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The term “credit event” is used in two different but related ways. In the general sense, it refers to any event which affects an entity's creditworthiness. Credit events occur suddenly and cause a decline in someone's credit rating. A classic example is a bankruptcy, which will lead to a downgrading of creditworthiness. In a more narrow sense, it refers to an event which will trigger a credit derivative contract, obliging the buyer to pay the seller.
Generally, credit events are events which adversely affect a credit rating. Some examples include defaulting on debt, declaring bankruptcy, or breaking the terms of a loan agreement. When a credit event is reported to a credit bureau or ratings agency, a downgrading will occur. The amount of the downgrade varies depending on the standards set by the rater and the nature of the credit event. Something like making a late payment, for example, is rated less heavily than walking away from a mortgage.
In the world of credit derivative contracts, financial institutions spread risk by selling contracts based on the debt they hold. The buyer of the contract assumes the risk, which means that if the debtor fails to pay, the seller can demand payment from the buyer. In this case, a credit event is something which will cause the seller to consider the credit derivate contract due, in which case the buyer will be expected to pay.
Bankruptcy is an example of a credit event of this nature. Likewise, repudiation or moratorium, in which the validity of a contract is called into question, is another example. Failure to pay and obligation default are additional examples. A credit derivative contract can also come due as a result of obligation acceleration, when a debt is due earlier than originally agreed as a result of a breach of the lending agreement. Once the credit event occurs and is documented, the seller can require payment from the buyer.
Credit derivatives can be a risky business. Generally such financial products are sold in packages which are organized by credit risk, allowing buyers to pick and choose the nature of the debt they would like to assume the risk for. Buyers take on high risk instruments with the understanding that they may be forced to pay for them. When a credit event occurs, a buyer must be prepared to made good on the credit derivative contract and if multiple events occur at the same time this can be a problem for the buyer.
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