Presentation on theme: "1 CDS on ABS Documentation American Securitization Forum Sunset Seminar-CDS of ABS March 8, 2006 John J. McGreevy Director and Senior Counsel Merrill Lynch."— Presentation transcript:
1 CDS on ABS Documentation American Securitization Forum Sunset Seminar-CDS of ABS March 8, 2006 John J. McGreevy Director and Senior Counsel Merrill Lynch
2 CDS on ABS Overview
3 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
4 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.
5 CDS on ABS Documentation
6 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?
7 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
8 Form I: Pay-As-You-Go or Physical Settlement
9 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 I
10 Form I Reference Obligation Notional Amount: −Decreases upon Principal Payment −Decreases upon Writedown −Increases upon Writedown Reimbursement −Decreases upon Physical Settlement (part or whole )
11 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 I
12 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
13 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 I
14 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”
15 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
16 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
17 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
18 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?
19 Form II: Pay-As-You-Go
20 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
21 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
22 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
23 Form II Documentation Issues Dealers won’t use it Anecdotally - very few trades booked on this form
24 Cash or Physical Settlement
25 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
26 Cash or Physical Settlement Credit Events Failure to Pay Loss Event Bankruptcy (optional) Restructuring Rating Downgrade to CC (optional)
27 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 calendar days after Event Determination Date Physical Settlement - Reference Obligation Only Payment of Floating Amount and accrued interest - 60 Business Day cap
28 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
30 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.
31 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?