A debate surrounding what should constitute a credit event is a delaying the International Swaps and Derivatives Association's standard document for credit derivatives referenced to asset-backed securities. Market participants are eager to get the documents because they think it will increase liquidity and confidence in the settlement process, something Fitch Ratings has said it is concerned about. The argument hinges on whether an asset-backed security that stops paying its noteholders because of a lack of funds should be considered as defaulted.
One of the reasons for the argument is some ABS participants want the documents to facilitate a liquid traded market, while others want to use it to hedge or invest in ABS in the same way as they would in the true-sale market. Chip Goodrich, managing director in the legal department of Deutsche Bank in New York and co-head of ISDA's North American documentation committee, said, "Banks have different views on how they want to use the product." He added, however, "I think the market is kind of searching for some business standards."
ISDA has been preparing two templates, one which includes a pay-as-you-go event and another which tries to replicate the true-sale ABS market. It is now thinking of collapsing the two confirmation templates into one. ISDA will propose the idea to the working group for the project in January.
In the pay-as-you-go contracts, protection buyers would be guaranteed principal and interest payments when due according to the original schedule as if no trigger had been hit, said Claude Brown, partner at Clifford Chance in London. Brown explained that the ABS is designed to stop making coupon payments to the noteholders if it hits certain triggers. For example, if the mortgages in an MBS redeem more quickly than anticipated, the MBS might start replenishing its stock to either rebuild the portfolio or start amortizing early.
Pay-as-you-go settlement has proven beneficial to monolines because it enables them to carry on their wrapping business in synthetic form, while cash settlement is designed for the inter-dealer market, explained Lary Stromfeld, a partner in the capital markets department of Cadwalader, Wickersham & Taft in New York. Monolines are in the business of taking on credit risk and guaranteeing payment if an underlying obligor defaults, he said. That means monolines are not paying based on changing market value, but guaranteeing scheduled payments when due. To the extent they are going to be selling credit protection in the derivatives market, monolines generally prefer to have settlement payments occurring over time. "It helps their liquidity," Stromfeld said. Dealers, on the other hand, generally prefer to just settle up on a mark-to-market basis on both the buy and sell side, he said.
But Matt Riba, director of legal counsel at Deutsche Bank in New York, said dealers stand in the middle because they increasingly find themselves on both sides of the transaction. "They are in a good position to say what should be the standards in the marketplace," he said.
While the two approaches are servicing different bases, there is enough overlap between them that ISDA thinks it may be better to combine the two templates, said Kimberly Summe, general counsel at ISDA in New York. Stromfeld thinks having one template is a good idea because it will allow parties to be more efficient in developing the product itself. Still, ISDA recognizes the template won't suit all deals because the ABS world is too big. For certain deals, the template will have to be adapted, Summe said.
