The collapse of Lehman Brothers was a major test of the procedures developed by market participants to address counterparty credit risk and has uncovered deficiencies in risk management policies and their application.
The fact that a major, international trading counterparty such as Lehman Brothers can fail has changed risk assessment and perception among dealers, hedge funds, mutual funds and various other financial institutions and market participants (the “End-users”), many of whom have been reassessing mechanisms to manage credit risk exposure to their trading counterparties, in particular major market dealers (the “Counterparties”).
In many cases, in addition to reconsidering their Counterparties’ creditworthiness, End-users are seeking to implement stricter contractual provisions in various facilities, such as swaps, repos and stock lending facilities (each, a “Facility”), as well as prime brokerage agreements, to mitigate counterparty credit risk, protect payment rights and facilitate access to posted collateral in the event that a Counterparty were to default.
This alert describes several practical risk mitigation strategies to consider implementing from the End-user’s perspective when negotiating or revisiting Facilities and prime brokerage agreements with Counterparties.
Matching the collateral posted to the exposure
Ideally, under a Facility, both the End-user and the Counterparty should have appropriate rights to call for collateral and the collateral posted by a party should correspond to the other party’s aggregate net exposure across all transactions underlying the Facility. By holding insufficient collateral or posting excess collateral, an End-user may become a general unsecured creditor for the shortfall (or the excess) if the Counterparty becomes insolvent.
End-users should, therefore, resist contractual provisions that do not provide for full collateralization by their Counterparty and insist on eliminating any unsecured exposure to their Counterparty either when the Facility is negotiated or revisited or upon a deterioration of the Counterparty’s creditworthiness. In the latter case, End-users may also require the Counterparty to post additional collateral to account for increased counterparty credit risk. In addition, End-users should ensure that they canmake regularmargin calls and should carefully consider transfer timing requirements so that they result in timely transfers.
Often, Counterparties require End-users to post initial margin, which is a pre-determined amount of collateral posted to the Counterparty without regard to the mark-to-market value of underlying transactions in order to account for the expected volatility of the transactions and the perceived creditworthiness of the End-user. As a result, the Counterparty could very well hold collateral exceeding its net exposure to the End-user, including when the End-user is actually “in-the-money” with respect transactions underlying a Facility on a net basis.
End-users may reduce over-collateralization risk by posting a letter of credit (rather than cash) that may be drawn only if the End-user is in default under the Facility. Alternatively, End-users may seek to reduce any initial margin posted to a Counterparty to zero or have such initial margin segregated with a third party custodian upon a deterioration of the Counterparty’s creditworthiness.
Protecting Posted Collateral
If the collateral posted by an End-user is commingled with the Counterparty’s other assets (for instance because the Counterparty has a right to invest, lend, pledge, sell or rehypothecate the collateral), the End-user is likely to have the status of a general unsecured creditor with respect to such collateral if the Counterparty becomes insolvent. Instead, if the parties agree that the collateral posted is to be held in a segregated account with the Counterparty or with a third party custodian, the Enduser may be able to expedite the return of its collateral.
The Counterparty will probably resist, or charge additional fees in connection with, any obligation to segregate the collateral because the right to use the collateral constitutes an additional source of income and, in some instances, the collateral is needed by the Counterparty to satisfy its own collateral posting obligations vis-à-vis other trading counterparties. Therefore, if the Counterparty is unwilling to segregate collateral at the time when the Facility is negotiated or revisited, the End-user should insist on prompt collateral segregation (preferably with a custodian) upon a deterioration of the Counterparty’s creditworthiness.
Cross Facility Margining and Netting
End-users should consider negotiating cross margining and netting agreements to net out exposure across Facilities with the same Counterparty. Such agreements can facilitate the satisfaction of margin calls and close-out netting across Facilities in the context of a termination event.
In order to maximize recovery in a bankruptcy proceeding, an End-user may want to novate “in-themoney” trades to third-parties that are “out-of-the-money” on their trades facing the same Counterparty. Such third parties might be able to use such novated trades to offset amounts owed by them to the Counterparty, thereby maximizing their use of close-out netting rights under Facilities. As such a novation typically requires the Counterparty’s consent, the End-user might want to seek to obtain a blanket novation consent from the Counterparty, effective either at all times or upon a deterioration of the Counterparty’s creditworthiness.
Early Termination Rights – Set-off
The End-user may want to have the right to force an early termination of the Facility and all outstanding transactions thereunder before the Counterparty defaults under the Facility and/or becomes insolvent, including upon the credit deterioration of its Counterparties or upon a failure of a Counterparty to provide adequate assurances of its condition.
Also, in establishing several Facilities with a Counterparty, End-users should seek to negotiate terms that will maximize its use of set-off rights. Under swap Facilities, set-off rights are typically available only in the event of a termination, but could be broadened to capture amounts due outside of termination and across affiliates.
Credit Deterioration Early Warning Triggers
The difficulty in implementing many of the risk mitigation techniques that we have highlighted often resides in identifying trigger events that constitute effective and objective indicators of a deterioration in a Counterparty’s creditworthiness.
Although a trigger linked to the falling credit rating of a Counterparty might be used to activate certain rights of the End-user, the time lag often associated with a credit rating downgrade might prevent an End-user from achieving the contemplated risk mitigation benefits as the Counterparty may actually seek the protection of a bankruptcy court before a rating agency downgrades the Counterparty to the trigger level.
More volatile triggers, such as the credit default swap spread on the Counterparty’s debt, the change in commercial paper spread or, if publicly traded, the Counterparty’s stock price may be more appropriate measures from the End-user’s perspective, but the Counterparty may resist such metrics.
Credit rating agencies have recently developed models showing a correlation between future agency rating action and CDS implied ratings, which are generated on a daily basis. Such CDS implied ratings or other market implied ratings (based also on the bond, loan and equity markets) may provide a more refined risk signal than credit default swap spreads, commercial paper spreads or stock price and could, therefore, be viewed as an acceptable and objective early warning trigger by both parties.
Prime Brokerage Agreements – Specific Issues
In addition to the general concerns regarding collateral protection described above, End-users may wish to consider maintaining a back-up prime brokerage relationship to provide maximum flexibility at the first threat of a Counterparty’s insolvency.
End-users should also restrict their Counterparty’s ability to rehypothecate illiquid collateral or collateral that is unique to the End-users’ investment strategy, and should limit rehypothecation (and the custody of collateral in general) to U.S. based entities only and arrange for periodic (daily or weekly would be ideal) “sweeps” to retrieve assets constituting excess margin collateral.
When negotiating early termination rights or events of defaults in prime brokerage agreements, Endusers should seek to limit the ability of their prime broker to trigger an immediate termination of the agreement or, in the context of a cross-default, to ‘cherry-pick’ which of its agreements with the Enduser it will close-out and terminate.
The Counterparty’s right to terminate the prime broker agreement should be limited to situations that genuinely merit such decisive action. Therefore, default triggers should be drafted as objectively as possible and should include notice requirements, grace periods (particularly with respect to increases in margin requirements, fees and optional termination rights) and cure periods that are sufficient to allow for the cure of inadvertent breaches or for mitigating action.