Transcript Synthetic CDO and CDS on ABS

CDS on ABS Documentation
American Securitization Forum
Sunset Seminar-CDS of ABS
March 8, 2006
John J. McGreevy
Director and Senior Counsel
Merrill Lynch
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CDS on ABS Overview
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CDS on ABS Overview
• The structured product synthetics market has experienced
tremendous growth over the past year. Product development has
been consistent with the growth pattern of the corporate credit
derivatives market
• CDS on ABS allows protection sellers to gain exposure to ABS
assets that are not readily available in the cash market due to
supply constraints
• Allows protection buyers to hedge or take a short directional
view in a more efficient manner than available in the cash
market
• Provides protection sellers leverage
• Flexibility provides exposure types (index trades, tranche trades)
not available before in the cash market
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CDS on ABS Overview
• Prior to 2005:
− Trades were individually negotiated
− No inter-dealer market
− Broadly speaking, trades covered Interest Shortfalls and
ultimate principle, but there was no standardization
• Early 2005: standard terms crystallized very quickly. While the
ISDA drafting process was not complete, there was consensus
among dealers on basic terms
• Many trades done on dealer docs pre-ISDA have been novated
to the ISDA standard.
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CDS on ABS Documentation
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CDS on ABS Documentation
Current forms
• Credit Derivative Transaction on Mortgage Backed Security
with Pay-As-You-Go and Physical Settlement (ISDA “Form I”)
• Credit Derivative Transaction on Asset-Backed Security with
Pay-As-You-Go Settlement (ISDA “Form II”)
• Credit Derivative Transaction on Asset-Backed Security with
Cash or Physical Settlement
• ABX/ CMBX
• To Come – ISDA CDO/Note form
• To Come – ABX/CMBX tranche confirm?
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CDS on ABS Documentation
• Thus far, ISDA has developed 3 different forms (i) Pay-As-YouGo and Physical Settlement (“Form I”), (ii) Cash and Physical
Settlement and (iii) Pay-As-You-Go Settlement (“Form II”)
• Form I terms form the basis for ABX and CMBX
• Form I is the dominant form in the U.S. dealer market and to
date is the standard for trading
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Form I: Pay-As-You-Go or Physical Settlement
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Form I
• Tenor
− Effective Maturity Date (the earlier of the Scheduled Termination
Date and Final Amortization Date)
− The last Floating Rate Payer Payment Date
− The last Delivery Date
− The last Additional Fixed Amount Payment Date (up to one year
after Effective Maturity Date if a Floating Event has occurred and
remains un-reimbursed)
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Form I
• Reference Obligation Notional Amount:
− Decreases upon Principal Payment
− Decreases upon Writedown
− Increases upon Writedown Reimbursement
− Decreases upon Physical Settlement (part or whole)
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Form I
• Applicable Percentage
• Percent covered of Outstanding Principal Amount - may be
more than 100% of the face amount of the Reference
Obligation
• Adjusted by: (i) further issuance of fungible securities; (ii)
cancellations of Outstanding Principal Amount resulting
from purchases; (iii) Physical Delivery; and (iv) Implied
Writedown (or reimbursements thereof)
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Form I
•
Floating Events : A payment is made by Seller to Buyer, but the
trade continues
– Writedown (which includes “Implied Writedown”)
– Failure to Pay Principal – at Legal Final or Final
Amortization Date
– Interest Shortfall – does cover PIK interest
• Additional Fixed Payments
− Writedown Reimbursements
−Principal Shortfall Reimbursements
−Interest Shortfall Reimbursements
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Form I
• Interest Shortfall Cap – election as “Applicable” or “Not Applicable”
• If Not Applicable, seller is liable dollar for dollar for
shortfalls in coupon payments
• If Applicable:
− “Fixed
Cap”- Seller is liable for shortfalls only up to an
amount equal to the Fixed Amount (i.e., Fixed Amount
nets to zero)
− “Variable
Cap”- Fixed Amount nets to zero and seller
must also pay Interest Shortfalls through LIBOR
(maximum out of pocket exposure is LIBOR on the
Notional Amount)
• To Date, Fixed Cap is market standard
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Form I
WAC Cap Interest Provision – “Applicable” or “Not Applicable”.
• If “Not Applicable”, then Interest Shortfalls are determined without
regard to WAC caps. That is, if a cap kicks in to lower the amount of
interest owed on the Reference Obligation, an Interest Shortfall DOES
OCCUR under the CDS.
• If “Applicable” and a cap kicks in to lower the amount of interest owed
on the Reference Obligation, an Interest Shortfall DOES NOT OCCUR.
• The original ISDA Form I had no such election but was drafted so that
the application of WAC Caps and the like would always cause an
Interest Shortfall.
• This concept was only recently introduced, but based in early returns
the market is sticking with “Not Applicable”
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Form I
• Credit Events
• Notifying Party: Buyer only
• Exercise in whole or in part
• Credit Events:
− Failure to Pay Principal:
− Writedown;
− Distressed Rating Downgrade to CCC or below
or rating withdrawal (subject to reinstatement
within 3 months)
• Physical Settlement –Reference Obligation only
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Form I
• Reference Obligation Coupon Step-Up
•
“Applicable” or “Not Applicable” on a confirm by confirm basis
•
Fixed Rate increased by step-up amount of Reference
Obligation
•
Buyer’s option: within five days after non-call, Buyer can
terminate flat
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Form I Documentation Issues
• Recent updates to Form I
− WAC Cap Applicable or Inapplicable
− Maturity Extension eliminated as a Credit Event
− Other technical fixes
• Implied Writedown
• Rating Agencies and natural protection sellers hate it.
• Issue: an implied writedown may occur while the cash
bond is still paying its full coupon.
• Documentation work-around for trades with CDOs
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Form I Documentation Issues
• What does the future hold
• Standard terms supplement and short form confirm, for
trading via DTC?
• Will individual firms’ systems build outs hold up when/if
Floating Events and Credit Events occur?
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Form II: Pay-As-You-Go
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Form II
• Based upon Form I, with amendments sought by a group of
CDS end users
• Intent of the amendments was to more closely mirror the
cashflow of the Reference Obligation
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Form II
• PAUG Settlement only unless Optional Physical Settlement
election is made at inception
− If Physical Settlement option is included, Physical
Settlement is “Seller Only” (Form I is “Buyer Only”)
− No “Credit Events”. Floating Events trigger right to deliver
notice of physical settlement, if applicable
− No Interest Shortfall Cap concept
− Implied Writedown eliminated
− Distressed Rating Downgrade eliminated
• Option to require pass through of Reference Obligation voting
rights
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Form II
•
Calculation of Expected Interest and Interest Shortfalls takes into
account available funds caps.
− In Form I terms, “WAC Cap” is always Applicable
− Make - Whole payments as well as payments in consideration of
amendments to the Reference Obligation are passed through to
Protection Seller as Additional Fixed Payments
− Such amounts, however, are not covered by Interest Shortfall
provisions
•
PAUG Floating Events:
− Writedown – actual applied loses or principal reductions only
− Principal Shortfall
− Interest Shortfall – deferring or capitalizing interest does not cause
an Interest Shortfall
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Form II Documentation Issues
• Dealers won’t use it
• Anecdotally - very few trades booked on this form
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Cash or Physical Settlement
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Cash or Physical Settlement
• The form most similar to corporate CDS
• Buyer pays Fixed Amounts, calculated by reference to an initial
notional amount which fluctuates depending upon amortization
etc.
• Seller pays Floating Amount on day Final Price is determined or
the Delivery Date
• Synthetic Delivery Mechanic –parties may use bidding for a
total return swap on the Reference Obligation to calculate Cash
Settlement Amount
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Cash or Physical Settlement
Credit Events
• Failure to Pay
• Loss Event
• Bankruptcy (optional)
• Restructuring
• Rating Downgrade to CC (optional)
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Cash or Physical Settlement
• Cash Settlement, unless, Seller receives Notice of Physical
Settlement prior to first Valuation Date
• Valuation Date. Seller selects a Business Day 120-140 calendar
days after Event Determination Date
• Physical Settlement - Reference Obligation Only
• Payment of Floating Amount and accrued interest - 60 Business
Day cap
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Cash or Physical Documentation Issues
• Primarily used in Europe, few trades in the U.S.
• Rating agency issues make cash settlement
difficult/uneconomical for trades with CDOs
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ABX/CMBX
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ABX/CMBX Documentation Issues
• Both use a Standard Terms Supplement with short form
confirm, for DTC Settlement
• Both are based on ISDA’s Form I
− No Physical Settlement, PAUG only
− Fixed Cap always applies
• An ABX Floating Amount Event has already occurred.
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Future Documentation Issues
• ISDA confirm for ABS other than RMBS/CMBS
− Conjecture – the form will include PAUG, Physical and
Cash Settlement
− Draft expected soon
• Tranche Confirms?
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