ISDA PRESS REPORT - MARCH 2, 2001

ISDA PRESS REPORT - MARCH 2, 2001

* Fed Study Hints Credit Risks Correlation Should Tighten -
Dow Jones
* House Passes Bankruptcy Reform - BNA
* What's A Default? - Derivatives Strategy
* Derivatives Give Extra Nudge To Falling Nikkei - Reuters

Fed Study Hints Credit Risks Correlation Should Tighten
Dow Jones - March 2, 2001

NEW YORK -(Dow Jones)- Banks should be prepared to tighten the coordination
between credit risks they are exposed to in different markets, as they adapt
to the changing requirements of the Basel Accord on capital requirements, a
Federal Reserve study says.

Specifically, the report cites exposure to derivatives as one area where
broader and more tightly integrated models of credit risk are likely to be a
future requirement for banks.

"Especially in such cases," of "positions that involve derivatives," banks
"credit risk models should reflect not only the uncertainty in future
exposures, but also the potential correlation of exposures across credits,"
the paper says.

The New York Federal Reserve study, entitled "Using Credit Risk Models For
Regulatory Capital: Issues And Options," is for future publication in a
forthcoming Economic Policy Review.

"The goal of this paper is to generate discussion and air alternative
scenarios" among regulators and among banks as they adapt their credit risk
models in future, said a co-author of the report, Beverly Hirtle, vice
president at the New York Federal Reserve for banking studies, speaking with
Dow Jones Newswires Wednesday.

Other co-authors were Mark Levonian, a director in the Banking Supervision
and Regulation Division at the Federal Reserve Bank of San Francisco, Marc
Saidenberg, a Bank Supervision officer and Stefan Walter, a vice president
at the New York Fed and David Wright, an assistant director of the Banking
Supervision and Regulation Division at the Board of Governors of the Federal
Reserve System.

When questioned, Hirtle said the study's reference to derivatives and to the
possible need for some banks to tighten correlations among different
instruments of credit risk going forward wasn't based on specific events or
problems in the financial sector.

Derivatives exposures were one factor that made a number of banks and
companies vulnerable to financial shocks during the 1990s, including Barings
Bank, German company Metallgesellschaft, Japan's Sumitomo Bank and the hedge
fund Long Term Capital Management.

"For positions that involve derivatives or that otherwise depend to a
material extent on market factors, standards likely would require integrated
models of market movements and credit exposures," the report said.

Unlike exposures to loans, exposures to derivatives can change more rapidly,
Hirtle said.

Correlating Different Loans Is Key

Hirtle stressed the importance of banks correlating the levels of credit
risk among loans to different borrowers.

When "a loan to a particular borrower has a rating in a bank's internal
ratings system" and the bank then decides that loan is "is better or worse"
than previously, then "if you looked across all of the loans in a bank's
books, that tends to mean other credits are also being downgraded" or
upgraded, Hirtle said.

"That correlation is a very important factor in the risks facing banks" and
one which many banks are already aware of, Hirtle added.

She also gave an example in general terms of how a chain of events might
lower the worth of a credit for a bank.

A firm might be downgraded by a credit ratings agency and they might draw
down on a line of credit from a bank, so the bank's exposure goes up and the
value of the loan goes down, Hirtle said. "That's an example of how three
factors can move against a bank at the same time," she added.

Banks' adaptation of their internal controls to monitor risk will be partly
driven by changes to an international agreement on the subject.

The coming revisions to the Basel Accord, planned for introduction by 2004,
aim to update the way that banks globally account for risk.

The new version of that agreement "will likely incorporate a greater
reliance on banks' internal risk rating systems in assessing regulatory
minimum capital requirements," the Fed paper said.

Derivatives Give Extra Nudge to Falling Nikkei.
Reuters English News Service
By Risa Maeda

A plunge in the Tokyo stock market partly reflects hedge selling related to
equity derivatives products, analysts said on Friday, forecasting more such
sales ahead if the benchmark Nikkei average crumbles further.

Selling related to derivatives products - mainly structured bonds with
returns linked to the Nikkei's level - has gathered steam since the Nikkei
dipped below 13,000, the analysts said.

On Friday it stood at 12,261.80 - a 15-year low.

The so called "Nikkei-linked bonds" have grown especially popular in the
last two years as cash-rich individual investors hunger for returns beyond
current rock-bottom interest rates offered by conventional government debt.

Financial Services Minister Hakuo Yanagisawa said on Friday that the recent
sharp drop in share prices was due in part to trading in equity derivatives
products.

"Equity derivatives products have been accelerating the decline (in Japan's
stock market)," Yanagisawa said.

Nobuaki Kurisu, chief fund manager at Sumisei Global Investment Trust
Management, also cited derivatives -related selling as a factor in the stock
market's plunge, and added that such selling should keep market volatility
high for the time being, making institutional investors hesitant to buy.

Analysts said speculators have been selling Nikkei futures contracts in the
past weeks, trying to nudge the Nikkei average to pre-determined levels that
will in turn trigger hedge-related selling. Many of the trigger points were
believed to be set at or below 12,600.

THE RUSH TO HEDGE

Equity linked derivative bonds, which usually mature in six months to one
year, offer higher interest rates than ordinary bonds if the Nikkei stays
above a pre-determined level.

But once the Nikkei drops below that level, the return at the bond's
maturity will be lower than the initial investment. This causes brokers to
hedge by lightening existing long positions or selling in the market.

"Arrangers of these products have to sell either Nikkei futures or a basket
of Nikkei 225 component stocks to hedge, and there are more trigger points
if the average dips to 12,000 and further to 11,500," said Hirokazu Kabeya,
analyst at Daiwa Institute of Research.

He said up to 100 billion yen ($852.2 million) worth of these bonds have
been launched at each of three different pre-set Nikkei levels - between
13,000 and 12,500, between 12,500 and 12,000 and between 12,000 and 11,500.

Another equity derivatives product which has attracted retail investors over
the past two years has been exchangeable bonds (EBs), often linked with the
stock prices of blue-chip high-tech issues such as Sony Corp and Nippon
Telegraph and Telephone Corp (NTT)

EBs are automatically redeemed if the value of a selected stock rises above
a pre-determined price.

If the value falls below the pre-determined price, as has often been the
case recently, the EBs are redeemed with stock certificates carrying latent
losses, causing many investors to unload the unwanted certificates in an
already bearish market. ($1=117.33 Yen).

House Passes Bankruptcy Reform
BNA - March 2, 2001
By Adam Walsh

Three years in the making, sweeping bankruptcy reform legislation (H.R. 333)
passed the House 306-108 March 1, sending waves of contentment through much
of the financial services sector and the ranks of Republicans, none of whom
voted to oppose the measure.

In the end, 93 Democrats crossed party lines to support the bill, which has
moved through the House before only to be pocket vetoed by former President
Clinton last year. The majority of Democrats opposed the measure, deploring
it for its treatment of lower- and middle-income Americans who depend upon
bankruptcy to achieve a "fresh start."

A Democratic replacement amendment, which Rep. F. James Sensenbrenner Jr.
(R-Wis.) said would "eviscerate" the present bill, was defeated 256-162.
Also, the House moved to defeat a motion by Rep. John Conyers (D-Mich.), the
ranking member of the House Judiciary Committee, to recommit the bill back
to committee. Conyers proposed a measure limiting the marketing of credit
cards to those who are under 21.

"This bill seeks to restore personal responsibility and integrity to the
bankruptcy system and ensure these laws are fair to both debtor and
creditors," Sensenbrenner said following the bill's passage. "Abuse of the
current system--estimated to cost the rest of us approximately $4 billion
each year--is the driving force behind this bipartisan, balanced, and
comprehensive legislation."

In a statement, Edward L. Yingling, executive director of the American
Bankers Association, said ABA "is very pleased to see bankruptcy reform pass
the House today by such a broad bipartisan margin." Saying the current
bankruptcy code permits individuals with higher incomes to walk away from
debts, he called bankruptcy reform "an urgent matter because the system is
broken and needs to be fixed."

In general, H.R. 333 and S. 220, its companion bill in the Senate, seek to
force more bankruptcy filers to file under Chapter 13, which requires some
repayment of debts, instead of Chapter 7, which discharges most debts.

Means Test Main Feature of Measure

Before moving off the House floor, three substantive amendments were made to
H.R. 333, in addition to one technical amendment. The first, which passed by
voice vote and was offered by Rep. Sheila Jackson-Lee (D-Texas), adds a
debtor's monthly public school expenses as an allowable expense under the
bill's means test and puts public school expenses on an equal footing with
that of private school expenses, which is already included in the bill. The
means test is the reform measure's primary feature. It is designed to serve
as a kind of calculation device to determine who can file under Chapter 13
and who can file under Chapter 7.
A second and third amendment also passed by voice vote. Offered by Rep. Mark
Green (R-Wis.), the second amendment would remove the names of children from
bankruptcy filings in order to shield minors from would-be predators. The
final substantive amendment offered jointly by Financial Services Committee
Chairman Michael Oxley (R-Ohio) and the committee's ranking member, Rep.
John J. LaFalce (D-N.Y.) aims to reduce uncertainty and limit systemic risk
in the banking system by simplifying the terms for settling large financial
contracts in the event that one counter-party becomes insolvent.

Former House Banking Committee Chairman James A. Leach (R-Iowa) rose to
support the bill, citing this sole amendment as reason enough to do so. A
similar amendment was made to the legislation during markup in the Senate
Judiciary Committee Feb. 28. Both amendments conform legal definitions
throughout the body of law that cover the bankruptcy of large financial
institutions.

House Majority Leader Dick Armey (R-Texas) rose to support the bill saying
it was a "matter of enormous pride" that the House adopt bankruptcy reform
legislation.

Rep. Mel Watt (D-N.C.) took a different view, alleging that the bill was the
result of special interests. "At the end of the day, this bill will not be
amended because it is a political statement," Watt said on the floor.
"People who wanted this bill knew that they could not get it unless they
exempted the poorest people from the system." Watt referred to a portion of
the bill's means test that exempts wage earners who make less than half of
their state's median income. The establishment of two classes of
debtors--one poorer and one richer--would be the "lasting legacy" of this
bill, Watt said.

Rep. Jerrold Nadler (D-N.Y.) called the bill a "poster child" for campaign
reform legislation. Commenting on the House rule that limited debate on H.R.
333, Rep. Adam Schiff (D-Calif.) said the House was delegating its
legislative responsibilities to the Senate.

The bill now must wait until the Senate passes its version before a
conference can be appointed to work out differences between the two bills
(see related report in this section).

What's a default?
Derivatives Strategy - February 2001
By Barclay T. Leib

Credit derivatives only came into existence in the latter half of the 199
Os, and the documentation behind the product has been lightly tested. But on
September 22 last fall, some credit derivatives traders got a rude wake-up
call. That was the day Bank of America and Chase announced the extension of
$2.8 billion in loans to the troubled Conseco Corp. While this helped
Conseco avoid an immediate bankruptcy declaration and sent the company's
bonds modestly higher, the loan extension was technically deemed a
restructuring. As such, it was also deemed a credit event-which allowed some
fast-footed dealers to deliver long-dated Conseco securities against credit
default swap agreements. Bonds that had previously been trading at a 60
handle could suddenly be tendered at par.

Since credit default events had been rare to that point- Rite Aid, Armstrong
Corp. and school-bus manufacturer Laidlaw being the only three high-profile
examples-several banks were caught completely off-guard by the Conseco
situation. "I think there was a gentleman's perception that this loan
restructuring should not have caused a default trigger, even though the
nitty-gritty of the [International Swaps and Derivatives Association]
document clearly allowed it to be such," notes a credit derivatives broker.
"Even fewer dealers thought it was an appropriate response to get delivered
longer-dated paper when it was a short-term loan that got extended."

Ever since, the usefulness of credit default swaps has been called into
question, and the market has been abuzz with proposed language changes to
the ISDA derivatives document. For all the deal flow these days, it's
suddenly become apparent that many people aren't entirely sure what it is
they've been trading: Is this a product that is supposed to pay off on
credit impairment, or is it a product intended to protect capital in case of
a cataclysmic inability to recover ones principal? Most people believe it
should be the latter, but the Conseco event suddenly raised disparate
interests and views that previously had been shoved under the rug.

Tailor-made contracts with specific restructuring provisions-either included
or not-can always be designed and traded, but suddenly no one knows what the
standard documentation for the interdealer market should be-and that has
regulators and industry groups scrambling for answers. In a research report
called "Restructuring: A Defining Event for Synthetic CDOs," dated December
22, the rating agency Fitch even stated that recent developments may
eventually necessitate changes in its rating criteria for credit derivatives
and the collateralized debt obligations into which they are sometimes
packaged. According to Roger Merritt, managing director in Fitch's global
loan products group, "a narrower definition as to what constitutes a credit
event, or the complete elimination of restructuring, should, in fact,
correspond with a lower incidence of credit protection payments for
synthetic CDOs and credit derivatives.

Important insurance
Credit default swaps stipulate that in one of several possible events-the
declaration of a bankruptcy; the failure to pay interest on a loan or bond,
or the restructuring, repudiation or acceleration of a loan that lowers the
overall creditworthiness of a counterparty-the buyer of the swap may deliver
to the seller any loan or bond extending out to a predefined maturity, and
receive back par value in return. In a market where it can be difficult and
time-intensive for bank portfolio managers to resell an actual loan, this is
an important and attractive product for lenders. Although delivery is
typically based on physical settlement of loans or bonds at their par value,
contracts are sometimes written for cash settlement of par value minus any
recovery from the sale of the asset.

Because of the product, loan portfolio managers on both sides of the
Atlantic have morphed in recent years into active traders, while insurance
company and hedge fund managers gained a new way to position themselves.

Within the credit default swap contract, restructuring is clearly a trigger
event important to many commercial banks. "There are increasing pressures on
banks to mark loans to market, and when a loan is restructured, it is
clearly a loss of value-often a step taken just to avoid an immediate
default," explains Hetty Harlan, a managing director in charge of credit
derivatives trading for BofA's portfolio management group. Harlan thus
considers structurings "de facto" or "prepackaged" defaults and a legitimate
credit event under standard ISDA document.

"Such loans become expensive to hang onto in terms of loan loss reserves or
charge-offs," she explains, "so we need to have some relief at that point to
help mitigate the risk of doing so. Nobody wants to throw a company into
bankruptcy if there's a glimmer of hope that a company may turn around with
time. Banks shouldn't be in a position where they have to push for default
because restructuring does not qualify for relief. That is in nobody's best
interest."

Not everyone in the credit market thinks this issue is quite that simple and
straightforward, however. According to sources close to the Conseco
situation, Bank of America was actually the first institution to start
delivering Conseco paper against long credit default swaps it had previously
purchased. Harlan claims the bank only delivered the restructured loans, but
other sources say BofA delivered the cheapest bonds it could get its hands
on. Merrill Lynch quickly followed. But since Bank of America also had a
hand in the loan extension, some cried foul at the potential conflict of
interest.

"Since the loan was renegotiated on the last day of the contract, BofA
certainly could have considered it a repaid loan, and then extended a new
loan if it had wanted to couch it in such terms," says one dealer. "That
path would have avoided the technical default. In lieu of that, however,
Bank of America termed the extension a restructuring, and quickly delivered
Conseco paper to get it off its books."

"At the end of the day, calling the Conseco loan a restructuring was
probably the commercially normal thing for BofA to have done," ventures
another senior dealer. "It knew the implications of its actions, and
coincidentally was happy to benefit. This is a financial market, not a
social club. You have to have compelling big-picture incentives for people
not to do short-term things in their economic best interest."

Nonetheless, these events highlight a moral hazard issue, and more than a
few fund and insurance sellers of credit derivatives protection felt burned.
After all, how can a bank extend a loan, collect big fees for doing so, then
come crying to the market that they need added compensation under their
credit default swaps? Many think there's something fundamentally wrong here.
Moreover, they argue, if Bank of America had been short credit default swaps
instead of long, might it have potentially followed a different path that
would have once again benefited its own book but potentially left those
actually betting on a Conseco default with less satisfaction?

Slow down, don't move too fast
A s a result of this debate, many U.S.-based dealers last MOctober
petitioned for the complete removal of restructuring as a trigger event in
credit derivatives documentation. Not long after, these dealers started
quoting standard credit derivative contracts with the restructuring language
removed. The broker market became a two-tier market of credit default swaps
"with restructuring" and "without restructuring."

But many again cried foul. "I was very taken aback," says BofNs Harlan, "A
credit default swap without a trigger for restructuring is a much less
valuable instrument to us. By proposing such a change, dealers were just
trying to simplify and provide a quick fix to the problem issue. But this
quick fix would truly eat away at the contract's very usefulness to many
buyers-particularly banks." Since then, Harlan has continued to insist that
restructuring be included in all new contracts she enters into.

European credit derivative participants also balked at the new direction
decided upon by their American counterparts. The European capital markets
contain a much higher percentage of bank loans vs. bond debt, and few
bankers want to lose the protection of a loan restructuring clause as a
trigger for credit default swaps. After all, isn't a loan restructuring just
one step removed from outright bankruptcy? And if people don't recognize it
as such, what's the point of buying credit protection in the first place?

The result to date of this Continental drift: all credit derivatives
transacted between U.S. and European counter-parties continue to include
restructuring in the documentation. But many contracts negotiated solely
between U.S. counterparties do not. The credit derivatives market has
effectively bifurcated itself into two distinctly different products, and
although it hasn't yet reached a critical stage, participants are concerned
that this bifurcation may start to hurt overall market liquidity.

Regulator warnings
If the rancor from European bankers was not already loud I enough, the
global regulatory community also posted a strong stop sign in front of the
"without restructuring" contracts. At the Chase-Derivatives Strategy Credit
Derivatives Conference in mid-November, Federal Reserve Board official
Thomas Boemio threw down the proverbial gauntlet. "If restructuring is taken
out of ISDA documentation," he said, "the Fed will ignore credit derivatives
for purposes of capital relief." There were loud oohs and aahs from the
bankers and dealers in the audience at Boemio's pronouncement. After all,
credit derivatives were born very much to help banks satisfy Fed-mandated
regulatory capital requirements. Take that regulatory relief away, and core
demand for the product would certainly be reduced.

Since that conference, dealers have met many more times to try to hash
things out. ISDA executive director and CEO Bob Pickel traveled to London in
early December to try to smooth the ruffled feathers of European bankers. At
the first of those meetings, held in the stately Fleet Street offices of
Goldman Sachs, several European bankers explained that French regulatory
officials had joined the Fed's Boemio in reiterating that credit derivatives
documentation needs to retain loan restructuring default clauses in order to
be deemed "good offset" to a loan or bond position. Such news caused further
groans from dealing participants across the Atlantic.
"I don't think the Fed or the Commission Banquaire [the French regulator]
have truly thought out their position on this," says one senior credit
derivatives dealer at a major New York investment bank. "Since all bank
loans can only be restructured with the 100-percent approval of those
holding these loans, where's the harm in allowing capital relief at least
until such a restructuring transpires?" In other words, if a bank has a
two-year loan covered by a two-year credit default swap, that bank would
naturally agree to a loan extension only on terms attractive to it. If not
offered such terms, it would simply demand repayment of the loan, even if
such demands forced the company into bankruptcy.

For its part, the Fed seems to have larger issues of fairness and security
in mind. It doesn't want banks to appear to have capital protection after
buying credit default swaps, only to be forced to effectively abandon such
protection by a corporate counterpart playing hardball in a loan
renegotiation process. For example, would a bank give up its collection
rights on a $20 million credit default swap if it had $1 billion in total
loans that could be thrown into the nonperforming category by a bankruptcy
declaration? Without a hard and fast rule that a loan restructuring is a
credit event, it might feel obliged to do so.

A pendulum
Over its short history, credit derivatives documentation has swung from
being overly vague to potentially too specific. ISDA's initial credit
derivative definitions, drafted in 1995 as an addendum to the ISDA master
derivatives document, stipulated that in order to trigger a credit event,
the change in the terms of any loan or bond obligation had to result in
terms that were "materially less favorable to any holders of the
obligation." Many deemed this language too vague and subjective; it tended
to encourage litigation rather than avoid it.

After the 1998 turmoil surrounding Russian paper- which many viewed as a
default, but some called a period of acute market stress-there was general
agreement in 1999 to try to tighten up the documentation language. Very
specific definitions of a credit event were introduced. Even then, some
participants were not fully confident of the new verbiage, but after much
discussion, exhaustion ruled. "People grew so sick of the debate on
restructuring that in the end, it was just easiest to go with the new
definitions and come back to the issue at a later date," says Richard
Kennaugh, co-head of credit derivatives trading at Chase Securities. "At the
time, the 1999 definitions were thought to at least be better than what was
used before."

The 1999 definitions lasted all of 18 months before hitting their first
stumbling block. Now, participants complain that the definition of a credit
default actually became far too precise back in 1999. The Conseco situation
showed how a technical default could trigger a credit derivatives exercise,
but without the debt of the underlying company being truly hurt. At the
center of the snafu is the presumption that, when a bank loan is
restructured, all other corporate debt becomes harmed and thus due and
payable. Events have clearly proven otherwise: not only has Conseco not
fallen into bankruptcy, but its various tranches of debt and bonds continue
to trade at markedly different valuations in the market.

"Almost every major institution wants some change to the restructuring
language now," says Kennaugh. "The status quo is not an acceptable option.
We have to establish a better standard for interdealer business, or risk
less liquidity and a great deal of added basis risk within dealer books."
Although achieving consensus will not be easy, Kennaugh's hope is that some
standard acceptable to investors, hedgers and dealers alike can be
established. Then anything different from that standard will continue to be
available in the market at a premium or discounted price depending upon the
specific language used.

The million-dollar question
So what should ISDA do to set the credit derivatives market back on course?

There are two basic paths-with numerous permutations buried within-the trade
group could take. First, it could try to narrow the definition of
restructuring and limit the deliverability under a restructuring to the
actual loans or bonds in question, or to paper with a shorter tenor than the
restructuring period. The language to accomplish this might require some
tricky drafting, but the goal would be to give sellers of credit derivatives
more solace that they could not be blindsided on a loan restructuring with
the delivery of longer-dated paper, while the buyers of credit default swaps
would still maintain the regulatory ability to tender restructured paper.

This compromise, however, could create a "two-step delivery option." On the
occasion of a loan restructuring, the holder of a credit default swap might
be able to either tender the actual loan affected or a similar short-term
piece of debt, or hold onto the credit derivative for the possibility of an
actual bankruptcy event at a later date. If bankruptcy eventually
transpired, then any paper out to a predefined maturity would be renderable.
In other words, there could be one central contract, but with a new delivery
twist within it.

"That might be a possible outcome," says BofA's Harlan. "But banks are so
conservative, I think almost everyone would exercise the credit derivative
on the first go-round. The pressure just to get troubled debt off one's
books would dominate the potential reward of gleaning even greater value
from the default swap later on."

Others aren't so sure this solution would work. "It might introduce too much
uncertainty into the delivery process. People want to know what they are
going to get, and when," says Hilmar Schaumann, head of credit derivatives
trading for Swiss Re New Markets in New York
At the moment, credit default swaps can be triggered by either the buyer or
seller of the swap, in order not to leave the seller hanging with a
contingent liability. If a narrowed restructuring delivery option is
introduced, it is likely that only the buyer of the default swap would have
the power to decide whether to deliver a specific restructured loan.

Some also argue that, to be completely fair, the party long the credit
default swap and tendering the loan should be forced to hand over any added
fees collected from the restructuring. This is not currently standard
practice.

The inclusion of a "materiality clause" is another possible permutation of
the restructuring language being bandied about. Such a clause could
stipulate that a restructuring only be considered a default event if the
credit rating of the underlying corporate entity subsequently deteriorates
beyond a stated level. Given the large range of potential underlying
credits, however, the specific drafting required here might be even more
difficult for participants to agree on in advance.

The other major alternative would be to continue allowing the two
contracts-one with restructuring and the other without-to simply develop of
their own accord, with Darwinian forces of supply and demand deciding which
is more useful and popular as a core product.

Restructuring would just become another check-box among many on the ISDA
document that people could either use or ignore. Such an approach might
result in more documentation mismatches and basis risk on dealer books, but
it might also keep diverse end-user participants more satisfied.

"ISDA cannot unilaterally tell the market what it should use," says Jeremy
Barnum, head credit derivatives trader at J.P. Morgan. "People will trade
what contracts they want to trade, and we may have to wait to see which
contract that will be. There is a perception that without regulatory capital
relief, the market just dies, but that is patently wrong. Banks are
increasingly a small percentage of the market. If banks still want relief
with restructuring included, that price exists today and will continue to
exist. It just may not be the standard contract anymore.

It is possible, of course, that the market will end up with a refined
restructuring definition and a check-box approach to whether restructuring
is included in a deal or not. Barnum, for one, thinks it is unrealistic to
expect a single contract that unifies bank loan people and bond
investors-two groups with fundamentally different needs and desires. "But
ISDA had the foresight to structure its document in a menu framework where
you can check off prepackaged definitions," he says, "so we're likely just
headed to another check-box solution, maybe with some improved definitions
within."

Whatever ISDA decides, it must do so quickly, before other credit derivative
problems pop up. A year ago, for example, Xerox credit default swaps were
trading at just 30 basis points per annum. Now they are 1,000 basis points
bid, with no offer. Overall Xerox has $17 billion in out standing debt and
is quickly approaching full usage of its bank lines of credit. Separately,
many of its interest rate and equity swap agreements have embedded credit
clauses that will force it to liquidate these contracts should it be
downgraded below a certain credit rating. It's easy to imagine yet another
situation where Xerox may technically fall into default on certain
obligations, but continue to pay interest on other paper.

It is also noteworthy that Conseco credit default swaps involved only a few
hundred million dollars in notional obligations, while the outstanding
amount of credit derivatives written on Xerox is quite a bit greater.
Lawsuits haven't sprung from the Conseco situation, but they could for Xerox
since there is more money on the table.

"We're just starting to see the world of distressed securities realize that
some of these clauses that many thought didn't matter actually matter a
great deal," says Leslie Rahl, president of Capital Market Risk Advisors.
"Xerox in particular may be a good example of documentation language that
was intended to protect counterparties in a downgrade situation, but now may
have unintended negative consequences if these clauses actually get
triggered."

Rahl acknowledges that credit trigger levels need to be precise, but she
also worries that they introduce a certain amount of systemic risk. "Given
the proclivity of rating agencies to downgrade whole industry sectors at the
same time," she says, " credit triggers are the one thing in my mind that
could cause systemic risk and bring on required knee-jerk reactions.

While ISDA is at it, some also think that language revolving around
"successor corporations" should be examined. ISDA documentation provides
that after a merger, spin-off or other corporate restructuring, a credit
derivative will apply to the surviving corporation that inherits the
majority of the original debt. But what happens to a credit derivative
contract if, say, AT&T gets split into four equal parts with equal debt
loads? Perhaps the credit derivative should really be split into pieces as
well, particularly given the massive debt load to be transferred.
Unfortunately, ISDA must work in a world in which financial nuances wreak
havoc on derivatives contracts originally designed to be relatively simple
and fungible.

"Have you every tried to cash in an insurance policy?" asks Rahl. "If you
haven't read the fine print, it's not always as easy as it should be," she
says. "This is what the credit derivatives market is currently grappling
with." In other words, credit derivatives documentation may have worked
reasonably well in good times, but what happens in bad?

That's an important question given the current spate of earnings warnings
and massive corporate debt loads. If more credit problems flare up soon,
ISDA documentation will likely come under even more scrutiny, with Conseco
simply having been the first warning shot across the bow of the credit
derivatives market. In a litigious society where a presidential election can
be contested for six weeks, don't expect an easy path to defining when a
real default begins and mere credit impairment ends.

Scott Marra
Administrator for Policy & Media Relations
ISDA
600 Fifth Avenue
Rockefeller Center - 27th floor
New York, NY 10020
Phone: (212) 332-2578
Fax: (212) 332-1212
Email: smarra@isda.org