What is a credit event?

A credit event is something bad that happens which shakes up the market for credit derivatives. Credit derivatives are a special kind of financial product – they’re sort of like insurance against a company or country not paying back the money it owes.

The whole point of a credit derivative is to protect the person who bought it in case the company or country they lent money to (called the “reference entity”) runs into trouble. If a certain trigger event happens (like the reference entity going bankrupt), then the credit derivative contract kicks in and the buyer gets paid.

These trigger events are what we call credit events. There’s a standard list of them that everyone in the market agrees to use. This list was put together by a group called the International Swaps and Derivatives Association (ISDA for short).

The big list of credit events

According to the ISDA, here are the main credit events everyone looks out for:

Bankruptcy

This one is pretty obvious – it means the reference entity has officially filed for bankruptcy protection because it can’t pay back its debts.

Failure to pay

A failure to pay happens when the reference entity misses a payment on a debt it owes, even after a certain waiting period (usually 30 days). This includes both interest payments and paying back the original amount they borrowed.

Restructuring

Restructuring is when the reference entity works out a deal with the people it owes money to change the original loan agreement. This could mean extending the payback period, lowering the interest rate, or the lenders agreeing to get paid less than the full amount.

Acceleration

Acceleration happens when the lender demands the reference entity pay back the entire loan amount right away, instead of sticking to the original payback schedule. The lender can do this if the reference entity breaks the rules of the loan agreement.

Repudiation/moratorium

This is a mouthful, but it basically means the reference entity straight up refuses to pay what it owes or puts a temporary stop on making payments.

Why credit events matter

You’re probably thinking, okay, so a credit event is bad news for somebody – but why do they matter to the wider financial world?

The truth is, credit derivatives have become a huge global market. There are a bunch of complex financial products (with names like credit default swaps and collateralized debt obligations) that are built on top of loans to reference entities.

When a credit event happens, it’s like a domino effect. Suddenly all those credit derivative contracts have to pay out at once. This can have a ripple effect on the broader market as everyone scrambles to cover their losses and figure out who owes what to whom.

We saw this play out big time during the global financial crisis in 2008. A wave of credit events (mostly mortgage defaults and bankruptcies) triggered massive payouts on credit derivatives, which contributed to some major banks and investment firms going under.

Keeping an eye on credit events

Since credit events can have such far-reaching consequences, there are companies whose entire job is to monitor the market for potential credit event triggers. They’re called credit rating agencies.

The big three credit rating agencies are Moody’s, Standard & Poor’s (S&P), and Fitch. They assign letter grades to reference entities and debt obligations based on how likely they think a credit event is to occur.

For example, a “AAA” rating from S&P means they think the chance of a credit event is super low, while a “C” rating means a credit event is imminent or has already happened. If a rating agency downgrades an entity or obligation, it’s a sign that they think the risk of a credit event has gone up.

Investors, banks, and really anyone involved in the credit derivatives market keep a close eye on these credit ratings. A rating downgrade can spook the market and send everyone scrambling to adjust their positions.