Abs CDS

Global Structured Finance Research
New York
March 7, 2005
Single Name CDS of ABS
Next Step in the Evolution of the ABS Market
The emergence of a single name ABS Credit Default Swap (ABCDS)
market represents a major development in the evolution of the ABS
market. To date, ABS has primarily been a long risk, cash only market.
ABCDS will now enable ABS investors the ability to take on risk
synthetically. More importantly, ABCDS will transform ABS away from
a long only risk market and provide ABS investors, dealers, and issuers,
the ability to short the market, hedge positions, or hedge loan pipelines.
The unique attributes of ABS mean that standard corporate CDS
documentation and settlement procedures must be modified to create a
viable single name ABCDS market.
Synthetic ABS trades have been completed in the past, but have
typically been negative basis trades that used trade-specific
documentation. Examples include new issue negative basis trades
and portfolio trades in synthetic CDOs of ABS.
In the past, the lack of standard documentation, a conservative rating
agency approach to ABCDS settlement issues, and a lack of protection
buyers for the product have been obstacles to the development of a
liquid single name market. Over the past few months, documentation
across dealers has become much more consistent. ISDA standard
documentation is expected to be finalized in the near future. However,
finding protection buyers in size will still represent a key challenge for
the future growth of the market.
CDOs of ABS, whether purely synthetic or cash deals with synthetic
buckets, and correlation books represent a potentially large source of
demand for the product. Single name ABCDS represent a building
block for these players, but it is unclear whether the single name
ABCDS market will ever offer the type of liquidity available in the
corporate CDS market. This is primarily due to the relative complexity
of ABCDS, as discussed in this report.
Contents
Introduction 2
ABCDS market participants 6
ABCDS contracts and mechanics
ABCDS versus Corporate CDS 8
Reference entities 9
Credit events 9
Valuation and settlement 11
Other considerations 14
Conclusion 15
Single Name CDS of ABS is available on the
JPMorganChase web site:
www.morganmarkets.com
Christopher Flanagan
AC
(1-212) 270-6515
christopher.t.flanagan@jpmorgan.com
Ryan Asato
(1-212) 270-0317
ryan.asato@jpmorgan.com
Edward Reardon
(44-207) 777-1260
edward.j.reardon@jpmorgan.com
North America
Christopher Muth
(1-212) 270-0967
chris_muth@bankone.com
Glenn Schultz, CFA
(1-312) 732-7069
glenn_schultz@bankone.com
Amy Sze, CFA
(1-212) 270-0030
amy.sze@jpmorgan.com
Tracy Van Voorhis
(1-212) 270-0157
tracy.vanvoorhis@jpmorgan.com
London
Rishad Ahluwalia
(44-207) 777-1045
rishad.ahluwalia@jpmorgan.com
Ting Ko
(44-207) 777-0363
ting.ko@jpmorgan.com
www.morganmarkets.com
The certifying analyst(s) is indicated by a superscript AC. See last page of the report for
analyst certification and important legal and regulatory disclosures.
AC
(1-212) 270-6515
Ryan Asato (1-212) 270-0317
Edward Reardon (44-207) 777-1260
2
Introduction
The emergence of a single name ABS Credit Default Swap (ABCDS) market
represents a major development in the evolution of the ABS market. To date, ABS
has primarily been a long risk, cash only market. ABCDS will now enable ABS
investors the ability to take on risk synthetically (sell protection). More importantly,
ABCDS will transform ABS away from a long only risk market and provide ABS
investors, dealers and issuers, the ability to short the market, hedge existing
positions, or hedge loan pipelines (buy protection).
In the past, two major obstacles have hindered the growth of the market.
First, no standard documentation exists for the product. To date, the majority of
synthetic CDS risk has been transferred via negative basis trades (as discussed
later in this section) using trade-specific documentation (i.e., an investor purchases
cash ABS and buys protection on the tranche).
Second, the ABS market has had a relatively undeveloped investor base for
hedging/shorting ABS risk.
More recently, liquidity in ABCDS has started to expand as the market has begun to
address these obstacles. Currently, dealers and investors are close to standardizing
credit event definitions and settlement procedures that are acceptable to both buyers
and sellers of protection. Over the past few months, documentation across dealers
has become much more consistent. ISDA standard documentation is also expected
to be finalized in the near future. In addition, protection buyers have begun to
emerge as the market has developed. However, finding protection buyers in size
will still represent a key challenge for the future growth of the market.
Brief review of CDS basics
A credit derivative is a financial contract that allows one to take or reduce default
exposure, generally on bonds or loans, of a sovereign, a corporate entity, and
increasingly, asset backed securities. Credit default swaps (CDS) are the
cornerstone of the credit derivatives market. CDS are an agreement between two
parties to exchange the credit risk of an issuer (reference entity) and does not
directly involve the issuer itself. CDS are primarily used to 1) reduce risk arising
from ownership of bonds or loans, 2) take exposure to an entity, as one might do by
buying a bond or loan issued by that entity, and 3) express a positive or negative
credit view on a single entity or a group of entities, independent of any other
exposures to the entity that one might have.
The seller under the credit default swap is said to sell protection. The seller usually
collects a periodic fee and profits if the credit of the reference entity remains stable
or improves while the swap is outstanding. Selling protection has a similar credit
risk position to owning a bond or loan, or going long risk. The buyer under the
credit default swap is said to buy protection. The buyer usually pays a periodic fee
and profits if the reference entity has a credit event, or if the credit worsens while
the swap is outstanding. Buying protection has a similar credit risk position to
selling a bond short, or going short risk. (Chart 1)
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In the corporate CDS market, credit events include bankruptcy, failing to pay
outstanding debt obligations, or in some CDS contracts, a restructuring of a
borrowed money obligation. Following one of these credit events, the buyer of
protection can deliver to the seller of protection defaulted bonds and/or loans with a
face amount equal to the notional amount of the credit default swap contract. The
seller of the protection then delivers the notional amount on the CDS contract in
cash to the buyer of protection. The buyer can deliver any bond or loan, meeting
certain criteria, issued by the reference entity that is at the same level of seniority as
the specific bond referenced in the contract. This is called physical settlement.
Alternatively, the buyer and seller can agree to unwind the trade based on the market
price of the defaulted bond. This is called cash settlement
1
.
Due to unique attributes of ABS, both credit events and settlement mechanics have
been modified to better fit these securities. These will be discussed in greater detail
in the following sections.
Evolution of synthetic ABS risk transference
Although the single name ABCDS market is in its development phase, ABS risk has,
for some time, been transferred synthetically through negative basis trades.
Negative basis trades entail the purchase of a cash bond and simultaneously buying
protection on the bond using CDS. Many synthetic CDOs of ABS use negative basis
trades, and we briefly review both of these below.
New issue negative basis trades
New issue negative basis trades have been completed in structured products for
some time. In these trades, a bank (the funder) purchases the senior-most CDO
tranche (already AAA rated) at the time the CDO prices. As part of the negative
basis trade, the bank also buys protection typically from a monoline insurer (the
AC
(1-212) 270-6515
Ryan Asato (1-212) 270-0317
March 7, 2005
Chart 1: Single name credit default swaps
Source: JPMorgan.
1. For more information, please refer to Credit Derivatives: A Primer, Beinstein/McGinty, January 2005.
Reference
Entity
Protection
Buyer
Protection
Seller
Risk
(Notional)
Fee/premium
Contingent payment upon a
Credit Event
Credit Risk Profile of shorting a bond Credit Risk Profile of owning a bond
Buy CDS
Buy Protection
Short risk
Pay periodic payments
Sell CDS
Sell Protection (against default)
Long risk
Receive periodic payments
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4
wrapper), and pays the monoline a running premium to protect against defaults.
The bank and the monoline each receive a portion of the CDO tranche spread -
determined through a negotiation prior to the deal pricing (Chart 2). From the
funding banks perspective, it has a super-AAA asset (i.e., a AAA-rated CDO
tranche, with an additional wrap from the monoline). From the monolines
perspective, it earns a running spread for taking an acceptable level of risk that is
typically a big part of its financial guarantee business.
New issue negative basis trades are distinct from single name ABCDS because 1)
monolines are extensively involved in the CDO and CDS documentation before the
deal is printed, 2) the trade normally takes place at new issue, and 3) the trade is
usually based on the entire tranche.
Currently, many single name ABCDS are completed via negative basis trades
(although not at new issue). An investor purchases the cash ABS and buys
protection, and earns the difference between the cash bond spread received and the
CDS premium paid.
Synthetic CDOs of ABS
Synthetic CDOs of ABS reference a large percentage of ABS synthetically (80-
100%), and examples include BNPs Thunderbird Investments and AXAs Tempo
CDO programs. However, in part, due to the lack of a liquid single name ABCDS
market, these CDOs also rely on negative basis trades and trade specific CDS to
source risk.
The bank, usually the CDO arranger, purchases cash ABS assets on its balance sheet
and then buys protection on a portfolio basis from the CDO. The arranging bank
(the swap counterparty) pays the CDO a running premium to take the credit risk of
the ABS portfolio (Chart 3). In this negative basis trade, the CDO arranging bank
may not retain any spread for its funding role. We typically assume that an
arranging bank provides LIBOR flat funding, so the CDS premium paid to the CDO
is equal to the spread on the cash ABS. The documentation is trade-specific, but
allows the CDO to reference the ABS portfolio synthetically.
March 7, 2005
Chart 2: New issue negative basis trade
Source: JPMorgan.
CDO Tranche
Receives
bond spread
Pays CDS
premium
Protection
Seller
Funder
Buys
Protection
Funder
Buys
Protection Par
Buys Bond
Bond
5
Arranging banks for these CDOs are among those pushing for standardized ABCDS
documentation. A liquid single name ABCDS market will allow these arrangers to
1) source/hedge risk in a single name market, rather than through negative basis
trades, and 2) manage any residual risks from single tranche synthetic CDOs of ABS
if the entire synthetic CDO capital structure is not distributed.
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Ryan Asato (1-212) 270-0317
March 7, 2005
Chart 3: Synthetic CDO of ABS
Source: JPMorgan, Fitch
Super-senior
swap
AA
BBB
First Loss
SF Security
Reference
Portfolio
AAA Collateral
Trust (protection
seller)
A
Proceeds
Principal &
Interest
Proceeds
Principal &
Interest
Swap
counterparty
CDS
premiums
Protection
payments
Protection
payments
Spread on Cash
ABS
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ABCDS market participants
Protection sellers
We expect a diverse group of investors to use single name ABCDS as protection
sellers, primarily those that currently invest in cash ABS. Given that in some
periods, the primary market has failed to meet strong investor demand, we believe a
number of investors would source additional ABS risk using ABCDS. CDOs should
provide a large source of demand as ABCDS would allow them to quickly ramp up
their portfolio and potentially give them the ability to diversify into different sectors,
issuers, or even vintages. In addition, unfunded ABCDS should appeal to investors
with smaller capital bases (e.g., hedge funds, monolines).
Protection buyers
A key challenge for a liquid single name market will be continuing to find new
buyers of protection, which we attribute to a variety of factors. To begin, structural
features in ABS (e.g., credit enhancement, performance-based triggers, etc.) are
designed to avoid default - even in highly stressed scenarios. Furthermore, ABS
deals tend to be primarily investment grade rated (AAAs alone represent 85-97% of
most deals). Given these structural protections and the high ratings, investors may
not want to pay a CDS premium to protect against such low expected losses,
especially higher up in the capital structure. Finally, few investors/ institutions have
natural credit exposures to ABS issues compared to corporates (e.g., through
loans, swaps, counterparty credit, etc). As a result, there is less potential demand
from institutions seeking to hedge ABS risk. Nevertheless, market participants may
seek to use ABCDS for a variety of reasons.
Relative value trades
Short the market. Historically, an inefficient ABS repo market has made
shorting ABS challenging. ABCDS may become the easiest way to express a
negative view. We see hedge funds as an investor class that may become more
active in the ABS market given the ability to execute short strategies. However,
hedge funds typically are fast money oriented and will likely be much more
sensitive to spread movements. As a result, they may be in-and-out of the market
and may not always be a stable source of demand.
Put on capital structure trades. Investors can exploit perceived inefficiencies
within a deals capital structure by going long risk in areas of the capital structure
they consider cheap and sell protection in areas they feel are rich. For example,
investors could buy lower rated tranches and hedge their exposure by buying
protection on a higher rated tranche from the same transaction.
Hedging
Manage counterparty credit exposure. Some institutions do have counterparty
credit exposure to ABS transactions via interest rate or currency swaps. These
institutions can reduce/hedge some of their risk to the ABS issuer using CDS.
However, this type of hedge would only be a proxy for the underlying risk, since the
actual swap payment risk would not typically be directly referenced in the contract.
Hedge issuer pipelines or CDO warehouse risk. Many ABS issuers originate
assets in a warehouse and use securitization as their exit strategy or long-term
funding source. Buying protection using ABCDS (with a similar credit profile)
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7
allows an originator the ability to hedge the risk that securitization spreads widen
during the warehouse period. Similarly, facilities warehousing CDOs in their
ramp-up period can hedge the risk of potential spread widening of the assets
purchased into the warehouse prior to the CDO funding.
Allow CDO mezzanine or equity investors the ability to hedge against
positions held by the CDO. To the extent that a CDO investor has a negative
view on a specific bond in a deal, the investor can buy protection against these
specific positions.
Delta hedging. Credit hybrids desks will find a liquid single name market
attractive because they can use this market to manage correlation risks of CDO
trades (both buying and selling protection).
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Ryan Asato (1-212) 270-0317
March 7, 2005
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8
ABCDS contracts and mechanics
First, we examine the differences between Corporates and ABS and how those need
to be reflected in ABCDS contracts and credit events. Next, we discuss the various
components of ABCDS, including reference entities/obligations, credit event
definitions, and valuation and settlement procedures.
ABCDS versus Corporate CDS
The ABCDS market has been able to leverage off the considerable development that
has already been done in the Corporate CDS market. However, the unique attributes
of ABS mean that standard Corporate CDS documentation and settlement
procedures must be modified. Some of these differences include:
Corporations may have more flexibility to avoid a credit event. With respect
to Corporates, a companys management can modify its capital structure,
expenses, etc. to continue as a going concern or avoid default. In contrast, ABS
rely on the asset cash flows for repayment of principal and interest, which are paid
according to specific bond documentation. There is no (or comparatively, very
little) management option that can increase or reduce the risks to ABS investors.
Deliverable obligations. In typical corporate CDS, credit events occur in respect
of a reference entity and its borrowed money obligations. If a credit event occurs,
a variety of deliverable obligations may be delivered. The range of deliverable
obligations typically includes bonds and loans, and may include other specified
obligations. The ability to deliver various obligations may create a cheapest-to-
deliver option. By contrast, because performance in ABS can vary across deals,
most ABCDS contracts will be reference obligation specific.
Accrued Interest / Payment-In-Kind (PIK). In stressed circumstances, cash
flows received from the assets may be insufficient to repay bond interest. Some ABS
transactions may use structural mechanisms to alter cash flows to prevent a default
since interest shortfalls may be a short-term liquidity issue. For example, some
bonds may accrue interest (pay-in-kind), or use principal payments to pay interest.
Principal writedowns. ABS principal may be reduced if losses exceed the
available credit enhancement, or if principal is used to cover an interest shortfall
(a debit to a principal deficiency ledger, or PDL). In some cases, the principal
reduction may be reimbursed if performance recovers.
Prepayment uncertainty. The majority of corporate bonds have a bullet
maturity a single payment of principal on a specified legal maturity date. If
principal is not paid at that time, a credit event occurs (failure to pay). In
contrast, most ABS amortize over time, and ABS average life estimates are
based on specific prepayment assumptions. As a result, failure to pay according
to the assumed prepayment schedule would not constitute a credit event.
Declining notional. Also due to prepayments and principal paydowns on the
underlying receivables, depending on the structure, the outstanding balance of the
reference obligation may decline over time. As a result, the notional amount of
the ABCDS contract should also decline in line with reductions to the outstanding
principal on the reference obligation.
Long legal final. ABCDS will feature long legal final maturities that match the
cash assets. The legal final maturity of ABS typically reflects the tenor of the
March 7, 2005
9
longest maturity asset in the pool (e.g., roughly 30 years for mortgages, 10 years
for auto loans, etc). Using a shorter CDS maturity would be equivalent to
writing/buying a put option on the reference obligation if it extends beyond the
expected maturity. However, this could be problematic for ABCDS on Home
Equities, for example, since a credit event, if one was to occur, is more likely to
happen later in a deal due to the timing of underlying collateral losses. Thus, if
the contract were to terminate before the maturity of the underlying bond, the
buyer of protection may lose their coverage when they need it the most.
Reference entities/obligations
ABCDS transactions are reference obligation specific. In most ABCDS, credit
events occur with respect to the reference entity (the issuer of the ABS) and a
specific security issued by that reference entity. With certain exceptions, settlement
of the transactions is affected either by delivery of that specific security or by
reference to the payment performance or market value of that specific security. The
rationale for referencing a specific tranche is that ABS performance can vary from
deal-to-deal, for a variety or reasons.
Vintage. Credit performance can vary depending on the year of origination.
Relaxed underwriting standards in a period of intense competition, for example,
may lead to higher losses in a particular vintage. Poor economic conditions (e.g.,
rising rates and higher unemployment) may also impact a specific origination year
more acutely.
Range of asset quality. Issuers frequently originate and securitize a broad range
of assets, and the underlying borrowers can have different credit profiles. Sellers
of protection seek to isolate credit risks, and therefore would not allow a default
of any issue to qualify as a credit event.
Senior and subordinate tranches. ABS transactions typically comprise senior
and subordinate bonds. By design, subordinate tranches absorb losses first (once
credit enhancement has eroded), and are thus more likely to default than more
senior tranches.
For these reasons, a protection seller does not want a default on any bond of an
issuer to trigger a credit event.
Credit Events
Credit events and settlement mechanisms in ABCDS may depend on the referenced
collateral type, and/or who the seller of protection is. For example, the rating
agencies may require different credit events and settlement mechanisms for cash-
settled contracts that are placed in a rated CDO. There may also be regional
variations in credti event definitions and settelement procedures, driven in part by
corresponding regional variations in the ABS cash market.
The following, are types of credit events that may be defined in ABCDS contracts.
Bankruptcy
ABS issuers achieve bankruptcy-remoteness from an originator/seller by
transferring assets into a special purpose vehicle (in other words, ring-fencing the
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assets from the balance sheet of the issuer). If the originator/seller defaults, ABS
investors will continue to receive cash flows from the segregated assets, and these
assets do not form part of the bankrupt originators estate for unsecured creditors.
In ABCDS, bankruptcy refers to a bankruptcy of the special purpose vehicle, a
dissolution of the SPV, or any lien/assignment against the assets such that ABS
investors no longer have an exclusive claim on the assets.
Some buyers of protection need bankruptcy to be included as a credit event in order
to qualify for regulatory capital relief.
Failure to pay
Failure to pay interest or principal on a scheduled payment date is a standard
corporate credit event definition. However, as discussed, in some cases, ABS can 1)
experience temporary interest deficiencies without defaulting, and 2) have principal
repayment profiles that do not typically follow a specific schedule.
In the context of ABCDS, failure to pay refers to the failure to pay required interest
or principal due on a scheduled distribution date. In some markets, in order for a
credit event to be deemed to have occurred, the ABS must also meet one or more of
the following conditions:
The failure to pay has occurred over an extended period (e.g., 24 months)
indicating the shortfall is no longer temporary.
The reference obligation does not allow for reimbursement of payment shortfalls.
The nonpayment of interest or principal is a default according to the terms of the
underlying ABS.
Failure to pay can also represent the failure to pay all principal on the reference
entity by the legal final maturity date or the date when all assets backing the ABS
have been sold and the proceeds distributed.
In order to ensure that the failure to pay is not due to any temporary technical issue,
this event may include a minimum grade period.
Loss or writedown event
Under certain circumstances, ABS permit a reduction to the principal amount of a
tranche. For example, if losses have eroded credit enhancement, or principal is used
to pay a temporary interest deficiency (i.e., principal deficiency ledger), the tranche
notional may be temporarily reduced. However, in some deals, a principal reduction
can be cured once performance improves. Therefore, in ABCDS trades that do not
provide for the buyer of protection to reimburse the seller in the event that there are
writedown reimbursements in the underlying ABS deal, a principal reduction must
often meet one or more of the following conditions to qualify as a credit event:
The underlying ABS does not provide for reimbursement of the principal reduction.
The underlying ABS does not provide for interest to be paid on the principal
reduction, or for any interest that would have accrued on the unpaid interest on a
principal reduction.
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Some contracts require the calculation agent or an independent third party to
determine that it is mathematically impossible for a future reimbursement to
occur. This calculation would have to include assumptions about future
performance and may be difficult to put into practice.
Ratings-based triggers
Under a ratings-based trigger, a credit event would occur if one or more public
ratings falls below a specified threshold. The threshold is somewhat dependent on
the type of settlement and whether or not the ABCDS is placed into a rated CDO.
For physically settled contracts, downgrade triggers can be set higher; some
contracts specify a Caa1/CCC+ (Moodys/S&P) threshold. For cash settled
contracts, Moodys currently requires triggers be set at Ca for a minimum of six
months or C for any period while S&P requires a CCC- on negative watch or a CC+
rating. In addition, the rating agencies generally prefer to have ratings-based
triggers coupled with some other credit event. However, we believe that stand-alone
ratings triggers not linked with other credit events can provide a catch all for
unforeseen credit issues not captured in other events. Ratings-based triggers may
also include withdrawn ratings.
Valuation and settlement
ABCDS may be physically or cash settled or settled on a pay-as-you-go basis. The
defined settlement mechanism depends on the type of reference obligation. ABCDS
referencing Credit Card Master Note Trusts will most likely be structured with
physical settlement. Contracts executed in Europe will likely favor physical
settlement with a cash settlement fall back, in part to prevent a documentation
mismatch for existing CDOs of ABS. Pay-as-you-go combined with a physical
settle option is the settlement mechanism of choice for ABCDS referencing Home
Equity ABS in the United States.
Physical settlement
In physical settlement, the protection buyer delivers the cash bond (or eligible asset)
and receives par. In turn, the protection seller receives the cash bond and pays par
(Chart 4). However, given the small size of some ABS tranches, protection buyers
may find it difficult to purchase and deliver bonds. As a result, physical settlement
will mainly be used for ABCDS referencing tranches issued from Credit Card
Master Note Trusts which could allow for multiple reference obligations to be
delivered. Since Credit Card Master Note Trusts are structured such that excess
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Chart 4: ABCDS physical settlement
Source: JPMorgan.
Protection
Seller
Protection
Seller
CDS
Premium
CDS
Premium
Protection
Buyer
Protection
Buyer
JPMorgan JPMorgan
Bond
Bond
Par
Par
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spread is allocated using a socialist methodology, and since writedowns are
applied pro-rata to all outstanding tranches with the same priority, if a credit event is
triggered, the buyer of protection would be able to deliver any tranche from the
Credit Card Master Note Trust with the same seniority as the reference entity.
Cash Settlement
In cash settlement, a minimum number of dealer bids, together with a specified
valuation method are used to attain a single settlement value. Cash settlement can
use a single valuation date or multiple valuation dates. On a determined number of
business days after a credit event, dealers will be asked to submit firm bids for the
defaulted ABS. While not yet finalized, current documentation frequently requires
five approved dealers to be solicited for quotes, and at least two full quotes to be
received. If the required number of quotes is received, the contract will settle
according to the agreed valuation method and settlement period. The valuation
method may be an average of bids, the highest bid, an average omitting the highest
and lowest bid, etc., and is determined at the outset of the contract. Once the
valuation is determined, the protection seller pays the protection buyer par less the
dealer poll price (Chart 5).
If the minimum number of bids is not received, settlement will not take place, and
the bidding process will be conducted at defined intervals until completed
successfully (e.g., once every 30 days for six months). This process will continue
until 1) the minimum number of bids are received or 2) a final bidding date, where
if still unsuccessful, the recovery value will be deemed to be zero.
However, cash settlement may pose additional challenges because of the valuation
process. When ABS performance deteriorates significantly, market participants
generally agree that accurate valuation is difficult for a variety of reasons (e.g., lack
of information, uncertainty about further defaults/prepayments, a small investor base
for distressed ABS, negative performance momentum). In distressed ABS valuation,
the market expects that 1) fewer dealers will bid distressed paper, 2) bids will not be
aggressive, and 3) there will be considerable dispersion of valuations among dealers.
Market participants also generally agree that over time, valuation accuracy is likely
to improve, as more information is received, and potential buyers emerge. However,
finding a minimum number of bids for distressed ABS may still be difficult. In
contrast to the corporate market, there is a less active market for trading distressed
March 7, 2005
Chart 5: ABCDS cash settlement
Source: JPMorgan.
Protection
Seller
Protection
Seller
CDS
Premium
CDS
Premium
Protection
Buyer
Protection
Buyer
JPMorgan JPMorgan
(1 Dealer
poll price)
(1 Dealer
poll price)
13
ABS names (in part, because there are relatively few distressed names),
comparatively little research on distressed ABS, and frequently greater uncertainty
on the timing and amount of final recoveries.
Another key question for cash settlement is whether dealers will bid (at all), and/or
at realistic levels in order to make the settlement process work. In order to protect
against dealers bidding too low, some contracts allow the protection seller to also
submit a bid. To guard against bids being too high, the protection buyer may be
able to hit the highest bid with a funded total return swap.
For cash settled ABCDS, these issues will present some challenges once a credit
event has occurred.
Pay As You Go / Physical Settle
US HELABS settlement will most likely be defined as Pay As You Go (PAYG)
with a physical settlement option. PAYG differs from cash and physical settlement
in that a single payment (or exchange of bond for par) may not take place. Under
PAYG, protection sellers make contingent cash payments equivalent to any
writedowns on the bond as the writedowns on the bond occur. The rationale for
PAYG settlement is that HEL losses are reversible, can occur over an extended
period of time, and there is also the potential for short squeezes if contracts could
only be physically settled given the relatively small sizes of mezzanine HEL
tranches. PAYG contracts also typically give the protection buyer the right, but not
the obligation, to physically settle the contract. In addition, PAYG does allow for
partial physical settlement if the protection buyer is unable to secure the full contract
amount in the cash bond market.
PAYG settlement presents some operational challenges because writedowns are
likely to occur over an extended period of time. Furthermore, a reduction in the
writedown amount (e.g., a writeup) can also take place. In some contracts, a
writeup would require the protection buyer to pay the subsequent writeup back
to the seller.
AC
(1-212) 270-6515
Ryan Asato (1-212) 270-0317
March 7, 2005
Chart 6: ABCDS pay as you go / physical settle
Source: JPMorgan.
Protection
Seller
Protection
Seller
CDS
Premium
CDS
Premium
Protection
Buyer
Protection
Buyer
JPMorgan
Writeups
Writeups
PAYG
Writedowns
PAYG
Writedowns
Bond
Bond
Physical
Par
Physical
Par
AC
(1-212) 270-6515
Ryan Asato (1-212) 270-0317
14
Other Considerations
Home Equity Available Funds Cap
The available funds cap embedded in Home Equity ABS pose additional
requirements for ABCDS contracts. The issue arises since the underlying cash bonds
pass-through rate is defined as the lesser of the available funds cap, which is the
weighted average expense adjusted net mortgage rate, and the bonds spread plus its
index (for floating rate securities). In the event that the available funds cap is hit, the
cash bond holders effective spread over its benchmark would be reduced. To
account for this in an ABCDS, if the underlying bond were to hit the available funds
cap, the protection buyers fixed payments would be haircut, reflecting the actual
coupon received on the cash ABS. The implication of this haircut is that ABCDS
contracts will not strip out the available funds cap risk embedded in the underlying
cash bonds. In the event that the available funds cap shortfall is reimbursed in future
periods, the protection buyers fixed payments would be increased by that amount.
The issue becomes more complicated when the cash bond is trading at a discount or
premium when the ABCDS is executed. In either case, the coupon being paid on the
cash bond is different than the ABCDS premium which is expected to be initially
executed as a par contract. For example, if the cash bond is trading at a premium,
the cash bond would hit the available funds cap before the theoretical strike you
would have if you were using the lower ABCDS premium. In this example, once
the cash bond hits the available funds cap, the fixed payments would be reduced by
the shortfall amount.
For simplicity of trading, the market is gravitating towards making the synthetics
look as close to the cash bonds as possible. At this point, the exact mechanics of
how to handle the available funds cap remain under discussion.
CDOs of ABS
For ABCDS put into CDOs, the rating agencies have concerns about accurate
valuations in a cash settlement. To address these concerns, the rating agencies
haircut recovery value estimates for ABCDS that use a short settlement period.
Moodys scales its recovery value based on the type of security, the perceived
liquidity in that sector and the length of the settlement period (Table 2). S&P
reduces recovery values based on the length of the settlement period.
Most synthetic CDO trades use a long cash settlement period to avoid rating agency
haircuts in order to reduce their required credit enhancement. If ABCDS
documentation uses shorter settlement periods, existing CDOs will have a
documentation mismatch (short settlement in single name ABCDS, versus a two
year settlement in existing CDO ABCDS).
March 7, 2005
Table 2: Moodys Recovery Values by Settlement Period
Time to Settlement Liquid Securities Illiquid Securities
3 Months 25% 15%
6 Months 75% 50%
1 Year 95% 65%
2 Year 100% 90%
Source: Moodys. Liquid securities include senior tranches of Automobile ABS, CF CBOs/CLOs, CMBS, Cards, Consumer Loan ABS,
HEL ABS, RMBS, Italian Government ABS, Student Loan ABS, all tranches of static CDOs, wrapped tranches depend on underlying.
15
AC
(1-212) 270-6515
Ryan Asato (1-212) 270-0317
March 7, 2005
The authors would like to thank Paul Glasgow for his knowledge and
insights on the CDS market.
In synthetic CDOs of ABS, a minimum recovery rate may be stated for each asset in
the portfolio. If dealer quotes are below this stated recovery rate, the asset manager
may defer settlement until the next quotation period. If the asset manager defers
settlement, the valuation process will extend in a similar way to that described
above, and the asset manager deferment option will continue over a defined period
(e.g., 1 year). Typically, the asset manager may accept a valuation below the
minimum recover rate after a specified period.
Conclusion
The ABCDS market will continue to grow as documentation becomes standardized
and more buyers of protection emerge. ABCDS will help to transform the ABS
market and not only increase the scope of the market but also its depth as new
players enter. A liquid ABCDS market represents an important building block for an
increased flow of complex trades, such as ABCDS indices, first-to-default baskets,
etc. and the development of ABS correlation books. However, due to the relative
complexity of ABCDS and the underlying referenced entities, at this point it remains
unclear whether the single name ABCDS market will ever offer the size and liquidity
available in Corporate CDS.
Analyst Certification
The analyst(s) denoted by an AC certifies that: (1) all of the views expressed in this research accurately reflect his or her
personal views about any and all of the subject securities or issuers; and (2) no part of any of the analysts compensation was,
is, or will be directly or indirectly related to the specific recommendations or views expressed by the analyst(s) in this research.
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To amend research distribution please
contact Kathryn Burfitt,
Research Administration, (212) 270-0740,
kathryn.burfitt@jpmorgan.com
Analysts Compensation: The research analysts responsible for the preparation of this report receive compensation based upon various factors, including the quality and accuracy of research, client feedback, competitive factors
and overall firm revenues. The firms overall revenues include revenues from its investment banking and fixed income business units.
Principal Trading: JPMorgan and/or its affiliates normally make a market and trade as principal in fixed income securities discussed in this report.
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Revised November 12, 2004
Copyright 2004 JPMorgan Chase & Co. All rights reserved. Additional information available upon request.
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