A negative basis trade is a credit derivative trade in which the buyer of a debt instrument purchases credit protection in the form of a credit-default swap. The negative basis trade protection seller universe has been dominated by AAA-rated financial guaranty insurance companies. The purpose of this Learning Curve is to discuss the major negotiating points in documenting negative basis trade with a monoline insurer.
Protection buyers are primarily, if not exclusively, commercial banks seeking regulatory capital relief, favorable accounting treatment, or both. Credit protection is often secondary, given that many negative basis trades reference AAA-rated notes.
Monolines can and do provide financial guaranties without a CDS but when one is required, they have to provide it through a so-called transformer structure, because they are subject to regulatory restrictions on derivatives trading. A transformer--so-named because it transforms what would be an impermissible trade for a monoline into a permitted trade--is a special purpose vehicle set up in a tax-neutral jurisdiction as a bankruptcy-remote entity solely to serve as a negative basis trade counterparty. The sponsoring monoline provides a financial guaranty to the protection buyer and will make payments under the financial guaranty if there is a credit event. These SPVs typically have no assets of their own, so either the monoline will give the money to the SPV in order to pay the protection buyer under the CDS or the monoline will pay the protection buyer directly pursuant to the guaranty.
Major Negotiating Points
Although each counterparty is different, and the issues below do not constitute an exhaustive list, the following issues frequently arise during negative basis trade negotiations.
Credit Issues
a. Settlement
Monolines have traditionally favored a modified version of physical settlement called pay-as-you-go, similar to the International Swaps and Derivatives Association's PAUG settlement, but with one distinctive feature. In all PAUG CDS, the seller's obligation is to make periodic interest and principal payments, on the dates on which such payments were scheduled to be made, in place of a reference entity. In a PAUG negative basis trade CDS with a monoline insurer, the buyer delivers the reference obligation to the transformer or monoline, the monoline makes the buyer whole for pre-delivery defaults and, after delivery, makes the full payments of scheduled interest and principal when due and receives any partial or full payments on the reference obligation directly from the reference entity. This delivery feature, which is not present in the ISDA PAUG CDS form, gives the monoline the ability to sell the reference obligation at the appropriate time to realize and maximize recoveries, thus mitigating the effect of financial guaranty payouts.
Settlement methods requiring banks to deliver the reference obligation can be unpopular with banks. Because some banks' credit departments are unwilling to take a monoline's credit risk for the life of the reference obligation, market participants have worked out a number of compromises, such as delivery of the reference obligation to a trust established for this purpose or pledging to the monoline the reference obligation or--at the bank's option--collateral with an equal value. The rationale behind these alternatives is that if a monoline becomes unable to satisfy its negative basis trade payment obligations but the bank has not delivered the reference obligation to the monoline, the reference obligation will not be tied up in the monoline's insolvency proceedings.
In such arrangements, the monoline generally continues to retain the ability to dispose of the reference obligation and to otherwise control the voting rights with respect to the reference obligation. The cash flows received under the reference obligation either go to the buyer (minus recoveries from the reference entity), in which case the monoline pays the buyer any shortfalls, or to the monoline, which would pay the buyer the Reference Obligation's scheduled payments, in each case after receiving notice and agreed upon documentation of the extent of a payment shortfall on each scheduled payment date.
b.Downgrade triggers
As noted above, some banks' credit departments often are uncomfortable being exposed to a monoline's credit risk for decades, particularly as monolines do not post collateral. Banks address this in various ways, including (1) negotiating alternatives to delivery to monolines (discussed above), (2) limiting the term of the CDS to five or 10 years but with an annual option to extend the trade for an additional year and (3) lining up a third party to serve as an intermediary between the bank and monoline--the intermediary acts as the protection seller to the bank and the protection buyer from the monoline.
Some protection buyers seek to reduce their credit exposure to the monoline by requiring a ratings downgrade of the monoline to constitute a so-called additional termination event or even an event of default under the CDS. This is problematic for monolines, because rating agencies survey the monolines regularly as part of their ratings reviews to determine, among other things, if the monolines have agreed to any downgrade triggers. The agencies' concern is that such triggers could exacerbate any credit problem a monoline faces, making the monoline less creditworthy and leading to a downward spiral. A downgrade trigger usually is a deal-breaker for monolines, as protection buyers trade with monoline counterparties due to their ratings, which are AAA/Aaa in most cases. If a monoline were downgraded, it effectively would be shut out of writing new business.
Voting Rights
Because monolines may end up responsible for decades of interest payments and payment of the principal of a defaulted reference obligation, they seek voting control over the reference obligation so that they can influence any votes regarding changes that could harm their interests. These rights are akin to what a monoline insurer would have if it issued a financial guaranty directly covering the reference obligation. Therefore, if a buyer wishes to purchase credit protection on USD250 million of a USD500 million tranche of collateralized debt obligation notes, the monoline will expect the buyer to agree to vote--or refrain from voting--50% of the tranche's voting rights, per the monoline's instructions.
To make it clear the buyer does not have an insurable interest in the reference obligation, the buyer is not required to hold the underlying at any point during the life of the CDS. This is because having an insurable interest in the subject of a credit protection contract may require the seller to be licensed by the relevant states and transformers are not. The buyer, however, is required to comply with CDS voting rights provisions, so in practice holds the reference obligation in negative basis trades.
Generally, a monoline will not require a buyer to follow the monoline's instructions with respect to votes on certain critical issues, such as extending the maturity or changing the principal or interest payable on the Reference Obligation. A monoline, however, also generally will not permit a protection buyer to vote on such issues at all absent the monoline's consent. In other words, buyers must vote per the monoline's instructions or refrain from voting. Protection buyers generally receive carveouts from the monoline's voting control for votes that would be illegal or in contravention of the reference obligation's governing documents or (unless the monoline agrees to indemnify the buyer) subject the buyer to liability.
Market Developments
Although, as mentioned above, the established monolines have been the primary negative basis trade protection sellers, with the recent entry into the CDS market of new monolines and a growing number of credit derivative product companies, the traditional monolines face growing competition. According to a Merrill Lynch European structured finance report published in August, however, Structured Credit Holdings and at least one other CDPC will post collateral to support their obligations as CDS sellers. Consequently, such CDPCs will not directly compete with monolines. Other CDPCs, however, will not post collateral, relying instead on their AAA/Aaa ratings, and therefore will compete more directly with monolines.
This week's Learning Curve was written by Craig Stein, partner, and David Aron, attorney, in the structured products and derivatives group at Schulte Roth & Zabelin New York.
