Some big collateralized debt obligation houses are gravitating toward variable caps in the event of shortfalls in credit-default swaps on CDOs, rather than hashing out provisions for implied write-downs; a point of contention in the dealer community. An implied write-down is a payment event triggered when a reference obligation is determined to be under-collateralized.
Dealers have been split over whether to include a clause for implied write-down provisions in CDS referencing CDOs. The issue is what determines losses when the underlying bonds don't have implied write-down provisions already built in.
Under variable caps the seller compensates the buyer for interest losses up to LIBOR plus a credit-default swap spread and essentially covers the interest shortfall over what could be an undetermined amount of time. "We are already deeply analyzing the structures as the underwriter and feel ok writing the protection even when it writes down to zero," said D'Vari. Other market participants cautioned, however, this could lead to a situation where the interest shortfall is not met and this would not become clear until the deal is winding down.
BlackRock is one of the CDO issuers that has adopted using no implied write-down and variable cap for their deals.
Officials from the rating agencies said protection sellers that insist on having a variable cap and the attached LIBOR risk over time might have counterparty ratings adjusted to reflect any interest-rate changes.
