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CDS on ABS Documentation. American Securitization Forum Sunset Seminar-CDS of ABS March 8, 2006 John J. McGreevy Director and Senior Counsel Merrill Lynch. CDS on ABS Overview. CDS on ABS Overview .

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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

  • 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

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


  • 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-You-Go 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

  • 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

    • 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

    • 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 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?