Nearly three months after the International Swaps and Derivatives Association released standard pay-as-you-go documentation for credit-default swaps referencing cashflow collateralized debt obligations, the dealer community is split down the middle over the inclusion of a clause for implied write-down provisions. ISDA deferred the inclusion of the clause in June, citing insufficient consensus. The issue remains open to election and negotiation and many dealers believe the lack of standardization has been an impediment to the full launch of this subset of the CDS market.
Implied write-down is a payment event triggered when a reference obligation is determined to be under-collateralized. The issue is what determines losses when the underlying bonds don't have implied write-down provisions already built in. This is specifically an issue with bonds from mortgage real estate investment trusts, which don't have implied write-down, and are often included in CDOs. Some dealers believe the CDS contracts on the CDOs should compensate for losses as the losses occur from an accounting perspective when there is an impaired security."If you are taking that impairment write-down on your accounting books, you should actually pay someone for that protection of a loss," said one trader. Implied write-downs are treated as pre-funding of principal for purposes of physical settlement payments, a second trader said. "The buyer should be obligated to pay 100% of the interest accruals allocated to the implied write-down amount," he said.
Another group thinks the buyer should pay just the fixed-protection premium on the portion of the implied write-down amount. By putting CDOs on an equal footing with the underlying ABS, the synthetic language introduces an event of default that does not exist in the CDO itself, said a trader at a firm that trades only in fixed-cap contracts.
As a result, the market has gravitated toward including an implied write-down with a fixed cap or no implied write-down with a variable cap, options that dealers concede have been so far essentially equal at the end of the day for clients. If the bulk of a firm's clients are CDO issuers who are essentially writing most of the protection, the firm has been supporting this side of the argument. For counterparties on the short side, keeping implied write-down also has benefits.
Under the variable option, the seller compensates the buyer for interest losses up to LIBOR plus the CDS spread and essentially covers the interest shortfall over what could be an undetermined amount of time. But some dealers said that this could become more of an issue in the future when the deals begin to wind down.
End users have pushed for standardized documents as they take away the bilateral nature of a trade. Prior to standardization of the CDS on ABS documents, there was a similar debate which resulted in fixed cap being decided upon as the fairest form. Now 100% of these trades are done that way.
