In 2004, the International Swaps and Derivatives Association formed a committee to draft a form of credit-default swap for asset-backed securities with a view toward jump starting the synthetic ABS market. Before the committee issued its draft, a dealer subgroup presented its own draft--the Dealer Template--to the committee. Many end users raised concerns regarding elements of the Dealer Template. In response, ISDA published the Dealer Template and encouraged objecting end users to prepare a separate End Investor Template. An initial draft of the End Investor Template was given to ISDA Sept. 13, 2005, and discussed in a conference call convened by the trade group Oct. 12, 2005. ISDA has invited members of the committee to comment on the End Investor Template.
The End Investor Template is designed for use in documenting synthetic pay-as-you-go flow transactions. Under a pay-as-you-go instrument, the seller of protection pays if an interest shortfall, a write-down or a principal shortfall occurs with respect to the reference obligation.
The Key Differences
(1) Elimination of physical settlement at buyer's option and use of credit events.
Under the Dealer Template, if a credit event occurs (including a failure to pay principal, a write-down, a distressed ratings downgrade or a maturity extension), the buyer has the option to reduce all or part of the reference obligation notional amount via physical settlement.
The End Investor Template eliminates the buyer's option for physical settlement and does not use the credit event concept.
(2) Elimination of implied write-downs/implied write-down reimbursement provisions.
Implied write-down and implied write-down reimbursement provisions in the Dealer Template apply. Payments are required by the seller and buyer respectively, if--under the underlying instruments of the reference obligation--certain write-downs, applied losses, principal deficiencies or realized losses occur that do not reduce the outstanding principal amount of the reference obligation, or are subsequently reimbursed. Under these provisions, the calculation agent determines the amount of the implied write-down/implied write-down reimbursement.
The End Investor Template eliminates these implied write-down provisions, requiring seller payments only if write-downs occur that are contemplated under the underlying instruments and that reduce either (a) the reference obligation's outstanding principal amount or (b) the amount of interest payable on the reference obligation.
(3) Elimination of buyer's option to terminate the transaction upon the occurrence of a step-up
Optional step-up provisions in the Dealer Template provide if a step-up occurs the buyer has the option to terminate the transaction or to continue the transaction at the higher rate. A step-up is defined as an increase in the reference obligation coupon due to the failure of the issuer or a third party to redeem, cancel or terminate the reference obligation, as the case may be, in accordance with the underlying instruments.
There is no such option under the End Investor Template: changes in the coupon of a fixed-rate reference obligation or spread of a floating rate reference obligation are given effect, and the transaction continues. If the coupon or spread of the reference obligation increases, the fixed rate also increases.
(4) Interest shortfall cap provisions/available funds cap
The Dealer Template determines interest shortfalls without giving effect to available funds cap or other provisions in the underlying instruments which limit distributions and provide for capitalizing or deferring interest, or that provide for extinguishing or reducing such payments.
As a corollary to the foregoing, the Dealer Template contains optional interest shortfall cap provisions that can be used to limit interest to either a fixed cap or a variable cap.
The End Investor Template takes the opposite approach. It eliminates the interest shortfall cap provisions and determines any interest shortfall after giving effect to all available funds cap reduction provisions. This includes any provision of the underlying instruments that (a) provide for capitalizing or deferring interest on the reference obligation or (b) limit the interest entitlement or rate at which interest is determined in relation to the reference obligation pursuant to a prepayment interest shortfall, basis risk shortfall, relief act shortfall, net weighted-average coupon rate cap or similar available funds cap provision.
(5) Adjustments in connection with reference policy
Under the End Investor Template, if the reference obligation is guaranteed under a reference policy that by its terms excludes any component of the expected interest amount or the expected principal amount for purposes of determining the liability of the relevant insurer, or the terms of the reference policy otherwise do not require the insurer to pay any such amounts, the relevant component or amount also is excluded for purposes of determining interest shortfall amounts and principal shortfall amounts, as applicable.
The Dealer Template has no corresponding provisions.
(6) Period for payment of additional fixed amounts
Under the Dealer Template, the seller may receive recoveries of amounts previously paid in respect of interest shortfalls, write-downs, and principal shortfalls, but only if a notice of the occurrence of the recovery has been delivered within one year of the earlier of:
(i) the legal final maturity date of the reference obligation;
(ii) the date when the reference obligation notional amount is reduced to zero; and
(iii) the date when the assets securing the reference obligation notional amount are fully liquidated and the proceeds are fully distributed.
Under the End Investor Template, the seller may continue to receive such recoveries until the later of either the date when the assets securing the reference obligation are liquidated, distributed or otherwise fully disposed of and the proceeds are distributed or otherwise fully disposed of or--if such disposition is at the direction of an insurer--the date the insurer is no longer obligated as to principal and/or interest amounts in respect of the reference obligation under the reference policy.
Under the End Investor Template, all amendments to the reference obligation are given effect, including any amendment that extends the legal final maturity date. In consideration of the seller's obligation to give effect to each such amendment, the buyer is required to pay the seller the applicable percentage of any payment received in connection with such amendment.
Under the Dealer Template, an amendment, on or after the effective date, which extends the legal final maturity date is a credit event.
(8) Make-whole premiums payable to seller
Under the End Investor Template, a make-whole premium payment (the payment or distribution of any make-whole, redemption, call or prepayment premium to holders of the reference obligation in connection with any prepayment, redemption, early amortization or similar event under the terms of the underlying instruments) constitutes an additional fixed payment event and the buyer must pay the applicable percentage of such make-whole premium payment to the seller.
There is no similar concept in the Dealer Template.
(9) Delivery of servicer reports
Under the Dealer Template, a counterparty is required to provide a servicer report only to the extent that such servicer report is reasonably available to the counterparty.
Under the End Investor Template, the buyer is required, without exception, to provide the seller with a servicer report promptly following the delivery of such servicer report to the holders of the reference obligation.
In many cases, ABS servicer reports are available only to holders of the reference obligations. The End Investor Template provision is intended to move the market in the direction of providing parties to ABS CDS transactions with broader access to these servicer reports.
(10) Determination of amounts
Under both templates, the calculation agent generally is responsible for determining fixed amounts, floating amounts and additional fixed amounts. Both templates also state that such determinations shall be based solely on servicer reports, to the extent such reports are reasonably available to the Calculation Agent.
In order to address situations in which a servicer report is not reasonably available to the calculation agent, however, the End Investor Template permits the calculation agent to make its determination based on publicly available information from at least two public sources. The End Investor Template further clarifies that in the absence of both a servicer report and such publicly available information, no floating amount shall be payable.
(11) Optional physical settlement and voting rights
Finally, the End Investor Template includes optional provisions relating to physical settlement--at the seller's option only--and voting rights that can be used to address certain moral hazard issues. Since moral hazard issues generally should not arise in true synthetic pay-as-you-go flow transactions, it is anticipated that these provisions will rarely be used.
This week's Learning Curve was written byCraig Mills, an associate, andMark RaeandJeffrey Stern, partners atStroock & Stroock & Lavan.