In order for a payment to be collected by the protection buyer upon the occurrence of a credit event, three conditions must be satisfied:
1. The affected party must deliver a credit event notice.
2. The affected party must deliver a notice of publicly available informa- tion.
3. The calculation agent must determine that materiality exists.
Credit Event Notice
A credit event noticeis an irrevocable notice given by one party to the credit default swap to its counterparty that a credit event has occurred.
ISDA allows for the notice to be given in writing or orally, including by telephone, but the parties may negotiate their preferred type of notice.
Notice of Publicly Available Information
A notice of publicly available information is a notice that confirms the occurrence of a credit event. This notice must reference a source of “publicly available information,” which can include any internationally recognized published or electronically displayed news source such as the Wall Street Journal, Reuters electronic terminals, or Bloomberg terminals. Addition- ally, the parties to the credit default swap can specify a minimum number of publicly available information sources that must confirm the occur- rence of a credit event (see the appendix to this chapter).
Calculation Agent and the Determination of Materiality
Thecalculation agentis the party designated to determine the required payments under the credit derivative transaction. For a payment to occur, the calculation agent must determine that materiality exists.
Materialityis a term that is negotiated by the parties. For instance, if the reference obligation is a high-yield corporate bond, materiality can be defined in terms of a price decline. The parties to the trade can state what dollar or percentage decline in value of the reference obliga- tion is sufficient to qualify as a material credit event. Usually, material- ity is stated as a 1% to 5% price decline from the initial price (referred to as the “price decline requirement”). The initial price may equal the reference (strike) price, or the reference price may be set at a different value.
Conversely, instead of a price decline, materiality can be defined in terms of increasing credit spreads. Recall that an increase in credit spreads for a reference issuer means a decline in value for a reference obligation of that issuer. Therefore, materiality can be defined in terms of a minimum credit spread increase (the “spread widening require- ment”) that must occur before a credit event is recognized.
Materiality, however, is determined by the calculation agent. The calculation agent is usually a point of negotiation in ISDA agreements.
Almost always, the dealer who is selling the credit derivative wishes to remain the calculation agent. However, this raises a potential conflict of interest because the dealer/calculation agent might not want to recog- nize a credit event to prevent its payment obligation to the protection buyer.
Fortunately, ISDA provides for a dispute resolution provision in the contract. In the event that a party to the credit default swap does not agree with a determination made by the calculation agent, the disputing party has the right to require that the determination be made by a disin- terested third party that is a dealer of credit derivative instruments. The calculation agent gets to pick the disinterested third party, but only after consultation with the disputing party.
The determination made by the third party is binding on the credit derivative participants unless there is manifest error. The costs, if any, from using the third party are borne by the disputing party if the third party substantially agrees with the calculation agent, and are borne by the nondisputing party if the third party does not substantially agree with the calculation agent. Bottom line: if the disputing party believes that the dealer/calculation agent has not properly recognized a credit event, it can challenge the dealer, but it must be prepared to pay any costs associated with the challenge should its dispute prove unjustified.
The parties can agree to be joint calculation agents. This can allevi- ate conflicts of interest. However, if the joint calculation agents cannot agree, the same dispute resolution techniques apply.
It is rare for the parties to a credit derivative trade to use an outside calculation agent. The norm is that the broker/dealer is usually the cal- culation agent, and if there is a dispute, then the parties to the trade turn to an outside calculation agent to resolve the disagreement. This is because it is expensive and time consuming to use an outside calculation agent. Also, the parties to the swap have the best knowledge of the terms of the trade. In contrast, an independent third-party calculation agent is almost always named whenever credit derivative contracts are used as part of structured finance vehicles such as synthetic collateral- ized debt obligations discussed in Chapter 7. Rating agencies such as Moody’s specify that a third-party be named to carry out this role. For some structures, a third-party is required only to confirm that a credit event has occurred. Subsequent market valuations are then carried out by the swap dealer. In this case, the third-party is known as a verifica- tion agent and not a calculation agent.
Upon the occurrence of a credit event, the calculation agent must determine the current market value of the reference obligation to deter- mine if there has been a material decline in value. This is accomplished by obtaining third-party quotes from other dealers and taking the aver- age of the bids, offers, or midmarket quotes. This is just one more check and balance to ensure that the calculation agent performs its determina- tions in an objective fashion.