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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
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
  • 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
cds on abs overview1
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.
cds on abs documentation1
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?
cds on abs documentation2
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
form i
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)
form i1
Form I
  • Reference Obligation Notional Amount:
    • Decreases upon Principal Payment
    • Decreases upon Writedown
    • Increases upon Writedown Reimbursement
    • Decreases upon Physical Settlement (part or whole)

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)
form i2
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

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
form i3
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”
form i4
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

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
form i documentation issues
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
form i documentation issues1
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?
form ii
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
form ii1
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
form ii2
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
form ii documentation issues
Form II Documentation Issues
  • Dealers won’t use it
  • Anecdotally - very few trades booked on this form
cash or physical settlement
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
cash or physical settlement1
Cash or Physical Settlement

Credit Events

  • Failure to Pay
  • Loss Event
  • Bankruptcy (optional)
  • Restructuring
  • Rating Downgrade to CC (optional)
cash or physical settlement2
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
cash or physical documentation issues
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
abx cmbx documentation issues
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.
future documentation issues
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?