With the hotly anticipated results of Moody's ratings review of 17 global banks expected in June, we concentrate on the impact any rating downgrades may have on derivatives arrangements that Trustees have. (Of course, any downgrades may also have an impact on other contractual arrangements with banks, for example, letters of credit.1
In this Alert:
LDI arrangements - check ISDA agreements
Schemes that use derivatives for liability driven investment often have "credit downgrade events" written into their ISDA agreements. Commonly these give the Trustees the option to terminate the ISDA if the bank is downgraded below a minimum rating. Alternatively they may add an "Independent Amount" to the collateral calculation. (In this case, the Independent Amount would be added to the value of the banks' obligations to the Trustees when calculating collateral so if the bank is out of the money, it will be obliged to post more collateral and if the bank is in the money the Trustees will have to post less collateral.)
Trustees with LDI arrangements should check:
- whether they have a ratings trigger in their ISDAs and what form they take; and
- whether there is a deadline for exercising any rights.
The investment manager may have authority under the IMA to decide what course of action to take, but with downgrades affecting lots of banks, they are likely to take the Trustees' views before taking any action.
Bond managers (and other managers who use over the counter derivatives)
Some discretionary investment managers may have authority to use derivatives as part of their portfolios and the investment management agreement may include specific minimum ratings requirements for the banks used as counterparties. Some managers will develop their counterparty risk management policies and it is worth checking with managers how they propose to approach the current round of downgrades.
If you have an option to terminate - consider your options
- If a ratings trigger breach occurs, discuss whether it is advisable to actually exercise the rights that you have as a result of that breach with your investment manager and other advisers.
- Triggers which give the option to terminate were designed to give the Trustees the right to replace transactions where a specific bank is downgraded and there are serious concerns about that bank's creditworthiness. The dynamics are more complex in a situation where the credit ratings of banks generally are decreasing and there may not actually be serious concerns about the bank's ability to meet its obligations. Termination against downgraded banks could also leave the Trustees with a limited panel of banks to work with.
- The option to terminate should be seen as a "nuclear option". However, the existence of an option to terminate may sometimes put trustees in a strong position to negotiate something of value with a bank in return for not exercising them. The options available to the Trustees may include:
- re-couponing existing agreements at below market cost;
- reducing exposure to a particular bank on a voluntary basis; and
- narrowing the range of assets eligible to be posted as collateral.
Protect your rights
If a ratings trigger is breached but Trustees have no opportunity to negotiate improvements to their position and do not wish to terminate the relevant agreement, they should ensure that they preserve their rights against the downgraded bank in case there is a further deterioration. There is generally no deadline for exercising the option to terminate and Trustees will wish to say to the bank that if the Trustees continue to work with the bank under the ISDA that should not be treated as waiving the Trustees' option to terminate.
What is the position if the Trustees decide to use their option to terminate?
The broad idea of the ISDA is that the Trustees should be entitled to claim their reasonable "middle of the road" costs of replacing the terminated transactions with like transactions. There are, however, variants in the credit downgrade events we have seen and the position should be checked carefully. There are also some uncertainties in the process and opportunities for the bank to challenge the amount claimed, so it should not be assumed that this would be an easy process.
The potential downgrades of a range of banks pose some questions which were not envisaged when the triggers described above were negotiated. It is therefore inevitable that Trustees will need to assess the options available, in conjunction with their investment managers and advisers, before action is taken.
1For PPF purposes, a letter of credit can only be provided by a bank with a rating of at least AA- (or equivalent of S&P, Moody's and Fitch)