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But what triggers payment or settlement under a credi

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Title: But what triggers payment or settlement under a credi


1
CDS of ABS--Securitizations New Frontier
American Securitization Forum Sunset Seminar
  • A Fast Track to Understanding CDS of ABS
  • Gary Barnett
  • March 8, 2006

Gary Barnett, Partner Linklaters1345
Avenue of the Americas18th FloorNew York, NY
10105gary.barnett_at_linklaters.com
2
The Agenda
  • Securitization vs Synthetic Securitization (a way
    to introduce you to credit derivatives, credit
    default swaps and, ultimately, cds of abs)
  • Basics of credit derivatives what they are,
    common types, illustration of hedging credit
    exposure, example of use in a synthetic CDO
  • But what triggers payment or settlement under a
    credit default swap? traditional cds vs. mbs and
    abs

3
Typical Securitization
Sponsor
Sale of Financial Assets
Cash Securities (retained interests?)
Issuer
Asset-backed securities sold to investors
(bankruptcy remote entity)
Cash for asset-backed securities

4
Typical Securitization
Sponsor
Issuer (bankruptcy remote entity
and owner of obligations)

Payments on asset-backed securities
Obligors (making payments on their obligations)
5
Typical Securitization What other basics do we
need to make it work?
  • 1. Credit support (internal or external)
  • 2. Liquidity or timing support
  • 3. Servicing and administration
  • 4. Trustee

Sponsor
Issuer (bankruptcy remote entity and owner of
obligations)

Payments on asset-backed securities
Obligors (making payments on their obligations)
6
One Type of Synthetic Securitization
Some types of risk brought into the structure
Sponsor
Issuer (bankruptcy remote entity
and owner of obligations)

Payments on asset-backed securities but subject
to the synthetic risk
High Grade Obligors
7
One Type of Synthetic Securitization
Some types of risk brought into the structure
credit risk casualty and other insurance type
risks market value risks, from commodities prices
to others investment returms and on and on
Sponsor
Issuer (bankruptcy remote entity
and owner of obligations)

Payments on asset-backed securities but subject
to the synthetic risk
High Grade Obligors
8
One Type of Synthetic Securitization
How risks are imported derivatives guarantees i
nsurance policies letters of credit EACH METHOD
RAISES ITS OWN TAX, ACCOUNTING AND REGULATORY
ISSUES
Sponsor
Issuer (bankruptcy remote entity
and owner of obligations)

Payments on asset-backed securities but subject
to the synthetic risk
High Grade Obligors
9
Basics on Credit Derivatives
  • Credit Derivatives are transactions designed to
    isolate and transfer credit risk associated with
    a third party or a third partys specific
    obligations.
  • Common Types of credit derivatives are
  • Credit default swaps (including Pay-as-you-go
    credit default swaps)
  • Total return swaps
  • Credit Linked Notes

10
Basics on Credit Derivatives
  • Credit default swaps (including Pay-as-you-go
    credit default swaps) swap agreement where one
    party pays a premium for credit protection
    payments from the other party

11
Basics on Credit Derivatives
  • Total return swaps one party pays the return on
    some reference obligations and the other party
    pays a finance based charge (like LIBOR plus x).
    At the end, the first party pays any appreciation
    in the value of the reference obligations to the
    second party, and the second party pays the first
    any depreciation in value of the reference
    obligation

12
Basics on Credit Derivatives
  • Credit Linked Notes a note whose payments of
    interest, or interest or principal, or principal
    can be conditioned or reduced for losses
    experienced by some reference obligation.

13
Hedging of Credit Exposure
To understand the economics and principles behind
credit derivatives, lets look at the following
example
Interest accruing
Principal
1B of 5 year Corporate Bonds
1B of 5 year Treasuries
14
Hedging of Credit Exposure
Risk premium or credit spread
Credit Risk
1B of 5 year Corporate Bonds
1B of 5 year Treasuries
15
Hedging of Credit Exposure
Risk premium paid for taking away credit risk
Credit Default Swap to provide protection/take on
risk
1B of 5 year Corporate Bonds
1B of 5 year Treasuries
Credit Risk is transferred
16
Hedging of Credit Exposure
Economically, the bonds should act like the
treasuries and the treasuries should act like the
bonds
1B of 5 year Treasuries burdened by CDS
1B of 5 year Corporate Bonds with benefit of CDS
17
Hedging of Credit Exposure
But there is no need for 1B of Treasuries to
cover all the risk in the bonds.
Credit spread on 1B
Treasury rate on 250M
250M of 5 year Treasuries burdened by CDS
1B of 5 year Corporate Bonds with benefit of CDS
18
A Derivative used in a Synthetic CDO Deal
250M Eligible Investments
Credit protection buyer wants protection on 1B
of corporate bonds
CLN 150M
SPV Issuer
CLN 60M
CLN 40M
19
A Derivative used in a Synthetic CDO Deal
250M Eligible Investments
Credit protection buyer wants protection on 1B
of corporate bonds
CLN 150M
SPV Issuer
CLN 60M
Promise to make credit protection payments
CLN 40M
20
A Derivative used in a Synthetic CDO Deal
250M Eligible Investments
Credit protection buyer wants protection on 1B
of corporate bonds
CLN 150M
SPV Issuer
CLN 60M
Promise to pay premiums equal to credit spread on
1B (adjusted for super senior)
CLN 40M
21
A Derivative used in a Synthetic CDO Deal
Interest Payments on Notes
22
A Derivative used in a Synthetic CDO Deal
Credit Protection Payment on Credit Default Swap
Reduction of Notional Amount of Swap and
Corresponding Loss for Notes allocated to most
junior class outstanding
250M Eligible Investments
Credit protection buyer wants protection on 1B
of corporate bonds
CLN 150M
SPV Issuer
Credit protection payment from Eligible
Investments
CLN 60M
CLN 40M
23
A Derivative used in a Synthetic CDO Deal
The CDO manager can create a synthetic portfolio
inside the CDO and by putting on and taking off
CDS, the Manager can trade reference
obligations much like a cash deal can trade its
underlying collateral debt securities.
(often consists of a TRS or asset swap)
(CDS)
24
Structure of a Credit Default Swap
Buyer/ Fixed Rate Payer (Swap Counterparty)
Seller/ Floating Rate Payer (SPV)
  • Text here.

If a Credit Event occurs with respect to
Reference Entity/Obligation
Conditions to Settlement satisfied
Cash Settlement
(100 - Value of Reference Obligation) x Notional
Amount or
Physical Settlement
Delivery of Deliverable Obligation
Par value of Deliverable Obligation
25
Structure of a Credit Default Swap
Cash Settlement Here the seller is obligated to
pay the Buyer the Cash Settlement Amount on the
Cash Settlement Date (3-5 business days after
calculating the final price. The Cash Settlement
Amount equals the swap notional times (100 minus
the Final Price) where the Final Price equals the
average of the highest firm bids obtained on each
valuation date.
Physical Settlement Buyer delivers a notice of
physical settlement, specifying the obligation to
be delivered on the Physical Settlement Date
against a payment in the amount of par. The
deliverable obligations must be of the types of
obligations of the Reference Entity that have
been agreed may be delivered in connection with
physical settlement. The types of obligations
that may be delivered are selected by choosing a
Deliverable Obligation Category (eg, payment,
borrowed money, bond, ref ob only, loan, bond or
loan, other) and Deliverable Obligation
Characteristics (eg not subordinated, specified
currency, listed, not contingent, assignable
loan, consent required loan, transferable,
maximum maturity, not bearer)
Consider the advantages and disadvantages of each
method!
26
Credit Events
  • When should a credit protection payment be made
    under a credit default swap?
  • Traditionally, when a Credit Event occurs with
    respect to a reference entity or obligation.
  • SO how should we define Credit Event?

27
Credit Events
  • 2003 ISDA Credit Derivatives Definitions Credit
    Events
  • Failure to Pay
  • Bankruptcy
  • Restructuring
  • Obligation Acceleration
  • Obligation Default
  • Repudiation/Moratorium

28
Credit Events
  • Those terms may work fine for corporate obligors.
    But how well do those terms capture a mortgage
    pass-through certificate in the throes of a very
    serious credit problem? Not very well!
  • Failure to Pay
  • Bankruptcy
  • Restructuring
  • Obligation Acceleration
  • Obligation Default
  • Repudiation/Moratorium

29
SO
  • A fair number of industry participants struck out
    on their own in an energetic and creative effort
    to design a CDS that contained appropriate credit
    events for mbs and abs. Then some dealers got
    togther to coordinate their thinking. Submitted
    their work to ISDA, who had already been working
    on an ABS form, the monolines had some thoughts
    as well. So at this point we have several
    templates for cds of abs to consider

30
What templates exist?
  • CDS on ABS with Cash or Physical Settlement
  • Published on 13 June 2005
  • CDS on ABS with Pay-As-You-Go (PAUG) Settlement
    (Form II)
  • Published on 19 December 2005
  • CDS on MBS with PAUG or Physical Settlement (Form
    I) (Dealer Form)
  • First published on 21 June 2005
  • Superseded by form published on 23 January 2006

31
CDS on ABS with Cash or Physical Settlement (June
2005)
  • This form was published on June 13, 2005
  • Designed for use for abs ref obs of any type but
    with a caution to make appropriate modifications
    for the particular ref obs
  • It has a traditional structure in that it
    requires payment and settlement upon the
    occurrence of a Credit Event. But through its
    credit event definitions, it seeks to use events
    that include losses that are final and can not be
    undone which is one way of rationalizing the
    settlement and termination of the swap

32
CDS on ABS with Cash or Physical Settlement (June
2005)
  • Credit Events include
  • Failure to Pay
  • Loss Event
  • Optionally bankruptcy and Ratings Downgrade (to
    CC and lower)

33
CDS on ABS with Cash or Physical Settlement (June
2005)
  • Failure to Pay
  • (x) non-payment of an Expected Payment Amount AND
    the occurrence of one of three situations the
    terms of the ref ob do not call for
    reimbursement optionally, they do not call for
    late interest at a sufficiently high interest
    rate or non-payment gives rise to an event of
    default allowing acceleration of the ref ob and
  • (y) failure to pay the full principal balance of
    the ref ob (without regard to restructuring or
    writedown) at the earlier of maturity or final
    distribution on the ref ob

34
CDS on ABS with Cash or Physical Settlement (June
2005)
  • Loss Event
  • A principal reduction pursuant to the terms of
    the ref ob AND satisfaction of one of the
    following conditions
  • the terms of the ref ob do not call for
    reinstatement or reimbursement of principal or
  • do not provide for interest to be paid on the
    reduction til so reinstated or reimbursed or
  • optionally, if the terms of the ref ob do not
    provide for interest on interest on the principal
    reduction

35
CDS on ABS with Cash or Physical Settlement (June
2005)
  • Once a credit event occurs, for purposes of the
    sellers floating payment, you follow a pattern
    of cash or physical settlement akin to the
    traditional CDS route already discussed.

36
MBS Pay-As-You-Go or Physical Settlement (Form
I)(Dealer Form)
37
MBS Pay-As-You-Go or Physical Settlement (Form
I)(Dealer Form)
  • This swap provides for two types of seller credit
    protection payments
  • the first type are payments that are required to
    be made during the life of the swap, with the
    swap continuing on after such payments. These
    payments are called floating payments, are paid
    if a Floating Amount Event occurs, and require
    payment of the Floating Amount.
  • The second type are payments that result in
    termination of all or a portion of the swap. This
    occurs upon the occurrence of a Credit Event.

38
MBS Pay-As-You-Go or Physical Settlement (Form
I)(Dealer Form)
  • For the next part of the discussion, it may be
    helpful to know that Floating Amount Events and
    Credit Events overlap significantly. Where there
    is overlap, the buyer has the right to choose to
    receive a pay-as-you-go payment and keep the
    trade going or cause all or a portion of the
    swap to terminate (subject to physical delivery).
  • Floating Amount Events Credit Events
  • Writedown Writedown
  • Failure to Pay Principal Failure
    to Pay Principal
  • Interest Shortfall Distressed Ratings
    Downgrade

39
MBS Pay-As-You-Go Floating Amount Events
  • Interest Shortfalls
  • Covers the Interest Shortfall Amount which
  • Covers PIK Interest
  • May or May not be subject to a WAC cap on the
    related ref ob (as the parties elect)
  • Does not cover interest on write-downs (actual or
    implied)
  • Payment may or may not be (but in practice
    usually is) subject to an Interest Shortfall Cap

40
MBS Pay-As-You-Go Floating Amount Events
  • Interest Shortfalls
  • Interest Shortfalls are not Credit Events so
    do not, on their own, result in a termination of
    the swap.
  • Because late or defaulted interest can later be
    recovered on the ref ob, the fixed rate payer
    (the buyer of protection) is required to pay the
    seller an Additional Fixed Amount if such a
    recovery occurs on the ref ob.
  • It is common that an interest shortfall cap is
    set at a rate equal to the premium being paid to
    the protection seller. The result is that the
    premium and the interest shortfall are offset so
    that, if only interest shortfalls are occurring,
    no payments may be made on either side of the
    swap.

41
MBS Pay-As-You-Go Floating Amount Events
  • Writedowns
  • Covers (i) actual principal writedowns on the
    ref ob, (ii) the attribution of realized losses
    that results in a reduction or subordination of
    interest thereon, (iii) the forgiveness of
    principal by the holders pursuant to an amendment
    of the underlying docs, and (iv) an Implied
    Writedown (which, in general, is the amount by
    which the principal of the ref ob is not secured
    by principal of the assets underlying that ref
    ob).
  • Because written down principal may be later
    recovered on the ref ob, the fixed rate payer
    (the buyer of protection) is required to pay the
    seller an Additional Fixed Amount if such a
    recovery occurs on the ref ob.

42
MBS Pay-As-You-Go Floating Amount Events
  • Writedowns
  • Remember a Writedown is also a Credit Event.
    Thus, if a Writedown occurs, the buyer of
    protection may elect to receive the floating
    amount for the writedown and continue, or to
    treat it as a Credit Event and terminate all or a
    portion of the swap subject to being able to
    physically deliver the written down bonds.

43
MBS Pay-As-You-Go Floating Amount Events
  • Failure to Pay Principal
  • A Failure to Pay Principal only occurs on the
    Final Amortization Date of the ref ob (the day it
    is paid out to the extent possible) or the Legal
    Final Maturity Date of the ref ob.
  • It may seem strange to call this a floating
    amount since it occurs at the end of the swap.
    Another way to think about it is to think of it
    as providing for something akin to cash
    settlement (without valuation etc) for this event
    notwithstanding the fact that we think of Form
    I as only permitting physical delivery for
    settlement of credit events. In any event, if the
    ref ob fails to pay in full at maturity and the
    buyer does not have the ref ob for purposes of
    physical delivery as a Credit Event, the buyer
    can receive a payment for the Principal Shortfall
    Amount.

44
MBS Pay-As-You-Go Floating Amount Events
  • Failure to Pay Principal
  • Because principal shortfalls may also be later
    recovered, the fixed rate payer (the buyer of
    protection) is required to pay the seller an
    Additional Fixed Amount if such a recovery occurs
    on the ref ob.
  • How can this happen if we are indeed at the end
    of the swap? The buyers obligation to pay
    Additional Fixed Amounts, whether for recoveries
    of interest shortfalls, writedowns or principal
    shortfalls, survives for one year after the end
    of the swap.

45
MBS Pay-As-You-Go Credit Events
  • We have already discussed Writedowns and Failure
    to Pay Principal
  • Remember that a Writedown can occur during the
    life of the swap, giving the buyer the right to
    terminate the swap by treating it as a Credit
    Event rather than as a Floating Amount Event.
    But to do so, the buyer must give notice of
    physical delivery and be able to physically
    deliver the ref ob.
  • The Failure to Pay Principal doesnt create this
    early termination risk since it only picks up
    failures to pay principal at legal final or final
    amortization on the ref ob.

46
MBS Pay-As-You-Go Credit Events
  • Distressed Ratings Downgrade.
  • A Distressed Ratings Downgrade occurs if the ref
    obs rating is downgraded to CCC/Caa or below.
    Like the Writedown, this event can occur during
    the life of the swap, giving the buyer the right
    to terminate the swap (provided the buyer is able
    to physically deliver the ref ob).
  • If the buyer can not deliver the ref ob, the
    buyer must wait til another event occurs
    interest shortfall, writedown or failure to pay
    principal.

47
ABS with Pay-As-You-Go Settlement (Form II)
48
ABS with Pay-As-You-Go Settlement (Form II)
  • Supported by the monolines
  • Does not contain provisions that could accelerate
    the termination of the transaction. Thus no
    distressed ratings downgrade no implied
    writedowns
  • Does not contain provisions that could result in
    payments not actually required by the terms of
    the ref obs underlying docs. Thus no payments in
    excess of a wac cap, covering interest that is
    being capitalized or deferred, or covering
    implied writedowns.

49
ABS with Pay-As-You-Go Settlement (Form II)
  • Supported by the monolines
  • Does provide that buyer must make Additional
    Fixed Payments of any Writedown Reimbursement,
    Principal Shortfall Reimbursement, or Interest
    Shortfall Reimbursement
  • Care is taken to put the seller of protection
    into control of voting rights under the related
    ref ob
  • No physical settlement unless the seller of
    protection so elects. Otherwise the buyer of
    protection only has the right to receive payment
    of shortfalls of the amounts described.
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