Collateralized debt obligations referencing synthetic asset-backed securities are being held back because of confusion as to what constitutes a synthetic ABS credit event. Harald Berlinicke, senior portfolio manager of asset backed securities at New Bond Street Asset Management in London, said he approaches synthetic deals with caution. "There is a risk signing up that you have to take," he said. "There is scope for huge relative value gains, but also huge risk because it's an opaque market segment."
The heart of the problem is determining when an underlying ABS has defaulted and whether this will trigger payment from protection seller to protection buyer. This is difficult because many ABS, such as mortgages and loans, allow for 'failure to pay' throughout the life of a deal, but in a CDS that event triggers a default. "We can really only prove definite failure to pay at the end of a 25-year mortgage, which of course is too long," noted Richard Gambel, managing director in European structured credit at Fitch Ratings in London. Gambel said standards will increase liquidity.
Firms are currently writing their own definitions tailored to individual deals, specifying on a case-by-case basis the period in which non payment on the ABS is tolerated.
Market players are concerned the situation may lead to credit events occurring in synthetic deals where they would not in the cash equivalent and investors may be reluctant to buy into the transactions unless the dealer community agrees on standard definitions. Rating agencies say there needs to be language defining bankruptcy, credit downgrade and failure to pay.
Perry Inglis, managing director in structured finance ratings at Standard & Poor's in London, said standard language is needed from the dealer community and the International Swaps and Derivatives Association if it is to further develop. "It's not there at the moment," he added.
ButLoic Fery, managing director and global head of structured credit and CDOs at Calyon in London, said the firm has done many deals and its clients are comfortable with the consistency of wording it uses in the documentation.
ISDA last month published a template for CDS on ABS and market officials said the trade association will be looking to tailor templates to define credit events for every asset class, beginning with credit cards and student loans. Louise Marshall, spokeswoman for ISDA in New York, declined comment.
