Thursday, October 8, 2009

ISDA Documentation Architecture 4: Credit Support

As I've mentioned in the past, one of the hazards of derivatives transactions not executed through a clearinghouse is that the parties are responsible for policing each others credit. Each party must satisfy itself that its counterparty will be able to execute the transaction without defaulting.

In the 1980's parties began trying to control credit risk by taking collateral from each other. Basically, when one party is in a more tenuous financial position than the other, the shakier counterparty will pass some collateral (usually cash) to the stronger party as a guarantee. In its 1996 report, the ISDA Collateral Working Group identified three ways that collateral makes derivatives more attractive: it equalizes disparities in creditworthiness thus opening up a wider range of potential counterparties, it can reduce the interest charged to less creditworthy counterparties, and it may help regulated financial institutions reduce their capital requirements by lowering the risk weighting associated with the transaction.

OTC derivatives executed via the ISDA Master Agreement are structured using one of three ISDA credit support annexes to the Master Agreement schedule. All three establish the same framework for the operation of the collateral transfer - how collateral calls are calculated, when collateral can be substituted or exchanged, how disputes will be resolved, etc.

There are three of them because each is governed by the law of a different jurisdiction. The 1994 Credit Support Annex (security interest - New York Law) and the 2008 Credit Support Annex (Loan/Japanese pledge) create a lien on the collateral while the 1995 Credit Support Annex (Transfer - English Law) actually transfers ownership of the collateral to the other party. Each of the annexes has an explanatory "users guide" and the 1994 and 1995 annexes have standard conforming amendments to bring them out of the dark ages of the 1992 Master Agreement.

These collateral support agreements, of course, are what got AIG in trouble. Each time their rating was downgraded they found themselves facing many CDS-related collateral calls.

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