As issuance of synthetic CDOs linked to corporate reference entities has slowed, arrangers in the European market have looked to alternative reference assets-and in particular ABS-to maintain deal flow. The peculiarities of ABS assets, and of the ABS market, mean that these transactions give rise to specific structuring and documentation issues.
A principal motivation for the recent popularity of synthetic re-securitization deals has been to distribute corporate synthetic CDOs in the face of tightening protection spreads and a difficult credit environment. These assets are combined with other more conventional classes of ABS (RMBS, CMBS, student loans, credit cards etc.) in an attempt to provide investors with increased ratings stability. To date this intention has been borne out by the relatively low level of ratings actions to which these transactions have been subject.
Synthetic re-securitizations use the same structure as conventional synthetic CDOs, but substitute a portfolio of ABS in place of conventional corporate names. These assets have several features which impact on documentation:
¥ payments of interest may be deferred, or made only on an available funds basis,
¥ expected life may be substantially different from legal final maturity and payments of principal may be subject to accelerated amortisation, deferral or reduction,
¥ assuming the effectiveness of bankruptcy remoteness the credit status of the ABS issuer should be irrelevant to the credit status of a given issue,
¥ a single issue may be divided into tranches, and defaults on a subordinated tranche may not necessarily lead to acceleration of more senior tranches.
The optimum size and composition of the reference portfolio will be determined by the parameters and methodology applied by the relevant rating agency. The two key areas for lawyers are:
¥ re-defining the ISDA Credit Events in appropriate terms for ABS assets, and satisfying the rating agency that they only transfer the risk of actual credit losses to investors in the deal,
¥ agreeing a valuation procedure which is appropriate and efficient, and which is consistent with the modeling of anticipated recoveries.
Credit Event triggers applicable to synthetic resecuritizations can be broken down into two subsets. Firstly, there are scenarios in which the investor in the ABS is likely to suffer a credit loss because of an impairment in the market value of the relevant asset. In particular, this will include:
¥ failure to make payment of principal where and when due and payableÑprobably the earlier of legal final maturity and accelerationÑor on the liquidation of the assets designated to fund the relevant payment,
¥ failure to make a payment of interest where and when due and payable, although not (with some exceptions) where that interest payment is subject to deferral under the terms of the relevant ABS,
¥ more rarely, accelerated amortization of the relevant asset.
Rating agencies will be concerned to ensure that settlement payments can only be triggered following a real credit loss for the holders of the relevant ABS. The more aggressively that these triggers are formulated, the more likely it is that they will only be permitted in a transaction which is seeking a high rating in tandem with a ratings downgrade trigger. Ratings downgrade (typically to the C level) may also be permitted as a standalone credit triggerÑsubject in some cases to a designated waiting period.
Secondly, investors in an asset may suffer an immediately quantifiable credit loss due to, for instance, the operation of a principal reduction mechanism under the terms of that asset. Alternatively, despite the absence of such a mechanism, it may be clear that there is a shortfall in the value of the assets available to fund principal and that such a shortfall cannot or will not be cured. Again, rating agencies and investors will look to ensure that any settlement reflects a real credit loss. For example, by excluding settlements in which there is any possibility that a principal reduction will be reversed.
Bankruptcy and Restructuring Credit Events found in corporate synthetic CDOs will rarely appear in synthetic resecuritization transactions unless their presence is required to achieve regulatory capital relief.
Issuing synthetic CDO debt expressly for inclusion within a synthetic re-securitization implies initial and ongoing costs (for example, maintenance of the relevant SPV and fees for the trustee, agent and local counsel). There may be structural and tax risks too, although the latter should be marginal. These costs can be avoided by referencing the CDS which is part of the synthetic re-securitization transaction not to an actual asset-backed security but to an actual or (increasingly) a notional swap. The corollary is some additional drafting because the terms of the notional CDS transactions need to be established and suitable portfolio criteria identified. The settlement trigger as it relates to swap assets will be the occurrence of an actual or notional cash settlement under the relevant reference swap.
Credit Losses & Valuation
The market for certain classes of ABS, and for distressed ABS generally, can be highly illiquid. This may make it difficult to obtain satisfactory valuations within the usual timescale applicable to corporate synthetic CDOs. It also means that the swap counterparty is likely to hedge its exposure under the transaction by actually holding the ABS assets in question. Because of this, long-stop valuation periods are typically much longer than in CDOs referencing corporate entities. Many transactions specify a maximum period in excess of two years; shorter periods will lead to a penalty in terms of assumed recovery rates. There is, however, relatively little standardization within this periodÑsome transactions begin the valuation process shortly after the applicable conditions to settlement are satisfied, whilst under the terms of others no valuations are sought until close to the end of the specified valuation period. Most transactions will specify a series of increasingly permissive auction procedures applicable during successive valuation sub-periods, with the ultimate fallback being either to a deemed market price of zero or occasionally to the highest recovery rate which the rating agencies have modeled for the asset in question. In all cases, the rating agencyÕs key concern will be to minimize the extent to which a given assetÕs valuation will diverge from the expected recovery previously modeled.
Whilst a long valuation period maximizes the potential for interim distributions, it may also impose a substantial cost-of-carry on the protection buyer. This can be mitigated either by providing for interim settlements (as the calculation agent is able to achieve acceptable bids for parcels of the relevant obligation which are smaller than the total protection amount purchased on that obligation), or by including missed coupon payments in the settlement calculation.
Principal reduction or writedown-type Credit Events do not require the application of a conventional valuation procedure; instead the appropriate measure here is the amount of the reduction in the principal amount of the relevant tranche of ABS (subject to a reduction to reflect the proportion of that amount which corresponds to the notional amount of the swap as it applies to that asset). In order to avoid unnecessary re-characterization of risk (in this context, the risk that a credit default swap will be treated as a contract of insurance) it is important to ensure that this calculation is framed in notional terms and does not track an actual loss suffered by the protection buyer.
Other Documentation Issues
There are several additional documentation issues which are specific to synthetic re-securitizations. For example:
¥ there should be a reduction in notional credit protection amounts to reflect the amortization of the referenced assetsÑthe precision with which this is required to be monitored may be a subject of discussion between the swap counterparty, the relevant rating agencies and any third party administrators,
¥ information as to defaults or writedowns may not be publicly available, and, subject to appropriate safeguards, the swap counterparty may require the right to certify that such an event has occurred,
¥ certain standard provisions of the ISDA Definitions, for instance as to successor Reference Entities and substitute Reference Obligations, may not be appropriate in the context of ABS.
Conclusions & The Way forward
Documentation of synthetic re-securitizations in Europe has undergone rapid evolution in important respects. This evolution has largely reflected the evolving analysis of the rating agencies, as well as the increasing sophistication of synthetic CDO documentation generally and can probably now be said to have stabilized. The emphasis, from the perspective of this lawyer, is now twofold. In the first place, arrangers and their advisors are seeking to capitalize on distribution capacity and developed product technology by commoditizing transactions, ensuring that a complex product can be delivered as rapidly as possible at minimal cost. In parallel with this, capital structures are becoming increasingly flexible as between funded and unfunded components, between different protection tranches and different sources of funding. Reconciling these requirements will continue to provide challenges for counsel.