GMRA A-Z: Default Market Value
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Whilst the definition of “Market Value” is used for the purposes of calculating the value of securities under the margin maintenance provisions, a different concept is used to value collateral on a close-out. This is the concept of “Default Market Value”.
If we take a step back, it makes sense to use ‘just the normal’ market value when calculating margin calls, as the underlying assumption is that nothing has ‘gone wrong’. However, following a default, it may be necessary, for example, to sell the underlying securities quickly (which may prevent realising their full market value). It would also be natural to be more protective of the position of the non-Defaulting Party in a default scenario. Hopefully, therefore, it is relatively easy to appreciate why a different approach to default valuations of collateral might be used than would be the case in relation to ‘normal business as usual’ valuations of collateral.
Under Paragraph 10(d)(ii) of the 2011 GMRA, on a close-out of one or more transactions, instead of either party being required to actually deliver any securities they have back to the ‘original owner’, that delivery obligation is replaced by a separate obligation to pay to the other the “Default Market Value” (as calculated by the non-Defaulting Party as at the Early Termination Date) of those securities. Because the obligation to make physical delivery has now been replaced by an obligation to pay an amount of money, these obligations can be set-off against any outstanding obligations to repay cash margin (which are, by definition, obligations pay money as well). In turn, this facilitates the calculation of a single, net, cash payment to be made by one party to the other.
Whilst the definition of “Default Market Value” is used to determine the close-out payment which is due from one party to the other following the occurrence of an Event of Default, it is also used in the 2011 GMRA to calculate the “Cash Equivalent Amount” under paragraph 4(h) where one party fails to deliver margin securities under the GMRA’s margin maintenance provisions.
There are essentially three methodologies for arriving at the “Default Market Value”. All are set out in Paragraph 10(f) of the 2011 GMRA.
Paragraph 10(f)(i)
Paragraph 10(f)(i) provides one option for a non-Defaulting Party to arrive at a “Default Market Value” for a particular type of security. It says that if, on or around the Early Termination Date, the non-Defaulting Party has sold “Receivable Securities” or purchased “Deliverable Securities” which form part of the same issue and are of an identical type and description to the securities sold or purchased under the GMRA then the non-Defaulting Party can treat either (a) the net proceeds of sale (in the case of “Receivable Securities”), or (b) the aggregate cost of purchase (in the case of “Deliverable Securities”) as being the “Default Market Value”. Default Market Values should be dealt with on a pro-rata basis if different amounts of the underlying securities have been sold/purchased (as the case may be).
It helps to take a step back in order to understand this provision in its wider context. If a lender has loaned money to its counterparty and that counterparty subsequently defaults, the first thing the lender is going to want to do is to ‘sell the collateral’ its counterparty transferred to it in an attempt to make itself whole and so avoid a loss. Doing so would allow the lender to crystallise the value of those securities for the purposes of making close-out calculations and determine the final, single, net payment which will be owing by the lender to its counterparty (or vice versa). Therefore, in doing all of this, if possible, the lender will want to use the actual figure for the proceeds of sale that it generated when selling those securities. This is exactly what paragraph 10(f)(i)(A) is talking about in the context of “Receivable Securities”. It effectively says “if you are the non-Defaulting Party and you have sold securities similar to the collateral that was transferred to you then you can use the net proceeds of sale for the purposes of your calculations”. In doing so, the non-Defaulting Party can also deduct all of the costs and expenses incurred in the sale process – the point being that the non-Defaulting Party should not be left out of pocket.
Conversely, if a borrower has borrowed money from its counterparty and that counterparty subsequently defaults, the borrower may want to use the money that it has borrowed in order to replace the securities which it transferred to the lender as collateral for the loan (and that it probably won’t get back from its counterparty – because they have now gone into default). Paragraph 10(f)(i)(B) addresses this scenario in its references to “Deliverable Securities”. Effectively, paragraph 10(f)(i)(B) says that “if you are the non-Defaulting Party and you have recently purchased securities similar to the collateral that you posted to the defaulting counterparty then you can use that purchase cost (including any costs associated with the purchase) for the purposes of your close-out calculations”.
Paragraph 10(f)(ii)
Paragraph 10(f)(ii) provides a SECOND option for a non-Defaulting Party to arrive at a “Default Market Value” for a particular type of security. It states that if, on or around the Early Termination Date, the non-Defaulting Party has received offer quotations (for Deliverable Securities) or bid quotations (for Receivable Securities) from at least two market makers then the non-Defaulting Party may choose to take the average of those values as the “Default Market Value”. The non-Defaulting Party may adjust the quotes received in order to (a) account for accrued but unpaid coupons and (b) reflect the fact that we may be dealing with a “Pool Factor Affected Security” (basically, this is a reference to an asset back security where the principal has been written down to reflect insufficiency of underlying asset values or cashflows). The non-Defaulting Party may also factor in its transaction costs in selling or purchasing the relevant securities.
What is really happening under paragraph 10(f)(ii)? Well, we are talking about circumstances where either:
- Firstly, the non-Defaulting Party has not received “Deliverable Securities” and so may have to ‘buy them in’ from a market maker. In doing so, it would have to pay the Offer Price quoted by the market maker for those securities (the “Offer Price” is the price at which the dealer would be prepared to sell the securities in question (this will be higher than the price at which the same dealer would be prepared to buy those same securities)).
- Secondly, the non-Defaulting Party needs to sell “Receivable Securities” in order to make itself whole and so may need to ‘get rid of them’ to a market maker. In doing so, it would receive the Bid Price quoted by the market maker for those securities (the “Bid Price” is the price at which the market maker would be prepared to buy the securities in question. This will be lower than the price at which the market maker would be prepared to sell the same securities).
Either way, the non-Defaulting Party is able to treat the price quoted by the market maker as the “Default Market Value”. In this way, the close-out calculations under the GMRA should accurately reflect the actual losses or gains of the non-Defaulting Party – meaning that the non-Defaulting Party should not be left out of pocket.
Note that, under this provision, the quotes received do not need to be for the actual amount of securities which are the subject of the close-out. Rather, they just need to be “in a commercially reasonable size”. This gives extra flexibility to the non-Defaulting Party, which seems fair in the context of a close-out.
Paragraph 10(f)(iii)
Paragraph 10(f)(iii) provides the non-Defaulting Party with a fall-back for valuing “Default Market Value” in the event that it has not been able to buy or sell the actual securities or it has not received quotes for the purchase or sale of the actual securities.
More specifically, paragraph 10(f)(iii) states that, if the non-Defaulting Party (acting in good faith):
- has been unable to sell/purchase or obtain quotations in relation to securities in accordance with Paragraph 10(f)(i) or Paragraph 10(f)(ii); or
- has determined that it would not be commercially reasonable to sell/purchase securities at the prices obtained or not commercially reasonable to use any quotations received
then the non-Defaulting Party may determine the “Net Value” for the securities in question and use that “Net Value” (being, essentially, the fair market value) as the “Default Market Value”.
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