This Learning Curve follows on from last week's discussion of the Pay-As-You-Go form for credit-default swaps on asset-backed securities.
Factor, Applicable Percentage
Where the mortgage-backed securities are not new issues, the outstanding balance of the reference obligation as of the date of the swap transaction may be less than its original balance. Also, the notional amount on which parties agree to execute the transaction may be more, less or equal to such outstanding balance. The concepts known as 'factor' and 'applicable percentage' are the calculation mechanisms by which the Dealer Form preserves the economic rights, benefits and risks that the parties initially agreed by maintaining the proportional relationship between the initial notional size of the transaction and the outstanding balance of the reference obligation as of the date the transaction is executed. These features emphasize the nature of any transaction based on the Dealer Form as notional contract under which parties are expressing a credit view and taking exposure to an agreed-upon credit risk size. The agreed-upon credit risk size may be reduced if the buyer effects a physical settlement and may be proportionally adjusted if the overall class or tranche of the reference obligation changes, for example, because of additional issues of same or fungible securities, buy-backs of the relevant class or cancellations.
Credit Events
* Failure to pay principal;
* Writedown;
* Distressed ratings downgrade--primarily for residential mortgage-backed securities--to CCC or below, or the withdrawal of assigned rating.
Each of these events will trigger a physical settlement at the option of the buyer if it owns or can procure the reference obligation. Because mezzanine and subordinated classes of sub-prime mortgage-backed securities--often the reference obligation--are illiquid, it is unlikely that a buyer will be able to deliver the reference obligation. The seller, however, assumes the theoretical funding risk associated with any physical settlement.
Available Funds Cap Risk
The risk payments on the reference obligation will be limited to funds available to the issuer is allocated to the seller under the Dealer Form. This is one of the features distinguishing the Dealer Form from a total-return swap. The allocation of this risk to the seller is consistent with the nature of the Dealer Form as a credit-default swap. It also reflects the influence of the two-way flow trading market which evolved from a desire by market participants to trade pure credit spread on an unfunded basis.
Implied Writedown Risk
Implied writedowns, unlike actual writedowns, do not require a reduction in the face amount of the reference obligation or a realization of the loss resulting from the collateral deficiency under the reference obligation. While the reference obligation may continue to pay accrued interest on a principal balance that is not reduced for implied writedowns, the protection premiums are based on a reduced swap notional amount. Therefore, the seller is not compensated for interest accruals on the portion of the reference obligation that is implicitly written down under the pay-as-you-go swap. The exception to this--subject to effects of the interest shortfall cap in differing reimbursements--is that interest accruals allocated to the implied writedown amount increase the actual interest amount under the Dealer Form and increase the likelihood of interest shortfall reimbursements.
Some market participants have expressed the view that, just as implied writedowns are treated as pre-funding of principal for purposes of physical settlement payments (see Part 1), the buyer should be obligated to pay 100% of the interest accruals allocated to the implied writedown amount. An alternative view is for the buyer to pay the fixed-protection premium rate on that portion of the implied writedown amount. The Dealer Form does not adopt either of these approaches.
Risk Of Coupon Step-Up
Coupon step-up risk refers to the risk of the coupon rate on the reference obligation increasing in accordance with the terms of the reference obligation and not by way of a restructuring.
Also, if:
* "Step-up provisions: Applicable" is checked in the confirmation, the buyer will have an option to terminate the swap transaction on a so-called walk-away basis, meaning at a zero settlement amount, other than any due and unpaid amounts then outstanding and extension of the recovery period, as described below. If the buyer does not exercise this option, the transaction will continue with an incremental adjustment by the number of basis points by which the coupon is stepped up to the protection premium. The new stepped-up coupon rate will become the reference obligation coupon, that is, the rate of interest on which expected reference-obligation interest amounts will be calculated for purposes of determining whether an interest shortfall has occurred. Conceptually these represent adjustments to the economic terms of the swap to address the step up in coupon, the net effect being that the buyer pays a higher protection premium and the seller assumes a higher risk of interest shortfalls. Because the adjustment to the protection premium, however, is not based on a current assessment of the credit quality of the collateral backing the reference obligation but instead is a mechanical adjustment, the seller, arguably, bears the risk of step up in that instance; or if
* "Step-up provisions: Not Applicable" is checked, the buyer will not have an option to terminate the swap transaction. More importantly for purposes of determining whether an interest shortfall has occurred, (a) the old coupon rate will continue to be the reference obligation coupon, whereas (b) actual interest amount payments under the reference obligation will be determined based on the new stepped-up coupon rate, with the net effect being a reduced likelihood interest shortfalls will occur in the future under the swap transaction. Therefore, if "Step-up provisions: Not Applicable" is checked, the buyer will be assuming any risk associated with the step-up.
Recovery Period Extension
Following a liquidation of the mortgages backing a reference obligation or the maturity date of such reference obligation, there may continue to be a potential for some recoveries under the underlying mortgages. To address this, the Dealer Form preserves the right of the seller to receive any reimbursements made to holders of the reference obligation during a period of one year from the earlier of the scheduled termination date or the date the swap notional is reduced to zero and date the collateral backing the reference obligation is liquidated and distributed. This extension period is a holding period as no new obligations will arise, meaning no protection premium will accrue, and no new floating payment obligation will be incurred, during this period. The choice of one year represents a view that recoveries beyond one year are not reasonably feasible. This approach is also securitization-friendly as typical bankruptcy remoteness covenants usually expire one year after the final liquidation and distribution of the assets of the issuer.
Maturity Extension Risk
An extension of the final maturity date for the reference obligation will lead to an extension of the term of the Dealer Form. Many market participants take comfort in the fact the weighted average life of mortgage-backed securities is usually 10 or more years earlier than their final legal maturity date and, as such, the likelihood of the reference obligation remaining outstanding until its final maturity date is remote. The theoretical risk, however, of a maturity extension is primarily borne by the buyer as the effect of the extension is to defer any potential payment of principal shortfall amount until the extended maturity date.
Bankruptcy
Bankruptcy risk is generally believed not to be relevant to mortgage-backed securities as the issuers are typically bankruptcy remote special purpose vehicles.
Restructuring
Restructuring risk also tends not to be relevant to mortgage-backed securities as debt restructuring is seen as a very unlikely course for a mortgage-backed securities issuer to take. This is because, among other reasons, (x) other options such as deferment of interest, capitalization of interest, available funds cap or limited recourse provisions may make restructuring unnecessary and (y) the assets of the issuer are often a fixed pool of mortgages, so restructuring may not unlock any additional value.
For an actively-managed mortgage-backed issue where the performance of the manager is of key importance, restructuring may be theoretically possible. For example, if creditors agree a rehabilitation of a distressed issue is possible with a new manager, they may be willing to consent to some temporary relief--via restructuring--for the issuer. Under the terms of the Dealer Form, a restructuring, that is, a reduction, of the coupon rate--not to be confused with a coupon step in accordance with the terms of the reference obligation--or a reduction of the principal amount of the reference obligation would be disregarded for purposes of the transaction. The consequence would be an increased likelihood of interest shortfalls and principal shortfalls. This is because calculations under the Dealer Form will continue to be based on the original higher coupon rate or principal amount and, as such, the amount of interest or principal that is expected for purposes of determining whether or not a shortfall has occurred will be based on such higher rate or amount whereas the actual cash distributions under the reference obligation will be on the restructured rate or amount. The seller would bear the risk of such restructuring.
Amendments--besides changes to coupon and principal--to the terms of the reference obligation that, technically, constitute restructuring under the credit derivatives definitions will be giving effect under the transaction and corresponding periods and dates under the transaction will change accordingly. This feature is necessary for the cash flow of the reference obligation to continue to be the reference for shortfall and payment determinations under the transaction and for the servicer reports to continue to be relevant to calculations under the transaction, but the theoretical risk, if any, of such amendments will be borne by the buyer.
This week's Learning Curve was written by Chinedu Ezetah, director and counsel at UBS Securitiesin New York.
