CDS on ABS Documentation

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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

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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-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 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
• Buyers 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 wont 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 ISDAs 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?