Prior to the publication of the Credit Derivative Transaction On Mortgage-Backed Security With Pay-As-You-Go Or Physical Settlement by the International Swaps and Derivatives Association, dealers and users had started executing swaps on sub-prime MBS using customized versions of credit-default swaps and total-return swaps. And a significant market in two-way flow trading on spread exposure was already emerging. With the pay-as-you-go form--also known as Form I, or the Dealer Form--the market has settled for a CDS approach and liquidity is expected to increase.
This Learning Curve is organized in two parts. Part 1 discusses the pass-through or pay-as-you-go payments, including related calculations. Part II, next week, will provide a broad overview of the risk allocations under the Dealer Form.
Summary Of Pass-Through Cash Flow
The seller pays:
Interest shortfall amounts that occur under the reference obligation
Calculations of interest shortfalls disregard any provisions that limit payment obligations to available funds. At the election of the parties, the seller's payments in respect of interest shortfalls may be capped--based on a fixed or variable cap--and the calculation of interest shortfalls may take into account any weighted average-cap provisions that are applicable to the reference obligation. For purposes of determining whether an interest shortfall has occurred, pre-payment penalties and yield maintenance amounts are excluded from the expected interest amount. This is because in commercial mortgage-backed securities, which are more likely than RMBS to have prepayment penalties and yield maintenance charges, prepayment risks of the underlying commercial mortgage loans are often packaged as a separate tranche and sold off to investors or retained by the sponsor/depositor and re-securitized as interest-only securities.
Principal shortfall amounts that occur under the reference obligation
The determination of a principal shortfall takes into account principal amounts due on the maturity date or following the liquidation of the pool of mortgages backing the reference obligations and disregards provisions that limit payment obligations to available funds. Principal shortfalls do not contemplate failures to meet principal amortization payments or sinking fund payments, if any.
Writedown amounts
These include amounts determined in respect of:
* Actual writedowns. The key concept underlying an actual writedown is the actual realization, under the terms of the reference obligation, of a collateral deficiency or outright loss such as:
1. Actual reductions--without corresponding principal payments--of the principal balance of the reference obligation; and
2. Realized losses. These could take a variety of forms, including an actual attribution of a collateral deficiency amount to the principal of the reference obligation or a reduction in the nominal liquidation amount/book value of the collateral or the loan-to-value ratio which, in each case, lead to a reduction in interest payments or subordination of payments under the reference obligation; and
* Implied writedown amounts, determined in respect to reference obligations that cannot, by the terms of their governing instruments, be written down. These are amounts by which the collateral backing the reference obligation is deficient as determined by the calculation agent, taking into account the balance of such collateral relative to the aggregate principal balance of the reference obligation and all other pari passu and senior securities that are backed by such collateral. Implied writedown is the mechanism by which the Dealer Form realizes collateral deficiencies where a reference obligation does not permit actual writedowns as described above.
Physical settlement amounts
These are purchase amounts paid for settlement of reference obligations delivered by the buyer following a credit event. For purposes of determining a physical settlement amount, all implied writedown amounts paid by the seller and that have not been reimbursed by the buyer are treated as pre-funded principal amounts by the seller. This has the effect the buyer will be required to deliver a reference obligation with a principal balance that exceeds the physical settlement amount it receives, the excess being such outstanding implied writedown amounts.
The buyer pays:
Fixed amounts
Fixed amounts are protection premiums and they accrue during the interest accrual periods under the reference obligation. Unlike floating rate obligations, fixed-rate reference obligations typically have a delayed payment, as interest accrual periods may be calendar months with scheduled payment dates delayed until the 15th of each month, meaning a principal payment may occur in the middle of a fixed amount accrual period. To tackle this, the Dealer Form provides--at the election of the parties--a fixed amount calculation formula that retrospectively adjusts the fixed amount calculation amount to take into account any principal event. A principal event is an event affecting the reference obligation notional amount, such as a principal payment/shortfall/writedown or reversal of a writedown occurring on a delayed payment date during the fixed-amount accrual period.
Additional fixed amounts
These include:
* Interest shortfall reimbursements made under the reference obligation. Interest shortfall reimbursement payments by the buyer will be deferred where a cap--either fixed or variable--is applicable under the transaction, and any amount of interest shortfall previously due to the buyer has not been paid by the seller on account of the cap. Such deferral will continue until the interest shortfall reimbursement amounts paid under the reference obligation exceed such interest shortfall amount that is unpaid by the seller on account of the cap;
* Principal shortfall reimbursements made under the reference obligation; and
* Writedown reimbursements made under the reference obligation. These include (i) reimbursement in cash of a previous writedown amount under the reference obligation and/or a reversal of previous writedown under the reference obligation, and (ii) reversals of previous implied writedowns under the transaction based on the Dealer Form.
Delayed payments amounts
The concept of delayed payment is a claw-back payment mechanism addressing issues arising from any physical settlement of a portion of the swap notional amount, occurring when current information--from the latest servicer's report--about the reference obligation is not available or known to the parties. Such physical settlements have the same effect as a termination of the related portion of the transaction. This means the notional size of the transaction is reduced by the amount of reference obligations delivered in such physical settlement and subsequent calculations and payments on the swap will be based on the reduced transaction size. If a servicer's report received after the physical settlement date highlights (x) a principal payment, (y) a principal shortfall reimbursement or (z) a writedown reimbursement in cash, in each case that occurred under the reference obligation on or prior to a physical settlement date, then respective adjustments will be required. These are explained below:
* Principal payment. Because the principal payment ought to have resulted in a reduction of principal balance of the reference obligation prior to the physical settlement date, the physical settlement amount paid to the buyer is based on a higher reference-obligation balance than the actual balance of the reference obligation on the physical settlement date. This excess payment needs to be returned by the buyer.
* Principal shortfall reimbursement or writedown reimbursement in cash. The size of the swap and the applicable percentage is reduced following the physical settlement and, without a clawback, the amount of the principal shortfall reimbursement or a writedown reimbursement the seller will receive will be accordingly reduced. This is in spite of any reimbursement made by the issuer prior to the physical settlement date and, as such, is due to the seller without any reduction. This reduced amount needs to be paid by the buyer.
The buyer's reimbursements of such excess payments or reimbursement shortfalls are the delayed payments. A related concept, known as 'relevant amount', is used to adjust future payments.
Relevant Amount Adjustments
As discussed above, a physical settlement of a portion of the swap has the same effect as a partial termination that reduces the size of the transaction. Subsequent calculations and payments will be based on the reduced transaction size. Where any event that would usually lead to an adjustment of the reference obligation notional amount is effective on, or prior to, a physical settlement date but the parties are unaware of this event (for example, because the servicer report which announces the event is received after the physical settlement date), then retroactive adjustments will be required in order for future calculations and payments to be based on calculation amounts that reflect the appropriate transaction size. The convention in the cash market for similar situations is to effect a cancellation and correction of any payments that are based on the wrong principal balance. Attempts to replicate this convention in the Dealer Form proved too cumbersome. A simpler approach was adopted and that is to require, in respect of any physical settlement delivery, retroactive adjustments of the applicable percentage (see below) and reference obligation notional amount for all principal adjustment events occurring before the next payment/reimbursement date under the transaction. Where an actual clawback of cash payment is required in addition to such adjustment, the delayed payment concept addresses such cash payment.
This week's Learning Curve was written by Chinedu Ezetah, director and counsel at UBS Securitiesin New York.
