Transcript OVERVIEW OF CREDIT DERIVATIVES MARKETS Presentation to

Mortgage Credit Events
&
Floating Rate Payment Events
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10 July 2007
Credit Events & Floating Payment Events
 Credit Events (2006 ISDA PAUG Template Definitions):
 Failure to Pay Principal – The Ref Ob fails to make schedule principal payments
 Writedown – The Ref Ob writes down (decreases) its outstanding principal amount
 Distressed Ratings Downgrade – The Ref Ob is downgraded to CCC (or it’s equivalent) or lower
 Floating Rate Payment Events:
 Interest Shortfall – The Ref Ob pays interest less than the expected interest for that period
 Writedown – Same as above
 Principal Shortfall – Same as above
 Additional Fixed Payments:
 Interest Shortfall Reimbursement – the underlier pays more interest than the expected for that month,
i.e.. Compensates for previous interest shortfall
 Writedown Reimbursement – the underlier accrues enough money to compensate for the previous
writedown
 Principal Shortfall Reimbursement – the underlier makes up for the principal shortfall
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Pay-as-You-Go Credit Default Swap: Payment Diagram
terms defined later
Fixed Payment Amount
the amount, the buyer of the protection pays to the seller every month.
Formula: notional * current factor * rate * day count
IN CASE OF A Floating Rate Payment Event
Protection
Buyer
/
Fixed
Rate
Payer
Floating Payment Amount
Interest Shortfall Amount / Writedown Amount / Principal Shortfall Amount
Additional Fixed Payment Amount
Interest Shortfall Reimbursement Amount / Writedown Reimbursement Amount /
Principal Shortfall Reimbursement Amount
Protection
Seller
/
Floating
Rate
Payer
Physical Settlement Physical Settlement Amount
OR
Cash Settlement
Initial Payment
generally comes into question, in case of an assignment / novation.
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Settlement Mechanics for Floating Rate Payments and Credit Events
 Credit Events ( Failure to pay Principal, Writedown, Distressed Downgrade)
 Notice of settlement can be sent by Buyer only
 Usually if the event is deemed to be a ‘credit event’ by the Buyer the intent is to physically settle. The
Buyer of protection has the option to physically settle or cash settle- if the Buyer chooses to physically
settle, the a credit event has occurred.
 Floating Rate Payment Events (Failure to pay Principal, Interest Shortfall, Writedown)
 Notice of settlement can be sent by Calculation Agent and/or the Buyer of Protection
 For Failure to Pay Principal and Writedown , the difference between this being a Credit Event and a
Floating Rate Payment Event is that when a event occurs the buyer chooses to cash settle and the trade
continues (pay as you go).
 Interest shortfall is not considered a Credit Event in any instance and is always cash settle.
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Differences between Mortgage and Corporate CDS
Underlying
product
Credit Events
Mortgage
Corporate

Failure to pay principal

Bankruptcy

Write down – occurs when the reference
obligation is written down (realized losses usually)

Failure to pay

Restructuring

Sovereign failure to pay, in case of
emerging market underliers

Distressed ratings downgrade

Failure to Pay Interest
Interest Shortfall

Interest does not have to be fully paid, and can be
reimbursed at a later time

Not applicable
Factors

Bonds factor down, as mortgages are paid down

No factor issues
Payment
frequency

Monthly

Quarterly
Maturity

Generally 30 year bonds. The CDS trade
terminates with the maturity of the underlier

Five or ten years are most common. CDS
trades terminates with the maturity of the
underlier or a credit event.
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Interest Shortfalls
 An interest shortfall occurs when current scheduled interest is not paid on the reference obligation
 As per ISDA, the definition of interest shortfall amount is,
With respect to any Reference Obligation Payment Date, an amount equal to the greater of:
(a)
zero and
(b)
the amount equal to the product of:
(i)
(A) the Expected Interest Amount
minus
(B) the Actual Interest Amount and
(ii)
the Applicable Percentage
 As per ISDA, the definition of interest reimbursement amount is,
With respect to any Reference Obligation Payment Date, the product of
(a) the payment by or on behalf of the Issuer of an Actual Interest Amount in respect of the Reference
Obligation that is greater than the Expected Interest Amount. and
(b) the Applicable Percentage.
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 For sub-prime RMBS and CMBS reference obligations, coverage of interest shortfalls by the protection seller
can take the form of one of the following options:
 Cap Applicable – Fixed Cap: Capped at the amount of CDS premium owed by the protection buyer in
any period. Under this option, protection seller will not have to go out-of-pocket to cover interest
shortfalls.
 Cap Applicable – Variable Cap: Capped at an amount equal to LIBOR plus the CDS premium owed by
the protection buyer in any period. Under this option, protection seller may have to go out-of-pocket to
cover interest shortfalls.
 Cap Not Applicable: Uncapped at the full coupon on the reference obligation. This trade can only be
executed at a CDS premium rate equal to the margin above LIBOR or the associated benchmark rate in
the coupon and therefore would likely involve upfront payments by either buyer or seller. Under this
option, protection seller may have to go out-of-pocket to cover interest shortfalls.
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Principal Shortfalls
 Mortgage backed securities will either have a set pay down principal schedule or will pay down at maturity date
 A principal shortfall occurs when on a scheduled pay down date there is insufficient funds to pay the
predetermined principal amount on the reference obligation.
 If and when this deficit in the principal is paid back, it is called the principal reimbursement.
 As per ISDA the definition of Principal Shortfall Amount is,
in respect of a Failure to Pay Principal, an amount equal to the greater of:
(i)
zero; and
(ii)
the amount equal to the product of:
(A)
the Expected Principal Amount minus the Actual Principal Amount;
(B)
the Applicable Percentage; and
(C)
the Reference Price. (Standard is 1).
 As per ISDA the definition of Principal Shortfall Reimbursement Amount is,
with respect to any day, the product of
(i) the amount of any Principal Shortfall Reimbursement on such day,
(ii) the Applicable Percentage and
(iii) the Reference Price.
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Writedowns
 Writedown occurs when the reference obligation writes down its outstanding balance (i.e. decides not to pay the
outstanding balance to its bond holders). The effect is similar to that of notional amortization, i.e. factor of the
reference obligation changes.
 The impact on the swap:
1. Protection seller has to pay the writedown amount to the protection buyer
2. All the future coupons will be multiplied by the current factor, i.e.. the coupon changes.
 As per ISDA the definition of Writedown Amount is,
with respect to any day, the product of
(i) the amount of any Writedown on such day,
(ii) the Applicable Percentage and
(iii) the Reference Price.
As per ISDA the definition of Writedown Reimbursement Amount is ,
with respect to any day, an amount equal to the product of:
(i)
the sum of all Writedown Reimbursements on that day;
(ii)
the Applicable Percentage; and
(iii)
the Reference Price.
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Additional Information on Shortfalls
 Shortfalls are calculated as of the previous payment period and apply to the current settlement period
 Shortfalls apply to all open contracts for a given settlement period
 Support to identify PAUG/floating rate events that apply to a given contract at the confirm level will be
introduced as a part of FpML version 4.3. It is already a part of the working draft.
 DTCC & Shortfall Processing
 DTCC is set to start a UAT where it will test functionality for calculations of Shortfalls.
 For Shortfalls, DTCC will provide information
• the type of shortfall,
• payer/receiver,
• settlement date,
• the amount of the shortfalls
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