

the Matrix most recently amended and supplemented as at
the Trade Date of the relevant Credit Derivative
Transaction (unless otherwise agreed by the parties) as
published by ISDA on its website
Credit Derivatives
Net Operating Losses

(NOLs)
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NOLs
• In recent bankruptcy cases, investors and broker-dealers have been left
with no choice but to engage attorneys to object to overly broad
bankruptcy court orders designed to limit trading in claims in order to
preserve net operating losses for U.S. Federal income tax purposes.
• The orders are typically imposed at the debtors’ initiative, resulting in
the expenditure of substantial time and effort in order to debate the
proposed breadth of the orders and put in place ad hoc procedures to
ensure compliance.
• Although the debt provisions of NOL orders vary, they frequently
prohibit large holders of debt from acquiring any additional claims. At
early stages of a bankruptcy, an NOL order may even prohibit all
purchases and sales of a corporation’s debt. These restrictions are very
disruptive to trading, and are often imposed without meaningful notice to
the markets.
Credit Derivatives
Page 142
NOL Orders—Background
• NOL orders motivated by Sections of the Internal Revenue Code

intended to prevent trafficking in NOL carryovers and other tax
attributes.
• Section 382 of the Code significantly limits amount of NOL
carryovers that can be used after certain significant changes in
the ownership of a corporation’s stock. In general, the Section
382 limitation is triggered if increases in the percentage of the
stock of the corporation owned (directly or by attribution) by 5%
shareholders (including certain groups of public shareholders)
aggregate to more than 50% over a 3-year testing period. If the
ownership change occurs in a bankruptcy proceeding, however,
special rules may apply.
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Credit Derivatives
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NOL Orders—Background
• Under one of these special rules, a partial exemption from the Section 382 limitation is
available for an ownership change pursuant to a bankruptcy reorganization, so long as
the historic shareholders and “qualified creditors” of the debtor corporation own at
least 50% of the value and voting power of its stock after the change. In general, a
debtor corporation may treat a creditor as qualified if, immediately after the bankruptcy
reorganization, that person owns less than 5% of the debtor corporation’s equity.
• Pursuant to the basic Section 382 rule, normal trading in a debtor corporation’s equity
can directly result in significant limitations on future use of NOL carryovers, regardless
of the value of that equity. For this reason, NOL orders typically place significant
restrictions on equity trading during the course of a bankruptcy. Although trading in
debt cannot directly result in a limitation under Section 382, NOL orders also
frequently place restrictions on debt trading, in order to preserve the debtors’ ability to
benefit from the favorable qualified creditor presumption for less-than-5% holders. In
this regard, the emergence of a reorganized debtor from Chapter 11 frequently
constitutes a triggering ownership change for purposes of Section 382, and a large
portion of a reorganized debtor’s equity is frequently distributed to former creditors.
Credit Derivatives
Page 144
Model NOL Order
• The Model NOL Order (available on LSTA website) was developed as a

joint effort of The Bond Market Association and the Loan Syndications
and Trading Association.
• The goal of the Model NOL Order is to reduce the disruption and
expense resulting from NOL orders. The Model NOL Order aims to
reduce this burden for all parties, by creating a standard and less
restrictive mechanism for dealing with the tax issues raised by debt
trading during a bankruptcy.
• In producing the Model NOL Order, The Bond Market Association and
the Loan Syndications and Trading Association consulted extensively
with representatives of the debt trading community as well as leading
bankruptcy counsel for both debtors and creditors.
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Credit Derivatives
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Model NOL Order Approach

• The Model NOL Order is designed to put sufficient trading restrictions in
place to achieve a reasonable degree of protection for a debtor
corporation’s NOL carryovers, while at the same time avoiding
unnecessary disruptions to trading markets.
• With respect to debt trading, the Model NOL Order functions by way of a
“sell down” mechanism. Under the Model NOL Order, creditors remain
free to buy and sell debt throughout the course of a bankruptcy
proceeding, unless and until the debtor proposes a plan of
reorganization that relies on the qualified creditor presumption. The
order then generally requires large debt holders to sell claims to the
extent necessary to preserve the presumption.
• The Model NOL Order is also designed to ensure adequate notice to
markets of its restrictions. Under the order, notice must generally be
given via the Bloomberg newswire service before the trading restrictions
imposed by the order can become effective.
Credit Derivatives
Page 146
Overview of Recent CDS

Documentation
73
Credit Derivatives
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Overview of Recent CDS Documentation

• Confirmation for use with Credit Derivatives Physical
Settlement Matrix (September 19, 2005)
• Physical Settlement Matrix (September 2009 version)
• Commentary on Physical Settlement Matrix (March 7,

2005)
• Additional Provisions for Constant Maturity Credit Default

Swaps
• Recovery Lock Credit Derivative Transaction (May 1,

2006)
Credit Derivatives
Page 148
• Confirmation for use with Syndicated Secured Loan Credit

Default Swap Standard Terms Supplement (June 8, 2006)
• Syndicated Secured Loan Credit Default Swap Standard

Terms Supplement (June 8, 2006)
• Net Settlement Agreement (May 8, 2006)
• Credit Derivative Transaction on Asset-Backed Security

with Cash or Physical Settlement (June 7, 2006)
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• Credit Derivative Transaction on Mortgage-Backed

Security with Pay As You Go or Physical Settlement (Form
I) (Dealer Form) (April 11, 2006)
• Credit Derivative Transaction on Asset-Backed Security

with Pay As You Go or Physical Settlement (Form II)
(December 19, 2005)
• Credit Derivative Transaction on Collateralized Debt

Obligation with Pay As You Go or Physical Settlement
(June 7, 2006—recently revised)
Credit Derivatives
Page 150
Variants on Basic CDS
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Variants on Basic CDS—LCDS
Credit Derivatives
Page 152
Credit Default Swaps on Secured Loans
• A market has developed consisting of a diverse group of buyers

and sellers of protection
• Market participants are now trading standardized swap contracts

referencing single names, indices and tranche indices
• Numerous dealers and other market participants are involved

and have begun trading the standardized product
• As documentation was standardized, volumes traded in loan-

only CDS grew rapidly in 2007 and 2008
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The Participants
Protection Buyers
– Commercial and Investment Banks
Revolver exposure
Bridge loans
Non-tradeable loans
– Hedge funds
Until recently, arbitrage opportunities due to tight CDS spreads
Until recently, shorting 2nd lien market
Credit Derivatives
Page 154
The Participants (cont’d)

Protection Sellers
– Hedge Funds
Cheaper and greater leverage than TRS
Fewer operational headaches
– CLOs and traditional money managers
Access to illiquid and over-subscribed deals
Ability to tailor the product (maturity, coupon, callability)
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The Market Standard Loan CDS Contract
z Goal: Create a contract which mimics standard CDS

terms as much as possible while accounting for the
nuances of loans
z Process: Give and take between dealers and largest

buyers and sellers of protection
z Key decision #1: As with CDS on bonds, this should be a

cap structure trade, not a synthetic loan or TRS
z Key decision #2: Callability should be limited
Credit Derivatives
Page 156
The Market Standard Loan CDS Contract

Summary of Important Terms
z Event triggers: Bankruptcy and Failure to pay on Borrowed Money
z Reference Obligation: The obligations listed on the Secured List published by
Markit from time to time (which may include term loans or revolvers of Reference
Entity, whether as a primary obligor or guarantor)
z Designated Priority: 1st, 2nd or 3rd lien
z Substitute Reference Obligation: If Reference Obligation is refinanced, new one
of same priority must be selected; otherwise, an optional termination right exists
z “Syndicated Secured” Characteristic: Only loans of Designated Priority or better
are deliverable
z Revolvers are deliverable
z Relevant Secured List: Markit Group’s role
z Optional Termination upon no secured bank debt existing following a refinancing
z Settlement: Discussed in detail later
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Page 157
Basis between Loan and CDS Spreads

There are a number of major factors that drive the basis
between CDS and Loans:
Factors that Decrease the Factors that Increase the Basis

Basis
Non-callable nature of CDS Liquidity
(in general)
Leverage Absence of voting rights,
amendment fees, relationship
with issuer
Not subject to amortizations, Presence of large Revolver
pre-payments, re-pricings
Credit Derivatives
Page 158
Rationale for players in Loan-only CDS

Market
Sellers of Protection Buyers of Protection
When a loan is trading at a premium, the Cheaper than Unsecured CDS Protection.
premium above par is lost upon a
Eliminate Basis Risk – hedge 1-for-1 with loan.
refinancing or default. CDS contracts
always reference par so at inception the Blind to the Issuer.
seller of protection is only exposed at par. No alternative way to short loans currently.
CDS will act like a fully funded position with Contract will terminate upon absence of Loans
a premium similar to a term loan spread. of the relevant priority of Issuer outstanding.
Can achieve leveraged loan position through
CDS.
Settlement, documentation, and operational

aspects of CDS may be easier than those of
cash loan market.
Potential for greater return given non-

callable nature of product (in most
circumstances).
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Credit Derivatives
Page 159
Trade Ideas:
There are many strategies that can be employed when
trading LCDS
Strategy Specific Trade Rationale
Outright Long Sell Protection Get exposure synthetically to credit for relative value reasons; add
incremental exposure after primary market allocations
Outright Short Buy Protection No way to short loans in cash market; hedge positions; take
advantage of potential spread widening situations
Cap Arb Trade Sell Loan CDS, Buy Take advantage of perceived mispricing of unsecured (bond) vs.
Unsecured Bond CDS secured (loan) parts of capital structure for appreciation and carry
Replace Cash with Sell Loan, Sell Loan Sell/monetize call-constrained loan trading at premium; gain
Synthetic CDS exposure to par CDS instrument at comparable or better spreads
Refinancing Trade Buy Revolver, Buy Earn carry from Revolver commitment fees vs. paying for Loan CDS
Loan CDS Protection to short date that corresponds to expected refinancing date. Early
refinancing while CDS still has value – or additional funding (at a
higher spread) – will result in higher return on trade
Credit Derivatives
Page 160
Why Secured Loan CDS?
z Investor interest in secured loans driven by consistent and stable performance—

although events of the last twelve months have tested that theory
z Historically, driven in part by ballooning cash CLO issuance
z High yield investors seeking to move up in the capital structure
z Changes in regulatory capital regime (Basel II)
z Increasing risk management needs
z Demand/ supply imbalance
z Resulting in the need for an innovative, standardized synthetic instrument to

address long and short sides of the secured loan market
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Page 161
Strategic Advantages Offered by Secured

Loan CDS
z Ability to access credits beyond those actively traded in the cash
market
z Ability to short credit risk in the secured loan space
z Avoiding borrower/agent consent issues
z Avoiding loan trade settlement and administrative issues
z Capital efficient means of gaining exposure
z Ability to trade a "class" of assets at each part of the capital

structure
z Better prepayment protection relative to cash loans
z Ultimately, improve overall market liquidity
Credit Derivatives
Page 162
How Is Single-Name Secured Loan CDS

Different from Bond CDS?
Leveraged Loans Bonds
Reference Entity/Reference Depends on Issuer (Specify tranche/lien (Markit to Depends on Issuer (Specify bond)
Obligation maintain database))
Credit Events 1. Bankruptcy 1. Bankruptcy
2. Failure to pay (non-curable default) 2. Failure to pay (non-curable default)
3. Restructuring is NOT a credit event in the US and is 3. Restructuring is a credit event for IG and NOT
a credit event in Europe for HY issuers in the US. Restructuring is a
credit event in Europe
Cancelability 1. European standard contracts are cancelable if loan Non-cancelable

prepays
2. US standard contracts are cancelable only if loans

go from secured to unsecured or if no secured loans
are outstanding
Settlement Cash settlement through auction methodology; physical Absent an auction-based cash settlement, physical
settlement is a fallback delivery generally used for single name (T+3 from
NOPs); Cash settlement protocols have been used
to settle index and single-name trades
Buy-in permitted as fall-back but rarely used
Documentation issues — Par docs and distressed docs Standard Bond settlement mechanisms used for
single name
— Via assignments or via participations
— ISDA standards still evolving
81
Credit Derivatives
Standard CDS versus LCDS Page 163
Standard CDS LCDS
● Deliverable Obligations generally ● Deliverable Obligations are limited to

include all unsubordinated bonds and loans that are “Syndicated Secured”
loans of the Reference Entity
● Protection Buyer’s obligation to make ● If the Reference Obligation goes away

periodic payments continues or is no longer Syndicated Secured and
throughout the term of trade, whether no other Reference Obligation is
or not a Reference Obligation or other identified after 30 Business Days of
Deliverable Obligations of the searching, each party has the right to
Reference Entity exist tear up the trade with no further
payments to the other party
Credit Derivatives
Page 164
Standard CDS versus LCDS (cont’d)

Standard CDS LCDS
● Protection Buyer generally cannot ● Protection Buyer may deliver
deliver outstanding commitments outstanding commitments

such as revolvers and L/C facilities
● Delivery is effected “using ● Assuming cash settlement

documentation . . . customarily through use of auction procedures
used in the relevant market” for the does not apply, LCDS provides for
settlement of the applicable physical settlement without
Deliverable Obligations at that time negotiation of documents
82
Credit Derivatives
Page 165
What is a Syndicated Secured Loan?
• Definition:
• “Syndicated Secured” means any obligation, including any
contingent obligation to pay or repay borrowed money resulting
from the funding of an unfunded commitment, (i) that arises under
a syndicated loan agreement and (ii) that, on the relevant day,
trades as a loan of the Designated Priority under the then-current
trading practices in the primary or secondary loan market, as the
case may be
• A trading rather than a legal standard
• “Designated Priority” is specified on a trade-by-trade basis as

either “First Lien” or “Second Lien”
Credit Derivatives
Page 166
Determination of Syndicated Secured
• Markit Group will run periodic indicative polls of a group of

specified dealers as to the universe of obligations that are
Syndicated Secured in respect of widely traded Reference Entities
• Updated Syndicated Secured Lists will be published by Markit

Group from time to time
• Participating dealers may request that Markit Group cover new

names
• Dispute resolution may be employed regardless of whether the

challenged obligation appears on the relevant Syndicated Secured
6
List
83
Credit Derivatives
Page 167
Secured Loan CDS—Existing Standard US

Documentation
• Syndicated Secured Loan Credit Default Swap Standard Terms
Supplement and Confirmation published on May 22, 2007
• LCDX Untranched Transactions Standard Terms Supplement

and Confirmation published on May 22, 2007
• LCDX Tranched Transactions Standard Terms Supplement and

Confirmation published on September 25, 2007
• LCDS Auction Settlement Terms published on September 25,

2007
Credit Derivatives
Page 168
Settlement Mechanics: Bridging the Two

Markets
• Current state of U.S.Secondary Loan Market
• Each transaction is negotiated
• Chain of title is important; Loans are not considered fungible
— Upstream review
• Distressed settlement timeframes are long, and T+20 remains an
aspiration
— LSTA delayed comp helps to replicate the cash flows of a prompt
closing
• LSTA documentation and settlement conventions are widely accepted;
liquidity has increased
84
Credit Derivatives
Page 169
Settlement Mechanics: Bridging the Two
Markets (cont’d)
• Projected Needs of the Syndicated Secured Loan Only CDS

Market
• Certainty of prompt settlement
• Concern that a Credit Event could overwhelm settlement

capacity and resources of current Loan Market
• Concern that “business as usual” negotiation of documents

could be exploited to detriment of Protection Seller or Protection
Buyer
Credit Derivatives
Page 170
Harmonization
• Among other things, these factors have made cash settlement through an auction
methodology the principal settlement method for LCDS
• Standard LCDS auction procedure is based on the precedent developed for bond CDS,
with appropriate changes to take account of the fact that the auction is in respect of loans
rather than bonds
• Starting Point: ISDA definition of Physical Settlement
• Streamline documentation choices and “hardwire” form of documentation
• LSTA distressed documentation, as of the NOPS Fixing Date
• Favor settlement by assignment, allow settlement by participation
• Harmonize conflicting conventions and risk allocations
• Settlement pricing
• Compensation for Delayed Settlement
• Borrow from ISDA when necessary: simplified form of Partial Cash Settlement
• In lieu of LSTA economic equivalent fallback
• Innovate: Market Standard Indemnity
85
Credit Derivatives
Page 171
Paths to Settlement
• Assignment
• Fall-Back Participation
• Initial Participation (including Participation, Subparticipation and
Assignment of Participation)
• Cash Election Notice and Partial Cash Settlement
• Additional Termination Event
• Future Netting Protocols
• Avoiding Obstacles, including NOL Orders
Credit Derivatives
Page 172
Market Standard Indemnity

z Physical delivery, where applicable, will utilize closing mechanics and
procedures developed by the Loan Syndication and Trading Association
("LSTA"), which will be modified to the extent required to ensure
efficient and expeditious settlement demanded by participants in the
credit default swap market.
z A key modification is the inclusion of the "market standard indemnity".
z What Is the Market Standard Indemnity?
z This indemnity makes the PSA for loan CDS a non-negotiable

document
z Protection seller is indemnified by the protection buyer for anything in

the PSA or upstreams inconsistent with the standard market practice
applicable to the specific loan
z The indemnity postpones disputes until it really matters
86
Credit Derivatives
Page 173
LCDX—BASIC TRADING TERMS
• LCDX consists of 100 Reference Entities determined by Markit and participating dealers to
be the most liquid in the single-name LCDS market
— Credit Event in respect of any Reference Entity triggers an auction and settlement for
that name for index and single-name trades
• Fixed Rate—Markit-published spread payable quarterly by the protection buyer on all LCDX
trades
• Roll Dates—Each April 3 and October 3
• Maturity—For April rolls, June 20th of the fifth following year; for October rolls, December
20th of the fifth following year
• Incorporates LCDX Standard Terms Supplement
— Only terms that are subject to election are: Trade Date, Effective Date (start paying
Fixed Amounts); Scheduled Termination Date, Original Notional Amount and Initial
Payment Amount (if any)
Credit Derivatives
Page 174
LCDX—BASIC TRADING TERMS (con’t)
• Initial Payment—Can be used to adjust for a spread that would otherwise be payable on a
trade on the 100 Reference Entities
• Credit Events—Bankruptcy and Failure to Pay with respect to Borrowed Money (includes
both Bonds and Loans)
• Conditions to Settlement must be satisfied for each trade (Credit Event Notice and Notice of
Publicly Available Information)
• If there is a Credit Event OR if the Relevant Secured List is withdrawn for any Reference
Entity, the trade terminates for that Reference Entity or Event Determination Date (for Credit
Event) or day withdrawal is announced—no further Fixed Amounts payable on that name
— Following a Credit Event, trades will be cash-settled through auction settlement
— No settlement or termination payment made in connection with a withdrawal
87
Credit Derivatives
Page 175
Where do we go from here?
• Cash Settlement: How has it worked in practice (e.g.,

Movie Gallery Credit Event)
• Public/Private Trading Issues for Secured Loan CDS
• Europe vs. U.S.:

— Cancellable vs. Non-Cancellable CDS—Current Status
Credit Derivatives
Page 176
Variants on Basic CDS—CCDS
88
Credit Derivatives
Page 177

• Conditional Credit Default Swaps ("CCDS") are a new form of
credit derivatives designed to hedge counterparty exposure on a
swap.
• After entering into a swap, one party's credit exposure to the

other party moves with the market to market value of the swap.
• The standard credit default swap provides for a fixed amount of

protection equal to the notional amount. Using a standard CDS
to hedge swap counterparty exposure will almost always result in
the buyer either buying too much or too little protection (because
exposure will not likely match the notional amount).
Credit Derivatives
Page 178

• In a CCDS, the amount of protection the buyer has any day is
equal to the mark to market value of a reference swap that is
typically the same as or similar to a swap the buyer has with the
Reference Entity.
• Enables the buyer to get the protection it actually needs if the

Reference Entity were to become the subject of a Credit Event.
• Because of the inherent optionality, the pricing of a CCDS is

cheaper than buying protection on the full notional of the
reference swap and even the estimated pre-settlement risk (the
probable maximum credit exposure to the counterparty).
89
Credit Derivatives
Page 179
• These derivatives are more difficult to hedge and typically only

sold be dealers and financial institutions interested in taking on
the exposure to the Reference Entity under the reference swap
(i.e., they would have entered into the swap with the Reference
Entity).
• Once a credit event occurs and the notional is fixed based on the
then current value of the reference swap, the CCDS is settled in
the same way as a standard swap.
Credit Derivatives
Page 180
Variants on Basic CDS—CDS on

Swap Obligations
90
Credit Derivatives
Page 181
Variants on Basic CDS—CDS on Swap

Obligations
• #
Credit Derivatives
Page 182
Variants on Basic CDS—CDS on

Asset Backed Securities
91
Credit Derivatives
Page 183
Asset-Backed Securities—Why the Need?

• Exposure that can’t be achieved in the cash market
— Long and short exposure to spreads and/or credit risk
— Exposure to to assets that are difficult to source
— Directional views as to structured finance generally
• Customized Leverage
• New Trade Types
— Basis Trades (e.g., CDS vs. Cash Bonds)
— Capital Structure Trades (i.e., long BBs vs. short BBBs)
— Cross-sector arbitrage
— Single tranche bespoke synthetic CDOs; Hybrid CDOs
Credit Derivatives
Page 184
Asset-Backed Securities
• Asset-Backed Securities don't typically default, and issuers typically

don't become subject to a bankruptcy or insolvency
• ABS issuers are “bankruptcy-remote”, making “Bankruptcy” not a
useful Credit Event
• “Failure to Pay” is often difficult to apply, particularly because many
ABS tranches have PIK features that, when operative, should not be
considered Credit Events
• In contrast, credit issues arise for ABS when a particular tranche of
securities (and all tranches senior to that tranche) are supported by
less performing collateral than is necessary to repay those tranches
(a “write down” or principal reduction)
92
Credit Derivatives
Page 185
• Physical settlement problematic because dealing with

small issuance of illiquid reference obligations which
are difficult to obtain
• Cash settlement problematic because dealing illiquid

reference obligations difficult to value (especially
mezzanine ABS)
Credit Derivatives
Page 186
• ISDA practitioners were faced with the need to apply credit

default swap technology to securities such as CMBS,
RMBS and CDOs
• However, there is a tension between need to determine

when an ABS is “distressed” and the need to have legal
certainty as to the occurrence of a Credit Event
93
Credit Derivatives
Page 187
Asset-Backed Securities—Pay As You Go CDS

• First specific form published for use with RMBS and CMBS.
• Second specific form published for use with CDOs.
• ISDA anticipates future publication of one or more template
Confirmations for use with other types of ABS, such as credit
cards.
• Parties should always consider what modifications to the form
may be appropriate to reflect the specific terms of the specified
Reference Obligation. Must understand underlying deal.
• Parties should also consider whether the form is appropriate
where the Reference Obligation has the benefit of a monoline
wrap.
Credit Derivatives
Page 188
ISDA’s Response: Pay-As-You-Go

Confirmation and Cash Confirmation
• ISDA published two forms of confirmation for use of

CDS on ABS in June 2005 (one of which has been
superceded):
— Confirmation of CDS of ABS with cash or physical settlement
(designed for most forms of ABS) (the “Cash Confirmation”)
— Pay-as-you-go confirmation of CDS on ABS with a physical

settlement option (designed for RMBS and CMBS but can be
modified) (the “PAUG Confirmation”)
94
Credit Derivatives
Page 189
Main Features of Confirmation

• PAUG Confirmation’s main features are:
— Hard credit events (e.g., writedown, failure to pay, distressed
downgrade) which permit (but do NOT require) physical
settlement at option of protection buyer
— Floating payments paid by Seller to Buyer in respect of

writedowns and interest and principal shortfalls that eliminate
need for cash settlement
— Additional fixed payments paid by Buyer to Seller (in addition

to premium) that reimburse Seller for any floating payments
made in respect of payment defaults/ writedowns that are
subsequently reversed.
Credit Derivatives
Page 190
Pay-As-You-Go and CDS Comparison:

Reduction of Notional Amount
PAUG Confirmation Cash Confirmation
Notional Amount Notional Amount will be reduced as a Notional Amount will be reduced as a result of
result of: Principal Payments, such as:
How is notional amount
affected by amortization - Principal Payment (scheduled or - Scheduled or accelerated amortization,
and write-downs of the unscheduled)
- Acceleration of payment obligations,
reference obligation?
- Failure to Pay Principal (FTP)
- Redemption
- Writedown (a decrease in principal
Does not take into account Writedowns / Writedown
other than scheduled/unscheduled
Reimbursements
payments; principal deficiency or
realized loss resulting in reduced
interest payable)
OR will be increased when

Writedown Reimbursement (a
reduction/reversal of prior Writedown,
ie write-ups) occurs
95
Credit Derivatives
Page 191

Payments by Protection Buyer
Fixed payment (made Buyer pays a fixed rate premium to The buyer is obliged to pay the fixed rate premium
by the Buyer of Seller PLUS (if any): until a Credit Event is triggered.
protection to the Seller
- Writedown Reimbursement
of protection)
- Principal Shortfall
Reimbursement (payment toward
previously deferred or FTP principal)
or
- Interest Shortfall Reimbursement

(negotiable – see later interest
shortfall description)
Credit Derivatives
Page 192
Pay-As-You-Go and CDS Comparison: Step-

Up Coupon
Treatment of the Step- If Step-Up occurs, the Fixed Rate will Fixed Rate payment (premium) paid by the buyer may
Up Coupon Feature increase by the same amount or be adjusted for any "step-up" feature of the Reference
alternatively Buyer may choose the Obligation.
Optional Step-up Early
Termination of the swap
96
Credit Derivatives
Page 193
Pay-As-You-Go and CDS Comparison: Credit

Events
Credit Events Floating Amount Events ("soft credit The agreement does not allow for "soft credit events".
events"):
"Soft credit events" (Floating Credit Events:
Amount Events) do not - Writedown
- Failure to Pay (of minimum $100,000, with no grace period
trigger settlement, instead
- Interest Shortfall (applies to both PIK-able extension) - Failure to pay principal or interest scheduled
Seller makes cash payments
and non-PIK-able interest) or due when one of the following three conditions is
to Buyer of interest/principal
satisfied:
shortfall or writedown amount. - Failure to Pay Principal (no minimum
requirement): (i) Reference obligation does not allow payment shortfall
"Hard" credit events allow
reversal/reimbursement
Buyer to trigger settlement. (i) a failure to pay an Expected Principal
Amount on the Final Amortization Date or the (ii) Reference obligation does not allow interest greater than or
Legal Final Maturity Date or equal to scheduled interest rate on payment shortfall
(ii) payment on any such day of an Actual (iii) Non-payment leads to Default for reference obligation.
Principal Amount that is less than the
- Loss Event - Principal Reduction when reference obligation:
Expected Principal Amount
(i) does not allow Principal Reduction reversal/reimbursement
Credit Events ("hard" credit events):
(ii) does not allow interest on Principal Reduction, or
- Failure to Pay Principal (note choice)
(iii) does not allow interest on interest, which would have accrued
- Writedown (note choice)
on Principal Reduction.
(continued on next page)
Credit Derivatives
Page 194
Pay-As-You-Go and CDS Comparison: Credit

Events (continued)
- Distressed Ratings Bankruptcy (the bankruptcy event must
Downgrade* (Caa2 or trigger Default for the Reference
below by Moody's, or CCC Obligation).
or below by S&P or Fitch)
Rating Downgrade (Ca or lower by
- Maturity Extension* Moody's or CC or lower by S&P or Fitch)
(Extension of Legal Final
Restructuring*
Maturity Date)
*Parties may wish to consider whether a
* The Distressed Ratings
standard or amended Restructuring
Downgrade and Maturity
Credit Event is required
Extension Credit Events
may not be applicable to
CMBS.
97
Credit Derivatives
Page 195

Interest Shortfalls
Interest Shortfall and There is no carve-out for PIK-able securities. No interest shortfalls or interest shortfall cap arrangement exists.
Interest Shortfall Cap However, they can be treated through the
interest shortfall mechanism as one of the
soft credit events, triggering cash payments
by the Seller. Such amounts may be netted
against the premium.
Interest Shortfalls may be subject to caps:
- Fixed Cap - Seller's exposure to interest

shortfall is capped at the fixed rate payable.
Applied primarily to RMBS.
- Variable Cap - Seller's exposure is equal

to the fixed rate payable PLUS Libor. Applied
mainly to CMBS.
- No Cap Applicable - Seller's exposure is

equal to the reference obligation coupon.
Credit Derivatives
Page 196
Pay-As-You-Go and CDS Comparison

Settlement Only Physical Settlement in whole or part at Cash Settlement unless Buyer chooses Physical Settlement. Only
Buyer’s option is allowed. Only Reference Reference Obligation is Deliverable.
Obligation is Deliverable.
- Cash Settlement N/A Three business days after final valuation, using the Highest Valuation
Method. Calculation based on a dealer poll valuation (2 dealers are
nominated by the Buyer, 2 dealers - by the Seller, for a total of at least 5
dealers). Poll is repeated every five days until two firm bids are received
or 60 days expire. The highest quotation determines settlement price: if
no quotations are received, then the price is zero.
The longest number of Business Days for settlement in accordance with

- Physical Settlement Period Five Business Days the current market practice for the Reference Obligation as determined
by the Calculation Agent after consultation with the parties, subject to a
maximum of 30 Business Days.
In addition to the amount payable by Seller (notional), Seller shall also

pay to Buyer an amount equal to any accrued but unpaid interest up to
- Physical Settlement Notional adjusted for previous settlements, and including the Delivery Date on the Deliverable Obligations that
Amount Writedowns and Writeups. Buyer has Delivered (the "Interest Amount")
98
Credit Derivatives
Page 197
EXAMPLE: Assume a CDS on an ABS reference

obligation with a notional amount of $100 and
annual premium of 1.5%.
(1) Before principal write-down
Fixed payment/
CDS premium 150 bp
Protection buyer or fixed-rate payer Protection seller/writer or floating-rate
(short credit risk) payer (long credit risk)
Reference obligation
Notional = $100
Credit Derivatives
Page 198
EXAMPLE (continued)
(2) After $20 principal write-down
Fixed payment/
CDS premium 150 bp ($1.20)
Floating payment/
Write-down amount $20
Notional = $80
99
Credit Derivatives
Page 199
EXAMPLE (continued)
(3) After $20 principal write-up
Fixed payment/
CDS premium 150 bp
Additional fixed payment/
Write-up amount $20
Notional = $100
Credit Derivatives
Page 200
PAUG CDS: Sample Credit Developments

What happens if…. ….Result
Underlying reference obligation reaches its cap Floating payment made from seller to buyer equal to the
amount of the shortfall, netted against the fixed payment
(CDS premium) paid by the buyer to the seller. If fixed cap
is applicable, then the floating payments in respect of
interest cannot exceed the CDS premium
Underlying reference obligation is below its cap after a Additional fixed payment made from buyer to seller equal to
period of being at its cap. Assume the obligation has paid any unreimbursed interest shortfalls (the protection buyer is
"catch up" interest first reimbursed for shortfalls)
Excess losses result in (a) an explicit writedown of principal Floating payment from seller to buyer equal to the
or (b) no explicit writedown of principal has occurred but an writedown amount + credit event: protection buyer has
implicit writedown has occurred based on pre-determined option to physically settle and deliver reference obligation to
variables (eg securities are under-collateralized, etc.) seller
Previously written down amounts have been written up due Additional fixed payment (reimbursement) from buyer to
to improvement in collateral pool seller equal to the write-up amount
Downgrade of reference obligation to a pre-agreed Credit event => protection buyer has option to physically
distressed level (triple-C, etc.) settle and deliver reference obligation to seller
100
Credit Derivatives
Page 201
Future Developments for ABS

• A significant market has developed in the last 12 months: forms
have allowed investors to access a wide variety of ABS which
were difficult to source in the cash market and enhanced liquidity
of the market
• CDS on CDOs has been published
• PAUG will be applied to a broader range of structured finance

securities
• PAUG will be standardized for monoline (and not just dealer)

transactions: monoline insurers only want actual default risk
(failure to pay or bankruptcy) and not market risk (“soft” credit
events such as loss event/writedown, rating downgrade and
maturity extension)
Credit Derivatives
Page 202
Big and Small Bang Protocols
101
Credit Derivatives
Page 203
Big and Small Bang Protocols

• During 2009, ISDA has published two industry Protocols
which implement significant changes to credit derivative
contracts
• By adhering to the Big Bang Protocol and the Small Bang

Protocol, parties to certain covered CDS transactions have
been able to effect amendments to their CDS trades with
other adhering parties
• ISDA recently announced a Subsequent Adherence Period

for the Small Bang Protocol, which opened on October 5,
2009 and will close on January 31, 2010
Credit Derivatives
Page 204
Big Bang Protocol
102
Credit Derivatives
Page 205
Big Bang Protocol
• The Big Bang Protocol implements the Supplement to the

2003 ISDA Credit Derivatives. Major changes contained in
the Supplement are:
— The Supplement incorporates the resolutions of the
Determinations Committees (the “DC”) into the Credit
Derivatives Definitions. The DC now supersedes the roles
the Calculation Agent and the parties previously had in
respects of Credit Events, Auction Terms and Succession
Events.
Credit Derivatives
Page 206
Big Bang Protocol
— Under the Supplement, Auction Settlement is hardwired as

the Settlement Method. While standard CDS contracts
historically contemplated Physical Settlement (with certain
Cash Settlement fallbacks), the industry since 2005 was
settling contracts in liquid credits by publishing individual
auction Protocols for each Credit Event. The changes
implemented through the Big Bang Protocol make Auction
Settlement standard.
103
Credit Derivatives
Page 207
Big Bang Protocol
— The Supplement also adds backstop dates for Credit Events

and Succession Events.
• A Succession Event must occur no more than 90 days

prior to notification to the DC
• A Credit Event must occur no more than 60 days prior to

notification to the DC
• Credit Events and Succession Events may be effective

even if they precede the Trade Date
Credit Derivatives
Page 208
Big Bang Protocol—Determinations Committee
• Responsibilities: Among other things, the DCs have

responsibility for the following: (i) determining whether a
Credit Event has occurred, its type and date; (ii)
determining whether to hold one or more auctions and the
specific terms of the auction; (iii) making determinations
about deliverable obligations and any substitute reference
obligations; and (iv) making determinations regarding
succession events.
• Resolutions of the DC are binding in respect of all CDS

transactions which have incorporated the Supplement.
104
Credit Derivatives
Page 209
Big Bang Protocol—Determinations Committee

• There is one DC for each of five regions. The DC for each region
deliberates issues involving Reference Entities traded under the
Transaction Type of the Relevant Region. The membership of each DC
is structured as follows:
— 8 Global Dealers
— 2 Regional Dealers for each of the 5 Regions
— 5 Buyside Members
— 2 non-voting Dealer members (one global, one regional), with one additional
non-voting global dealer for the first year
— 1 non-voting Buyside Member
— ISDA acts as the DC Secretary (non-voting)
• There are separate criteria for membership on a DC depending on

whether a candidate is a dealer or a buy-side member.
Credit Derivatives
Page 210
The Determinations Committees (cont.)

Any ISDA member may request that a DC be convened to consider a
question. At least one DC member must agree to consider the question.
Every DC member is required to vote in all binding votes with one excused
absence per year. All resolutions by a DC are published by ISDA. The
deliberations of a DC are confidential until relevant information is published.
The DC Secretary publishes the following information: (i) meeting requests

and the supporting information submitted with such request (e.g., Publicly
Available Information in connection with Credit Events); (ii) each convening
of a DC and the questions to be deliberated; (iii) each decision of a DC to not
deliberate a question, transfer a question or dismiss a question; (iv) each
binding vote of a DC (along with identity and vote of each member); and (v)
other information that the DC decides to publish by a majority.
105
Credit Derivatives
Page 211
The Determinations Committees (cont.)

Questions will be sent for External Review if
(A) a DC holds a binding vote on a question regarding a Credit
Event, Deliverable Obligation (and related issues), Succession
Event, Substitute Reference Obligation or the Merger of a
Reference Entity and Seller; and
(B) an 80% supermajority is not achieved.
An ISDA Member may nominate a candidate to be an

External Reviewer. Candidates will be confirmed by a
majority of a DC. Selected External Reviewers must disclose
potential conflicts of interest.
Credit Derivatives
Page 212
Credit Events
• Prior to the Big Bang Protocol and the 2003 Supplement,
credit derivative contracts were triggered by bilateral Credit
Event Notices exchanged between Buyer & Seller.
• The 2003 Supplement eliminates the need to exchange

bilateral CENs in respect of Credit Events for which the DC
makes a ruling (but CENs are still applicable where the DC
makes no ruling). Also, as noted below, the requirement to
trigger is still relevant in the context of a Restructuring Credit
Event (even after implementation of the Small Bang Protocol).
106
Credit Derivatives
Page 213
Credit Events
• The determination of a DC in respect of a Credit Event applies
to all Covered Transactions. The steps for initiating
consideration of a Credit Event question by a DC are as
follows:
— Any ISDA Member may notify the DC Secretary asking that a DC consider whether
a Credit Event has occurred. This notice to the DC Secretary must include Publicly
Available Information (“PAI”).
— The question must be endorsed by at least one DC member. If a DC agrees to

consider the question, the relevant settlement timelines for the credit derivatives
contracts are extended to accommodate the DC process.
— A DC may vote not to determine a question (by a 80% supermajority)
— If a DC agrees to consider a question, it must arrive at a decision within two

Business Days unless it votes (again, by a 80% supermajority) to extend.
Credit Derivatives
Page 214
Hardwiring of Auction Mechanism

• Prior to the Big Bang and the Supplement, CDS contracts
generally contemplated physical settlement. Beginning in
2005, an auction process was developed to determine the
recovery rate on a defaulted reference entity. Market
participants signed up to individual protocols administered
by ISDA to amend their trades.
• The Supplement hardwires the Auction mechanics into the

covered CDS contracts.
107
Credit Derivatives
Page 215
Hardwiring of Auction Mechanism

• The Auction methodology contained in the main section of the Auction
Settlement Terms was designed to remain largely consistent from
auction to auction. There is a template of auction specific terms which
are determined for each auction together with the Deliverable
Obligations.
• If a DC determines that a Credit Event has occurred, the DC also

decides whether to publish Auction Settlement Terms for the relevant
Reference Entity.
• The Auction-specific terms are set by the DC by a majority vote (e.g.,

the Auction Date). Deliverable Obligations to be valued in the auction
can be proposed by market participants for consideration by a DC. The
DC determines the Deliverable Obligations and the DC Secretary is
responsible for publishing lists.
Credit Derivatives
Page 216
Succession Events
• Prior to the changes in the Supplement, the Calculation Agent

was responsible for making determinations related to
Succession Events. Now the determinations of the DC govern
succession questions in covered CDS contracts.
• Any ISDA member may initiate consideration of a Succession

Event question by a DC; the process is similar to how the
consideration of a Credit Event is initiated.
• Once a question is posed, the DC will meet no earlier than 14

days after the event to consider whether a Succession Event has
occurred.
108
Credit Derivatives
Page 217
What Transactions were covered by the Big

Bang Protocol?
• A broad range of CDS transaction types were covered by the Big

Bang Protocol (exclusions were loan only CDS, US muni CDS,
CDS on ABS/CDO and transactions specifically excluded by
bilateral agreement)
• By adhering to the Big Bang Protocol, parties incorporated the

Supplement into all the Covered Transactions existing between
adhering parties on April 7, 2009.
Credit Derivatives
Page 218
What Transactions were covered by the Big

Bang Protocol?
• Certain transactions were covered by the Big Bang Protocol but

excluded from the application of any Auction Settlement Terms.
This group of trades includes Reference Obligation only CDS,
Preferred CDS, Fixed Recovery CDS and any transaction for
which documents already said that auction settlement will not
apply.
• The Supplement is also incorporated into future Covered

Transactions (or novations) between adhering parties. The
amendments apply to all trades through January 31, 2011.
109
Credit Derivatives
Page 219
Small Bang Protocol
Credit Derivatives
Page 220
Small Bang Protocol

• Following the publication of the March 2009 Supplement,
market participants developed a series of amendments to
apply Auction Settlement following a Restructuring, while
replicating, to the extent practicable, the maturity limitation
requirements for Deliverable Obligations contained in the
Definitions.
• Changes set out in a new supplement to the 2003

Definitions, the Restructuring Supplement.
• To be incorporated into Confirmations of new CDS

contracts and into existing CDS contracts via a new ISDA
Protocol.
110
Credit Derivatives
Page 221
Small Bang Protocol

• Restructuring Auction Problem:
— Mod R and Mod Mod R maturity limitations
— What is deliverable for a transaction with one Scheduled

Termination Date may not be deliverable for a Transaction
with a different Scheduled Termination Date
— Auction requires a single list of Deliverable Obligation
— Allocation of Transactions to maturity buckets allows for the

determination of a list of Deliverable Obligations for each of
the maturity buckets and an auction for each of the buckets
to settle the contracts.
— Buyer versus seller trigger.
Credit Derivatives
Page 222
Small Bang Protocol
• Benefits:
— Certainty--Enables settlement by auction following a
restructuring event
— Consistency--Consistent with the settlement mechanism in

place for bankruptcy and failure to pay
— Facilitates the use of central counterparties
— A robust settlement mechanism – delivered through proven

auction settlement – is critical for central clearing of
contracts with Restructuring
111
Credit Derivatives
Small Bang Protocol—Maturity Buckets Page 223
Following a Restructuring, CDS contracts are automatically assigned

to Maturity Buckets by reference to Scheduled Termination Date
The Maturity Bucket End Dates are the IMM Roll Dates occurring on
or immediately following the dates that are 2.5 years, 5 years. 7.5
years, 10 years, 12.5 years, 15 years, 20 years and 30 years after
the Restructuring Date.
Each Maturity Bucket runs from the Restructuring Date to its

respective Maturity Bucket End Date.
Maturity bucket concept applies regardless of whether or not the DC

determines:
(a) that a Restructuring has occurred or

(b) that Auctions will be held
Credit Derivatives
Page 224
Small Bang Protocol—Triggering
• In all circumstances, a Notifying Party must trigger a CDS

contract in order for an Event Determination Date to occur
with respect to such CDS contract.
Buyer/seller retain the freedom to decide whether or not to
trigger settlement
• Once a Credit Event Notice (CEN) is sent, if an Auction will

be held, the date that the question was raised to the DC
will be the common Event Determination Date
• CEN must be effectively delivered prior to the exercise

Deadline
112
Credit Derivatives
Page 225
Small Bang Protocol—Deliverable Obligations

• The Deliverable Obligations for CDS contracts assigned to a
Maturity Bucket are those with a final maturity date on or prior to
the Maturity Bucket End Date
• Exception: Mod Mod 5 year Maturity Bucket

— Where Mod Mod R is applicable, Restructured Bonds or Loans with
a final maturity date up to 5 years after the Restructuring Date will
be deliverable to settle CDS contracts assigned to the 2.5-year
Maturity Bucket.
• Deliverable Obligations with a final maturity date on or prior to a

relevant Maturity Bucket End Date will be deliverable into
— (a) such Maturity Bucket and
— (b) Maturity Buckets with later Maturity Bucket End Dates
Credit Derivatives
Page 226
Small Bang Protocol—Maturity Bucket

Conventions
• Rounding down convention
— If the Scheduled Termination Date would occur prior to the final maturity
date of the Deliverable Obligation with the earliest final maturity date of any
Deliverable Obligation allocated to the Maturity Bucket to which such CDS
contract would be assigned based solely the Scheduled Termination Date
such CDS contract will instead be assigned to the Maturity Bucket with the
next earliest Maturity Bucket End Date.
— Example: If the Scheduled Termination Date would occur 6 years after the
Restructuring Date and there is no Deliverable Obligation with a final
maturity date occurring between 5 and 6 years following the Restructuring
Date, then the CDS contract will be assigned to the 5-year Maturity Bucket,
even though based solely on its Scheduled Termination Date, it would
otherwise be assigned to the 7.5-year Maturity Bucket.
113
Credit Derivatives
Page 227
Small Bang Protocol—Maturity Bucket

Conventions
• If Seller Triggers
— If Seller triggers, the CDS contract will be assigned to the 30-year Maturity
Bucket, regardless of the Scheduled Termination Date.
• The Movement Option—If the CDS contract is assigned to a Maturity

Bucket that will not have an Auction:
— (a) The Buyer can move the CDS contract down to the Maturity Bucket with
the next earliest Maturity Bucket End Date that is having an Auction
— (b) The Seller can move the CDS contract to the 30-year Maturity Bucket if
that Maturity Bucket is having an Auction.
Credit Derivatives
Page 228
Small Bang Protocol—Timeline
DC compiles Initial,
Supplemental and final Triggering Deadline Movement Option
lists of Deliverable (Use it or Lose it) deadline
Obligations for each
Maturity Bucket
5 business 3 business 2 business
Approximately 2 weeks days days days
1 business
day later
Earliest possible
Auction Date
DC publishes -latest date by which
-final list of Deliverable ISDA announces
Obligations auctions
-the range of Scheduled - announcement can be
Termination Dates for made earlier if the DC
Each Bucket learns from DTCC that
the 300/5 Criteria have
been satisfied
114
Credit Derivatives
Page 229
Small Bang Protocol—Procedures for Auctions

• DC determines that a Restructuring Credit Event has occurred.
• DC compiles an Initial List, a Supplemental List and a Final List of Deliverable

Obligations for each Maturity Bucket (over an approximate 2 week period).
• ISDA publishes range of Scheduled Termination Dates for each Bucket.
• Triggering Deadline: after publication of the Final Lists of Deliverable Obligations,

parties will have 5 Business Days to trigger CDS contracts.
• DC will determine whether each Bucket will have an Auction; ISDA announces
decision.
• Movement Option Deadline: parties to CDS contracts assigned to a Maturity

Bucket for which no Auction is held have 3 Business Days after the Triggering
Deadline to exercise the Movement Option.
• The Auction Date will be set to occur no earlier than 2 Business Days following
the Movement Option Deadline.
Credit Derivatives
Page 230
Ongoing Industry Initiatives
115
Credit Derivatives
Page 231

• To improve the fungibility and liquidity of CDS contracts,
ISDA and market participants agreed to new trading
conventions for the CDS markets.
• Changes include:
— Adoption of full first coupon periods for all contracts;
— A move from monthly to quarterly "roll" dates in emerging market CDS

transactions;
— A move to trade North American and Emerging Market investment grade

credits with a fixed premium of LIBOR+100 and high yield credits with a
fixed premium of LIBOR+500; and
— A move to trade European credits with fixed coupons of 25bp, 100bp,

500bp and 1000bp and, for the purposes of applying standard coupons
retroactively to outstanding European credits, additional standard coupons
of 300bp and 750bp.
Credit Derivatives
Page 232

• Dealers are actively engaged with central clearing
counterparties ("CCPs") to broaden the range of cleared
products and market participants
• Products that will be added in 2009 include liquid single

name CDS
• Further products will be added in 2010, including tranched

CDS
• Eventually, goal is to achieve buy-side access to CDS

clearing (through either direct CCP membership or
customer clearing) with customer initial margin segregation
and portability of customer transactions
116
Credit Derivatives
Page 233
• In September 2009, Group of 15 major OTC derivatives

dealers (G15) committed to New York Federal Reserve to
increase the usage of central counterparties for clearing.
• Result should be to significantly reduce the systemic risk

profile of the OTC derivatives market.
• Letter sets performance targets that are to increase over

time as results are achieved.
Credit Derivatives
Page 234
• Performance Targets for CDS

— Each G15 member (individually) committed to submitting
95% of new eligible trades (calculated on a notional basis)
for clearing beginning October 2009.
— The G15 members (collectively) committed to clearing

80% of all eligible trades (calculated on a weighted average
notional basis) beginning October 2009.
117
Credit Derivatives
Page 235
• In addition:
— Will issue performance metrics that address both new
transactions and the outstanding trade population on a
monthly basis.
— First report will be issued on the 10th business day of

October 2009 and will be in respect of September 2009, and
for each month thereafter, the relevant report will be issued
as part of the monthly metrics currently reported.
Credit Derivatives
Page 236

• Related commitments:
— Working with the regulators to explore means to improve
submission levels and clearing yields.
— Actively engaging with CCPs and regulators globally to

broaden the set of derivative products eligible for clearing,
taking into account risk, liquidity, default management and
other processes.
— Working with eligible CCPs and regulators globally to

expand the set of counterparties eligible to clear at each
eligible CCP taking into account appropriate counterparty
risk management considerations, including the development
of buy-side clearing.
118
Credit Derivatives
Page 237
Ongoing Industry Initiatives—Electronic Trade

Processing
• Submission and matching with an end goal of T+0

confirmation
• Increased electronic processing across asset classes
• Increased standardization of confirmation documentation
• Continued focus on aged confirmation reduction targets
Credit Derivatives
Page 238
Ongoing Industry Initiatives—Electronic Trade

Processing
• Commitment by Operations Management Group ("OMG") to
implement:
— By December 31, 2009, 90% T+0 submission for all electronically
eligible transactions
— By December 31, 2009, 100% T+0 matching for clearing eligible

transactions
— By December 31, 2009, 94% T+2 matching for all electronically

eligible transactions to ensure timely settlement of cash flows
• By September 30, 2009, all electronically eligible new trades and

novations where one or more parties to the transaction are OMG
members to be confirmed on DTCC or another electronic
platform
119
Credit Derivatives
Page 239
Ongoing Industry Initiatives—Trade

Repositories
• Commitment of OMG to report, from and after July 17,

2009, all credit derivative trade records to a trade
repository.
• Trade record registrations will be updated weekly.
• Regulators to have access to the trade repository.
Credit Derivatives
Page 240
Ongoing Industry Initiatives—Achievements So

Far
• First CCP went live for US index CDS as of March, 2009.
• Additional CCPs were launched in 2009 for Credit

Derivative (CDS) markets.
• $80 trillion in global interest rate swaps and $600 billion in

U.S. CDS have been cleared.
• CDS CCP clearing will expand to European CDS as

previously committed to the European Commission.
• Credit Event Settlement: Auction hardwiring completed

April 8, 2009, to allow for auction-based settlement of
CDS.
120
Credit Derivatives
Page 241
Ongoing Industry Initiatives—Achievements So

Far
• Since October, 2008, the gross notional value of outstanding
CDS and interest rate swap trades each decreased by
approximately $15 trillion, through tear up cycles. Progress is
ongoing and aggressive cycles continue.
• Electronic matching rates of eligible confirmation events

increased from 96% to 98% in CDS.
• Weekly (and in many cases, daily) reconciliation between the

undersigned dealers of collateralized portfolios since December,
2008.
• Aged confirmations declined steadily as a fraction of business

days' outstanding from 0.3 to 0.1 days for CDS.
Credit Derivatives
Page 242
Interesting Legal and Documentation

Issues
121
Credit Derivatives
Page 243
Legal and Documentation Issues—

Fannie/Freddie
• When Fannie Mae and Freddie Mac became subject to

conservatorship, a Bankruptcy Credit Event was triggered,
even though their debt was trading at close to par given
the support of the US government
• One type of the many Obligations issued by these entities

were bonds sold at a significant original issue discount
(“OID”)
Credit Derivatives
Page 244

Fannie/Freddie
• Under the 2003 Definitions, a zero coupon bond typically is

deliverable in a principal amount equal to its accreted
value and not its face amount. These bonds had terms
(i.e., no redemption price determined by reference to
accreted value) that many argued made them deliverable
at their face amount even though they were trading well
below par due to the OID
• If deliverable, sellers of protection would have to pay par

for bonds trading well below par due to their unique terms
as opposed to the financial condition of the Reference
Entities
122
Credit Derivatives
Page 245

Fannie/Freddie
• ISDA board determined that this result would have been

bad for the CDS product. It asked a law firm to issue an
opinion that the bonds were not good Deliverable
Obligations.
• Although all market participants did not agree with the

opinion, market participants did not deliver these unique
bonds and the CDS market avoided having sellers of
protection paying out large sums on CDS transactions
referencing a credit whose debt was trading at or close to
par.
Credit Derivatives
Page 246
Legal and Documentation Issues—Qualifying

Guarantees
• Qualifying Affiliate Guarantees are specified if the parties
agree that only parent-subsidiary guarantees can trigger
and be used to settle CDS
• In North American market, CDS trade using Qualifying

Affiliate Guarantees
• Guarantees that are not Qualifying Affiliate Guarantees

may be subject to enforceability issues due to lack of
consideration/fraudulent transfer/Section 548 of the
Bankruptcy Code
• Similar risks exist in Europe and Japan, but participants in

those markets have opted for All Guarantees
123
Credit Derivatives
Page 247
Legal and Documentation Issues—Qualifying

Affiliate Guarantee
• May be difficult to tell if the Reference Entity is a

Downstream Affiliate (measured at date of Credit
Event).
• Risk that guarantee may be void if guarantee given

prior to entity becoming a Downstream Affiliate.
Credit Derivatives
Page 248
Legal and Documentation Issues—Naked CDS
• Naked CDS is one where the buyer has no risk exposure

to the Reference Entity; hence a naked CDS does not
hedge risk per se, but is a speculative bet whose buyer will
be rewarded if there is a Credit Event
• Suggestion that a buyer should be required to own the

bond or loan that qualifies as a Deliverable Obligation in
order to reduce the risk that it may seek to foment a loss in
order to recover on a CDS
124
Credit Derivatives
Page 249
Legal and Documentation Issues—Credit

Protection and the Restructuring Process
• Restructurings of outstanding debt outside of bankruptcy

can be difficult
• Difficulties may increase when bondholders (or some but

not all bondholders) have purchased credit protection
• Sellers of protection that has not been exercised wish to

“sit at the table”
Credit Derivatives
Page 250

Restructuring Credit Event
• Thomson SA
• Determinations Committee for EMEA resolved that a

Credit Event has occurred on June 15, 2009
• This is the first Restructuring Credit Event to take effect

after the Small Bang Protocol
• Issues arising:
— Ability to exercise after Scheduled Termination Date
— Calculation of Premium
— Calculation of Exercise Amount based upon who delivers

notices
125
Credit Derivatives
Page 251

Restructuring Credit Event
• Cemex deferral of the payment of principal of $15 billion in

bank and private placement obligations
Credit Derivatives
Page 252
Legal and Documentation Issues—CDS in

Structured Transactions after Lehman
• As a condition to participating in many structured finance
transactions, swap counterparty typically agreed to
subordinate any claim against the issuer arising from an
event of default (and certain termination events) to the
claims of holders of rated securities
• Lehman now arguing that such a subordination provision is

not enforceable against it by reason of (a) ipso facto
provision in Section 365(e)(1) of Bankruptcy Code and (b)
its status as a forfeiture under Section 541 of the
Bankruptcy Code
126
Credit Derivatives
Page 253
Legal and Documentation Issues—CDS in

Structured Transactions after Lehman
• Subordination has been upheld in an English case
(Perpetual)
• That case is being appealed, but original decision is likely

to be upheld
• Could create interesting cross-border insolvency dispute,

perhaps one that will test whether cross-border insolvency
statutes or regulations such as those in Chapter 15 of the
Bankruptcy Code will be adequate to solve such an issue
Credit Derivatives
Page 254
CDS and the Financial Crisis
127
Credit Derivatives
Page 255
CDS and the Financial Crisis—Introduction
• Important to understand what went wrong and

why.
• In many cases, what went wrong has less to do

with CDS than with financial markets generally.
• But also important to understand what went right.
Credit Derivatives
Page 256
CDS and the Financial Crisis—Separation of

Ownership and Control
• Creation of financial assets (e.g., corporate and mortgage loans)
with fewer covenants and less attention paid to origination
standards
• Credit risk passed to hedge funds, insurance companies, etc.

As to any particular credit, they may have less of an incentive to
maximize recovery (free rider problem)
• Creation of these financial assets was facilitated by CDS

(together with collateralized debt obligation funds), which
provided a link to a market to bear the risk of such assets
128
Credit Derivatives
Page 257
CDS and the Financial Crisis—Separation of

Ownership and Control
• Investors relied on ratings as opposed to examining underlying
covenants and origination standards. Ratings frequently based
on a relatively recent period of economic history that coincided
with a robust general economic expansion as well as explosive
growth in securitization and derivatives.
• Lengthy period of low yields in U.S. Treasury and agency

markets caused investors to look for "yield enhancement“
• More "leverage" in the system as a result of these financial

assets caused underlying prices to increase (e.g., amounts paid
in corporate mergers and acquisition transactions and residential
real estate prices)
Credit Derivatives
Page 258
CDS and the Financial Crisis—AIG FP and CDS

on ABS CDOs
• Credit Default Swaps were written that referenced "Aaa/AAA"

rated tranches of collateralized debt obligation funds that
invested in residential mortgage-backed securities
• The CDO securities typically had legal final maturities of 35

years or more
• Given defaults and home price declines in the residential real

estate market (and market liquidity issues generally), it became
very difficult to observe the prices of the underlying residential
mortgage-backed securities held by these ABS CDOs
129
Credit Derivatives
Page 259

on ABS CDOs
• Credit Default Swaps were

— Pay As You Go—Seller of protection in many cases could defer
making payments until legal final maturity so long as writedowns
and interest payments were covered
— Puts—Buyer of protection was a Rule 2a-7 money market fund that

sought to invest in a short-term asset (397 days and less) based on
the put even though the underlying asset had a legal final maturity
of 35 years
• Obligations of AIG Financial Products ("AIG FP") were typically

guaranteed by AIG
Credit Derivatives
Page 260

on ABS CDOs
• Rating agencies required that AIG FP agree to post collateral or

locate a replacement swap counterparty in the event of a
downgrade of the rating of AIG as Credit Support Provider below
a specified threshold
• In many cases, AIG FP booked at time of origination the present

discounted value of all future premium income from the sale of
these Credit Default Swaps (because the CDS in question
provided for payment of the premium until legal final maturity,
with a make-whole in the event of early redemption)
130
Credit Derivatives
Page 261

on ABS CDOs
• When the enormity of the losses and potential losses became

known to the market, AIG's rating was downgraded, thereby
causing an obligation to post enormous amounts of collateral to
numerous OTC derivatives counterparties
• AIG and AIG FP did not have the liquidity to meet these posting
requirements, causing (a) further financial distress to AIG and
(b) risk to OTC derivatives counterparties of AIG FP that
accordingly faced serious mark-downs in the value of the credit
protection purchased (and other related consequences)
Credit Derivatives
Page 262
CDS and the Financial Crisis—Lack of

Transparency
• OTC credit default swaps are "over-the-counter",

meaning that they are not traded on an organized
exchange and generally do not have
standardized terms
• Given the foregoing, it is difficult for a buyer or

seller of an OTC credit default swap to value a
particular swap based on observable market
prices
131
Credit Derivatives
Page 263

Transparency
• Under FAS 157, companies must measure fair value by
segregating observable and unobservable inputs into
Level 1, Level 2 and Level 3 inputs:
— Level 1 inputs are market observed inputs such as quoted
prices
— Level 2 inputs refer to using quoted prices as inputs to

construct the price for an instrument (e.g., valuing an interest
rate swap based upon observable interest rate forward
contracts)
— Level 3 inputs refer to unobservable inputs (e.g., calibrated

model parameters) used to derive the fair value
Credit Derivatives
Page 264

Transparency
• Companies (both financial and non-financial)

were criticized for:
— Carrying CDS at values that did not reflect market
realities
— Lacking the sophistication necessary to produce

reliable valuations in the absence of quoted prices
132
Credit Derivatives
Page 265

Transparency
• This is the essence of Warren Buffet's criticism of
derivatives as financial weapons of mass destruction
— Before settlement, parties to credit default swaps (and other OTC
derivatives) report profits and losses in huge amounts, with
inaccuracies that may be reflected many years in the future
— Errors usually reflect the human tendency to take an optimistic view

of one's commitments
— However, parties to derivatives also have enormous incentives to

value them incorrectly. Traders are paid in part based on earnings
derived from mark-to-market accounting. But, in the absence of a
market, models are used—which Buffet believed creates the
potential for large-scale mischief.
Credit Derivatives
Page 266

Transparency
• Models of contracts involving multiple reference

obligations and distant settlement dates increase
the necessity for making complex assumptions,
with the scale of adverse consequences
increasing by making the wrong assumptions
133
Credit Derivatives
Page 267

Resolution Authority
• The current financial crisis revealed the consequences of a
regulatory gap when it came to addressing the failure (or
potential failure) of systemically significant financial
institutions that fall outside of the existing resolution
regime under the FDIC.
• For an FDIC-insured bank, the FDIC has extensive powers

under the Federal Deposit Insurance Act that are designed
to manage the resolution of the troubled bank in a manner
that limits the systemic risk with the least cost to
taxpayers.
Credit Derivatives
Page 268

• However, when a large, interconnected non-bank financial

firm is in severe distress, there are currently only two
options:
— Obtain outside capital or funding from the Federal
government as in the case of AIG
— File for bankruptcy as in the case of Lehman Brothers
134
Credit Derivatives
Page 269

• In the case of AIG, the Federal government provided

enormous amounts of financial assistance in order to avert
the risks to the global financial system of the rapid and
disorderly failure of such a large, complex entity in a fragile
market environment.
Credit Derivatives
Page 270

• In the case of Lehman Brothers, the impact of the
bankruptcy of a large interconnected financial firm during a
period of severe financial stress created a near financial
panic.
— Several money market funds had significant exposure to
Lehman. Concern about the stability of money market funds
caused investors to withdraw funds, thus creating further
instability in the financial system.
— That instability ultimately obliged the Treasury Department to

establish the money market fund guarantee program.
135
Credit Derivatives
Page 271

— Counterparties to other broker dealers, worried that their

assets would be compromised in their insolvency, sought to
withdraw those assets and move them to perceived safer
havens.
— The termination and liquidation of 900,000 financial contracts

with myriad counterparties has caused financial distress
across many markets.
Credit Derivatives
Page 272
CDS and the Financial Crisis—Loss of Initial

Margin
• Many OTC derivatives call for the provision of initial margin
(or, in ISDA terminology, an "Independent Amount")
• Initial margin represents:

— A buffer to cover required variation margin (or, in ISDA
terminology, "Exposure") in excess of collateral previously
posted due to the fact that a valuation determination and the
collateral posting do not occur instantaneously
— A minimum amount of "equity" in an OTC derivative

transaction (which limits the total notional exposure that can
be obtained from a derivative transaction)
136
Credit Derivatives
Page 273

Margin
• A counterparty to a dealer that did not worry too much

about the dealer's insolvency did not worry too much about
the failure of the dealer to return the initial margin
• The bankruptcy of Lehman Brothers caused every

financial participant to re-assess the risk of providing initial
margin to a dealer
Credit Derivatives
Page 274

Margin
• The Lehman bankruptcy turned the traditional secured
lending result on its head:
— In a secured financing, the lender that holds collateral
worries that the collateral cannot be sold promptly (due to
the automatic stay and the right of the debtor to use
collateral), thereby exposing the lender to the risk that the
borrower's equity in the collateral may diminish over time.
— In a derivative transaction, a counterparty that provides initial

margin to an OTC derivatives dealer that provides notional
exposure in return must now worry that its equity in the
transaction may be impaired
137
Credit Derivatives
Page 275

Margin
• Analogous concerns had to be addressed by the prime

brokerage businesses of many banks and broker-dealers
• Numerous new structures are being developed to protect

initial margin
Credit Derivatives
Page 276
CDS and the Financial Crisis—What Went

Right—Corporate CDS Market Held Up
• The CDS market has held up extremely well under the

strains of multiple failures of large market participants and
issuers of debt.
• Auction and settlement processes performed as intended.
• More than 40 Credit Events processed globally since

October, 2008
• Collateral and netting arrangements among market

participants have operated as intended.
138
Credit Derivatives
Page 277
CDS and the Financial Crisis—What Went

Right—Protocols and Cash Settlement Process
• ISDA has implemented numerous auctions to determine

the Cash Settlement Amount payable in connection with a
Credit Event in respect of a broadly traded name
• Auctions generally resulted in an orderly settlement of

obligations of buyers and sellers of credit protection,
without the difficulties of the myriad of settlements that
would have resulted from Physical Settlement
Credit Derivatives
Page 278
Proposed Legislation
139
Credit Derivatives
Page 279
Proposed Legislation
• On October 15, 2009, the House Financial Services Committee
approved legislation requiring the comprehensive regulation of
the market for OTC derivatives
• Bill sets out parallel regulatory frameworks for the regulation of

swap markets, dealers and major swap participants
• Rulemaking authority will held jointly by the CFTC, which has

jurisdiction over swaps, and the SEC, which has jurisdiction over
security-based swaps
• Treasury Department has authority to issue final rules if the

CFTC and SEC cannot decide on a joint approach within 180
days
• Subsequent interpretations of rules must be agreed to jointly by

the CFTC and SEC
Credit Derivatives
Page 280
Proposed Legislation—Clearing
• Bill provides a mechanism to determine which swap transactions
are sufficiently standardized that they must be submitted to a
clearinghouse. For clearable transactions, clearing is a
requirement when both counterparties are either dealers or
major swap participants.
• Clearing organizations must seek approval from the appropriate

regulator—either the CFTC or the SEC—before a swap or class
of swaps can be accepted for clearing
• Transactions in standardized swaps that involve end-users are

not required to be cleared. Such customized transactions must,
however, be reported to a trade repository
140
Credit Derivatives
Page 281
Proposed Legislation—Mandatory Trading on

Exchange or Swap Execution Facility
• A standardized and cleared swap transaction where both
counterparties are either dealers or major swap participants
must either be executed on a board of trade, a national securities
exchange or a “swap execution facility”
• If none of these venues makes a clearable swap available for

trading, the trading requirement would not apply. Counterparties
would, however, have to comply with transaction reporting
requirements established by the appropriate regulator.
• Bill also directs the regulators to eliminate unnecessary

obstacles to trading on a board of trade or a national securities
exchange
Credit Derivatives
Page 282
Proposed Legislation—Regulation of Swap

Dealers and Major Swap Participants
• Swap dealers and major swap participants must register
with the CFTC and SEC (as appropriate) and dual
registration is required in applicable cases
• Capital requirements for swap dealers' and major swap

participants' positions in cleared swaps must be set at
greater than zero
• Capital for non-cleared transaction must be set higher than

for cleared transactions
• CFTC and SEC will set capital for non-banks at a level that
is “as strict or stricter” than that set by banking regulators
141
Credit Derivatives
Page 283
Proposed Legislation—Margin Requirements
• Bill directs regulators to set margin levels for

counterparties in transactions that are not cleared
• Regulators not required to set margin in

transaction where one of the counterparties is not
a dealer or major swap participant. In cases
where an end user is a counterparty to a
transaction, any margin requirements must permit
the use of non-cash collateral.
Credit Derivatives
Page 284
Proposed Legislation—Swap Execution

Facilities
• Facilities for the trading of swaps that are not boards of trade or
national securities exchanges must register with the relevant
regulator as a swap execution facility (“SEF”)
• SEFs must also adhere to core regulatory principles relating to

enforcement, anti-manipulation, monitoring, information
collection and conflicts of interest, among others
• CFTC and SEC to prescribe joint rules governing the regulation

of swap execution facilities. May exempt a SEF from registration
if it is subject to comparable, comprehensive supervision and
regulation by another regulator.
142
Credit Derivatives
Page 285
Other Theoretical Issues
Credit Derivatives
Page 286
Credit Derivatives: Economic Analogues
• Purchasing a participation in an unfunded

financial asset
• Issuing a standby letter of credit
• Issuing a guarantee
• Issuing financial guaranty insurance
143
Credit Derivatives
Page 287
Is a Credit Default Swap a "Guarantee"?
• Claim against Seller is for cash or cash against Delivery of

a Deliverable Obligation
• If Seller defaults and Physical Settlement applies, Buyer

generally has duty to mitigate (by selling the Deliverable
Obligation) and can only sue Seller for the difference
• Seller does not agree to subordinate or defer any claim

against Reference Entity that would arise through
subrogation (analog in credit derivatives being physical
settlement), leaving Seller as a potential competing
creditor
Credit Derivatives
Page 288
Miscellaneous Legal/Regulatory/Tax
Issues
• Insurance
• Capital Adequacy
• Sale Treatment under FAS 140
• Tax Treatment
• Termination and Netting
• Insider Trading
144
Credit Derivatives
Page 289
Insurance
• Federal statute allocates responsibility for insurance

regulation to the States
• National Association of Insurance Commissioners tries to
ensure some uniformity
• States like New York and Connecticut are leaders due to
domicile of many companies in those states
• But statutory language in each state can be problematic
(statutes focus on nature of business conducted in each
state)
Credit Derivatives
Page 290
Insurance—New York Prohibition
• New York Insurance Law provides that no person shall do an

insurance business in New York State unless authorized by a
license in force
• Doing an "insurance business" includes making, or proposing to
make, as insurer, any insurance contract
• An "insurance contract" is any agreement whereby the insurer is
obligated to confer benefit of pecuniary value upon the
beneficiary, dependent upon the happening of a fortuitous event
in which the beneficiary has, or is expected to have at the time of
such happening, a material interest which will be adversely
affected by the happening of such event
145
Credit Derivatives
Page 291
Insurance—New York Interpretations
• Credit Linked Note (Nov. 1995): CLNs are not insurance

contracts because the purchaser makes no ongoing
undertaking or promise to make an additional payment
(and are fungible and transferable, unlike insurance
policies)
• Weather Derivatives (Feb. 2000): Not insurance contracts

because the terms of the instrument do not provide that
payment to the purchaser is dependent upon the
purchaser suffering a loss
Credit Derivatives
Page 292
Insurance—New York: Types of Insurance

• New York Insurance Law has two relevant categories of
insurance:
— Credit Insurance
— Financial Guaranty Insurance
• Not "credit insurance" because they are not entered into

with respect to goods and services sold in the ordinary
course of business
• Not "financial guaranty insurance" because Buyer’s right to
payment does not depend upon proof of financial loss
146
Credit Derivatives
Page 293
Insurance
• Regulators have threatened to regulate the CDS market by

treating CDS as insurance (whether or not buyer of
protection is required to have an insurable interest)
• Regulation seems less likely pending outcome of Federal

action to regulate OTC derivatives market
Credit Derivatives
Page 294
Insurance—Other Jurisdictions
Answers broadly the same in:
• United Kingdom
• France
• Germany
• Italy
147
Credit Derivatives
Page 295
Treatment as Insurance Contract: Factors

MORE LIKELY LESS LIKELY
Usage of words like premium, ensure, Periodic payment of credit spread

guarantee, claim from Buyer to Seller documented as
a "fixed payment" under a swap
Sale not arranged by a bank or Sale arranged by a bank or regulated

regulated broker dealer broker dealer
Recovery under policy depends upon Recovery by Buyer depends upon

showing actual loss showing decline in market value of
financial instrument by reference to
dealer quotes
No payment triggers other than Payment triggers tied to numerous

showing of actual loss structural events
Credit Derivatives
Page 296
Treatment as Insurance Contract: Factors

In order to have insurable instrument, No requirement that Buyer actually own the
requirement that the insured own the underlying asset that is subject of the credit
property that is the subject of the loss derivative. Right of Buyer to transfer
underlying assets without Seller consent,
even though underlying assets remain
subject to credit derivative
Significant part of entity's activities related Writer of credit default swap (Seller) is
to provision of this type of protection engaged to a substantial extent in other
transactions on an ongoing basis
Policy marketed to retail customer Credit default swap not marketed generally,
but geared specifically for a sophisticated
institutional customer
Writer of policy subrogated to the rights of Provider of credit default swap not
the insured (i.e., writer can seek to subrogated. Once payment based upon
minimize loss by acquiring underlying asset decline in market value is made, no right to
and enforcing against obligor) proceed against underlying obligor
148
Credit Derivatives
Page 297
Capital Adequacy
• Numerous issues under standard and market risk capital

guidelines
• Of particular interest, will a specific Credit Derivative

Transaction serve as an effective "guarantee", thereby
allowing the Buyer to reduce its risk weight to that of the
Seller?
• Basel II Guidelines (April 2003) and requirements for

guarantees and credit derivatives (see paragraphs 160
through 179)
Credit Derivatives
Page 298
Capital Adequacy
• Direct, irrevocable and unconditional claim on Seller
• Linked to specific exposures
• Credit Events must include, at a minimum, Failure to Pay, Bankruptcy and
Restructuring, although the inclusion of Restructuring is being discussed
• Cash Settlement permitted so long as there is a robust valuation process is in
place in order to estimate loss reliably and a clearly specified period for
obtaining post-Credit Event valuations, typically no more than 30 days
• Grace period in the Transaction must not be longer than the grace period agreed
upon under the loan agreement
• Buyer must have the right/ability to transfer the underlying exposure to the
Seller, if required in order to obtain payment
• Buyer must have the right/ability to inform the Seller of the occurrence of a
Credit Event
• Where there is an asset mismatch between the exposure and the Reference
Obligation, then the Reference Obligation and underlying assets must be issued
by the same obligor and the Reference Obligation must not be senior to the
underlying asset
149
Credit Derivatives
Page 299
Sale Treatment under FAS 140
• Similar to sale of loan participation
• Not a disguised secured loan, but a "true sale"
• Free transferability
• Non-Control
Credit Derivatives
Page 300
Tax: Alternative Characterizations
• Notional Principal Contract (payments based upon events

outside of parties’ control)
• Beneficial Interest in an underlying Reference Obligation
• Guarantee
• Insurance Contract
150
Credit Derivatives
Page 301
Termination and Netting
Eligibility for close out and netting (and related exceptions

from avoidance powers) under
• Bankruptcy Code
• Federal Deposit Insurance Act
• Other Insolvency Legislation
Credit Derivatives
Page 302
Termination and Netting
• Changes to the U.S. Bankruptcy Code and FDIA that took effect
on October 17, 2005 will increase certainty of termination and
netting for credit derivatives.
• The definitions of “swap agreement” and “qualified financial

contract” in the Bankruptcy Code and the FDIA have been
expanded to include "total return, credit spread or credit swap,
option, future, or forward agreements".
• Thus, there is greater legal certainty about the special protection

available for credit derivatives contracts.
151
Credit Derivatives
Page 303
Insider Trading
• Under the Commodities Futures Modernization Act of 2000, the

entry into a credit default swap with respect to a security is
subject to the anti-fraud provisions of Federal securities laws.
• In addition, delivery of Deliverable Obligation upon exercise of
Physical Settlement by Buyer may result in a sale of a "security"
• If Buyer or Seller is in possession of material inside information,
duty to disclose or refrain from trading
• Buyer or Seller may have contractual duties not to disclose
material inside information
Credit Derivatives
Page 304
Contacts
• Don Bendernagel, Citigroup
— E: donald.bendernagel@citi.com
• Amy Kim, Morgan Stanley

— E: amy.kim@morganstanley.com
• Darren Littlejohn, Goldman Sachs

— E: darren.littlejohn@gs.com
• Brian Rance, Freshfields Bruckhaus Deringer

— E: brian.rance@freshfields.com
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Credit Derivatives

Practicing Law Institute: Swaps and other Derivatives 2009

Don Bendernagel, Citigroup

New York City, October 21, 2009

• Overview of Recent CDS

Credit Derivatives—General Background

• Facilitate the trading of credit risk

• Can replicate, in part, long or short cash positions on

• By aggregating credit risk across obligors and

Credit Derivatives—General Background

• Credit derivatives separate out the risk of loss due to default

— Market risk (interest rate risk and currency risk)

• Credit derivatives allow institutions to acquire or dispose of credit

Credit Derivatives—Risks and Participants

Credit Derivatives—Market Volume

• According to ISDA survey as of June 30, 2008:

— Aggregate notional amount outstanding of credit derivatives

— For the purposes of the survey, credit derivatives comprise

Credit Derivatives—Market Volume

— Aggregate notional amount outstanding of interest rate

— Aggregate notional amount outstanding of equity derivatives

• Accordingly, credit derivatives account for approximately 10% of

Basic Mechanics of a Credit Default Swap

Credit default swap is a:

Basic Mechanics of a Credit Default Swap

Synt het ically Synt het ically

Alternative/Related Form – Structured Note

Pu rch ase Pr ice

* If a Cr ed it Even t o ccu r s, Issu er m ay sat isf y it s

Alternative/Related Form: Total Return Swap

Alternative/Related Form: Tranched Synthetic CDO Page 14

(often in Structured Note Form)

Credit Protection: Two Types of Settlement

• Most credit derivatives are documented using ISDA credit

• Basic Form of Confirmation, together with May 2003 Supplement

• Given that trades are often intermediated by dealers or other

— Objectivity (particularly because payoffs are binary)

Binary nature of CDS contracts and issues of

• Binary nature of payoffs in credit default swaps create

• Relative youth of the CDS documentation and market

• The Definitions make extensive use of fallback

Most Important Elements in any

Like all ISDA Agreements: Page 20

The Confirmation is the Key

General Terms: Familiar Appearance

• Same as any other financial derivative, except for

Reference Entity: Simple (or so it seems)

Identifying the Correct Reference Entity

• Vitally important to identify the correct Reference

• Holding company, operating company, etc.

• Note issue of identification of Armstrong World

Reference Entity and “Successors”

• The 2003 Definitions define the “Reference Entity” as

• In defining “Successor”, the 2003 Definitions

• “Succession Events” means an event such as a

Successor Issues in Practice

Successor Issues in Practice

• The various successor entities will have different credit

• From a legal point of view, obtaining the necessary information

• The definitions of “Successor” and “Successor Event” can lead

Operation of the “Successor” Provisions

• The diagram on the following two slides illustrates the