The Downgrade That Triggers a Cash Call by Contract

Contracts That Reference an Outside Opinion

A counterparty that provides credit or exposure to a company wants protection if that company weakens. Writing a test based on financial ratios requires monitoring and interpretation. Referencing a credit rating is simpler: the agency does the evaluation and publishes a result that everyone can observe

Then the contracts began to be incorporated rating triggers provisions that automatically go into effect when a grade falls below a specific level

The convenience is real and so is the consequence. The company has accepted that an external body which it does not control can create an immediate obligation by publishing an opinion

Where They Appear

The derivatives collateral trigger is the most dangerous because the amounts can be huge and the demand is immediate. A company with a large derivatives portfolio that has run out of money can face a multi-billion collateral call with a single downgrade

Why the Derivative Trigger Is the Dangerous One

It's worth laying out why that particular trigger dominates the others because the size of the call isn't written into the contract

Collateral agreements on derivatives work on two things: the current market exposure between the parties and a threshold i.e. how much of that exposure the counterparty is willing to leave unsecured

A rating trigger typically operates on the threshold and not the exposure. A company with a comfortable rating might enjoy a threshold that allows it a substantial unsecured position. Fall below the specified rating and that threshold falls frequently to zero at which point every dollar of existing exposure must be immediately collateralized

Look at what determines the amount. It's not a number that the company traded. It's whatever the position is worth against you on the day the downgrade occurs which depends entirely on where the markets are

That is the aggravating problem. The two inputs are not independent. A company is more likely to be downgraded during a period of stress and a period of stress is exactly when the derivatives positions have advanced a lot which means that the value of the market exposure is large at the same time when the threshold protecting it disappears

A company that models this as two separate risks with separate probabilities will seriously underestimate it. They arrive together because the same conditions produce both

The Triggers That Take Something Away

A guarantee call demands money and leaves the deal intact. Two other varieties in the table do something structurally worse and receive much less attention

The first is termination. Derivatives agreements commonly treat a downgrade as an event that allows the other party to terminate pending transactions and settle them at market value. That is not a requirement to ensure a continuing position. Close the position and crystallize everything it is worth that day

Think about what that does to a company that uses those derivatives as hedges rather than positions. The hedge disappears at the time the company is under the most stress leaving the underlying exposure it was hedging wide open. Replacing it means returning to the market during the turbulence like a counterparty that has just been downgraded and paying whatever a newly weakened name is trading at. The trigger didn't simply cost cash. It eliminated risk management ability and forced its buyback at the worst price.available

The second is the replacement of servicers in securitizations. The originator typically manages the loans it sold collecting payments handling arrears and earning a fee for the work. A qualifying trigger may require that role to be passed to a backup servicer

Therefore the company loses a stream of fee income and its operational contact with those customers and the transfer itself consumes management attention during a period when no one is available. The same documents frequently allow cash that would have returned to the originator to become trapped in a reserve closing off a source of liquidity in the same event

It's worth naming the pattern in all three. These clauses require more than money. They eliminate hedges fee income and cash flows - that is the same things a company would use to handle the downgrade - and take them with the same trigger at the same time

The Case That Defined the Risk

The clearest demonstration remains the insurance group that underwrote huge volumes of credit default protection through a financial products unit

Those contracts contained rating triggers that required the posting of collateral if the parent was downgraded. As the underlying reference obligations deteriorated and the parent's rating fell collateral requests came in for amounts that the group was unable to cover and a company that was solvent on its own accounting faced an immediate lack of liquidity

The episode established the mechanism as a systemic concern rather than a documentation detail. A rating action taken by a private company produced an immediate liability of billions of dollars which is a considerable amount of power to give to an opinion

The Reflexivity Problem

The structural criticism is that these clauses are reflexive. A rating agency assesses the likelihood that a company will not meet its obligations. If a downgrade itself creates obligations that the company cannot meet the assessment has contributed to the outcome it was evaluating

Agencies are aware of this and say they consider trigger exposure when rating a company which is a partial answer. It means that the trigger is included in the price of the rating and does not eliminate the discontinuity: a company can sit one notch above a cliff with the rating incorporating the cliff and still face a sudden liability if it crosses it

The Cliff Matters More Than the Level

That last sentence contains the real defect and it is a defect of form rather than severity

Credit quality continually deteriorates. A company loses customers margins compress leverage increases and none of that happens in steps. Ratings on the other hand are a discrete scale and a trigger written next to a rating turns a smooth decline into a step function

Therefore a company can be substantially weakened without any contractual consequences and then cross a border and owe a huge amount at once. The obligation has no relation to the deterioration of the company on the day of the dismissal. It relates to which side of the line the assessment landed on

A covenant linked to a financial ratio performs better here because the measure moves continuously and the consequence can be graduated. Coupon increases in bond contracts work the same way for the same reason: they add costs proportionally rather than demanding cash all at once

The second cliff problem is that everyone uses the same one. Trigger levels are grouped at conventional thresholds most obviously the line between investment grade and below. Therefore a single downgrade across that threshold does not activate a single trigger. It triggers derivatives thresholds facility pricing commercial letters of credit and securitization provisions simultaneously because they were all written to the same reference point by parties that never spoke to each other

Each counterparty individually took a sensible precaution. Collectively they built a coordinated demand for cash arriving in one morning

The Disclosure Requirement

Because the exposure is not visible in the financial statements disclosure rules require companies to describe important rating triggers typically in the discussion of liquidity including the amount of collateral that would be required at various downgrade levels

That disclosure is one of the most useful elements in a presentation for anyone assessing liquidity risk and it's commonly overlooked. A company with enough cash and a large contingent collateral requirement at the next rating tier has a different liquidity profile than one that doesn't

Rating agencies also publish comments on trigger exposure and treasurers of large companies track their aggregate exposure as an ongoing risk metric

Reading That Disclosure Properly

Since it's the element that matters it pays to be specific about how to use it because the numbers are easy to read in a way that understates them

The disclosure usually presents incremental guarantees at successive levels of downgrade: either one level or two. They are often presented as separate lines and are in practice cumulative. A two-level downgrade activates both the first and second triggers so the relevant figure is the cumulative total rather than the individual step

Then compare that total to the liquidity actually available i.e. unrestricted cash plus genuinely undrawn committed lines. Cash held in subsidiaries that cannot easily be promoted is not available for this purpose nor is anything already reserved

The question most often left out is whether those facilities have their own qualifying triggers. Look at the table again. Credit facilities exist and a downgrade can raise prices restrict draws or accelerate them

If the cushion a company depends on to meet a collateral call is on a line that a downgrade also hurts the two are correlated in the worst possible direction. Liquidity is expected to appear at the precise moment the event that removes it occurs. A company can appear comfortably covered on paper and not have any coverage in the only scenario that matters

How Companies Manage Them

Various approaches are used that combine costs with flexibility

Negotiating them is the cleanest and requires accepting worse prices elsewhere since the counterparty is giving up protection

Adjust the trigger low several notches below the current rating preserves counterparty protection while reducing the likelihood of triggering

Replacing Rating Triggers with Financial Covenants keeps protection under the control of the company itself since a ratio test depends on its performance rather than the judgment of an agency

Maintain a liquidity cushion compared to added trigger exposure which is expensive and what many companies actually do

Note that the last of these is the least elegant and the most common. Negotiation triggers the pricing of costs reducing them requires a counterparty to agree and exchanging them for covenants gives the counterparty proof that it must monitor itself. Holding cash does not require anyone's consent. It is the option that a treasurer can execute alone which is why he usually wins

The Regulatory Direction

Post-crisis reform included a broad effort to reduce the mechanical reliance on ratings in regulation removing references to capital rules and investment mandates based on the reasoning that automatic consequences amplify shocks

That effort addressed regulation rather than private contracts and rating triggers in trade agreements remain a matter entirely for the parties. The market has become more aware of them and has not stopped drafting them because they solve a real counterparty tracking problem

That asymmetry is worth considering. Regulators concluded that the automatic consequences of ratings were destabilizing and removed them from the rules they controlled. The identical mechanism which produces the same amplification remains standard in private contracts because each counterparty one signs manages its own exposure sensibly and no one of them is responsible for the whole

The Bottom Line

Rating triggers allow a contract to outsource its credit monitoring to an agency and in doing so create discontinuous obligations that kick in at exactly the time when a company is least able to meet them. The bankruptcy of the insurance group showed that the mechanism can be systemic and not simply inconvenient. For anyone assessing a company's liquidity the disclosure of contingent collateral requirements at successive rating levels is the element that matters and it is almost never in the summary. Read it cumulatively.and then check if the facilities intended to cover it have their own triggers