CDS of ABS-- Securitization’s New Frontier

CDS of ABS--Securitization’s New Frontier A Fast Track to Understanding CDS of ABS… Gary Barnett March 8, 2006 American Securitization Forum – Sunset Seminar Gary Barnett, Partner Linklaters1345 Avenue of the Americas18th FloorNew York, NY 10105gary.barnett@linklaters.com

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

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 $$

Typical Securitization Sponsor Issuer (bankruptcy remote entity and owner of obligations) $$ Payments on asset-backed securities Obligors (making payments on their obligations)

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)

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

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

One Type of Synthetic Securitization How risks are imported: derivatives guarantees insurance 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

Basics on Credit Derivatives • Credit Derivatives are transactions designed to isolate and transfer credit risk associated with a third party or a third party’s 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

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

Hedging of Credit Exposure To understand the economics and principles behind credit derivatives, let’s look at the following example: Interest accruing Principal $1B of 5 year Corporate Bonds $1B of 5 year Treasuries

Hedging of Credit Exposure Risk premium or credit spread Credit Risk $1B of 5 year Corporate Bonds $1B of 5 year Treasuries

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”

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

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

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

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

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

$250M Eligible Investments Credit protection buyer wants protection on $1B of corporate bonds Investment income on $250M CLN $150M SPV Issuer CLN $60M Premiums equal to credit spread on $1B (adjusted for super senior) CLN $40M A Derivative used in a Synthetic CDO Deal Interest Payments on Notes

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

$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 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)

Fixed Amounts (periodic payments) 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

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!

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”?

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

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

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 …

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

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

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)

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

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

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

MBS Pay-As-You-Go or Physical Settlement (Form I)(Dealer Form)

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.”

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 EventsCredit Events Writedown Writedown Failure to Pay Principal Failure to Pay Principal Interest Shortfall [Distressed Ratings Downgrade]

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

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.

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.

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.

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.

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 buyer’s 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.

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 doesn’t create this early termination risk since it only picks up failures to pay principal at legal final or final amortization on the ref ob.

MBS Pay-As-You-Go: Credit Events • Distressed Ratings Downgrade. A Distressed Ratings Downgrade occurs if the ref ob’s 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.

ABS with Pay-As-You-Go Settlement (Form II)

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 ob’s underlying docs. Thus no payments in excess of a wac cap, covering interest that is being capitalized or deferred, or covering implied writedowns.

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.

CDS of ABS-- Securitization’s New Frontier