The Basics
In Item 1115 of the SEC's Regulation AB, published in final form in December 2004, the SEC has taken big strides in coming to grips with swap agreements. Reg AB establishes rules for the scope of disclosure of financial and other information about swap providers in offering documents for registered asset-backed securities. This Learning Curve describes the basic operation of Item 1115. It then discusses the measurement dates on which the determination of the level of required disclosure needs to be made and some related market practices that have developed under it.
Item 1115, titled Certain derivatives instruments, relates to derivatives used to alter the payment characteristics of cashflows from the issuing entity, whose primary purpose is not to provide credit enhancement related to the pool assets or the asset-backed securities.
In all cases, the depositor will be required to disclose the name of the derivative counterparty, its organizational form, and the general character of its business. The operation and material terms of the derivative instrument, including any limits on the timing or amount of payments or any conditions to payments, must also be described, along with any material provisions regarding substitution of the derivative instrument. These disclosures are all items that were generally disclosed under market practice prior to adoption of Reg AB.
Significance Percentage
The significance percentage will generally be equal to a fraction, expressed as a percentage, whose numerator is the significance estimate and whose denonominator is the aggregate principal balance of the pool assets. An exception to this rule exists if the derivative instrument relates only to certain classes of the asset-backed securities. In that case, the denominator of the fraction will be the aggregate principal balance of such classes instead. The "significance estimate" is the depositor's estimate of the maximum probable exposure, as described below.
If the significance percentage for a swap provider is less than 10%, the required disclosure will be essentially the same as what is currently disclosed as a matter of market practice. If the significance percentage for a swap provider is 10% or more, but less than 20%, the depositor will be required to provide the financial data for the swap provider required by Item 301 of Regulation S-K. This consists of selected financial data for at least the last five fiscal years of the swap counterparty in comparative columnar format.
If the significance percentage is 20% or more, the depositor must provide financial statements for the counterparty meeting the requirements of Regulation S-X, Items 1-01 through 12-29, except for Article 3-05 (financial statements of business acquired or to be acquired) and Article 11 (pro forma financial information) of Regulation S-X. In addition to being disclosed in the registration statement, the financial statements for the counterparty [as required under 240.14a-3(b)] must be filed with the SEC.
Calculated By Depositor
The significance estimate of the derivative instrument is determined by a reasonable good-faith estimate of maximum probable exposure, made in substantially the same manner as that used in the sponsor's internal risk management process in respect of similar instruments. Since the only party with access to the sponsor's internal risk management process is the depositor, not the derivatives counterparty, it follows that the estimate is required to be made and the significance percentage is therefore required to be calulated by the depositor. As a practical matter, some depositors will turn to the swap provider for assistance in modeling this risk, however, while retaining responsibility for the estimate.
Maximum Probable Exposure
The only thing left to explain is "maximum probable exposure," a term not defined in Regulation AB. In fact, it is probably not possible to reliably interpret this phrase by reference to its plain meaning, or even by consulting the adopting release, SEC Release 33-3518. Upon reading a comment letter cited as a source in the Release, however, its meaning becomes clear. In the Release, the Commission referred to commenters that noted participants in the derivatives markets routinely evaluate their maximum probable exposure to a counterparty, to make a credit decision as to counterparty risk, in the case of an unsecured contract, or to set required collateral levels, in the case of a secured contract, for example. These commenters suggested that relying on maximum probable exposure would be more consistent with market practice.
In the comment letter submitted by the American Securitization Forum, it is stated that while the precise method for determining maximum probable exposure may vary among market participants, a typical approach would be to determine the maximum net amount that the counterparty might be required to pay under a statistical analysis using a range of scenarios that are within two or more standard deviations from the base case. Base case is also not defined, but presumably refers to the shape of the yield curve at the time the derivative was priced. Thus, in an interest-rate swap, the maximum probable exposure would refer to the net amount the counterparty would be required to pay to the issuing entity, if the actual changes in rates over the contract's term conformed to the least favorable rates scenario for the counterparty.
Probable Exposure Distinguished
Note the maximum probable exposure cannot be the same thing as the probable exposure to the derivatives counterparty. To use a specific example, the maximum probable exposure to an interest-rate cap cannot be the cap purchase price. That amount only expresses the amount the cap provider expects to pay, plus a profit margin. But economic theory would indicate that the cap provider cannot charge a purchase price calculated on its maximum probable payment rather than its probable payment; if it did, competitors could come in at a lower price and still make a profit over time. This is unfortunate because the cap price is a contract term known to the sponsor without the requirement of undertaking additional modeling, and it will be lower than the maximum probable exposure, making it less likely that the derivative would hit the 10% or 20% threshold if the cap price were used.
Loss Distinguished
The maximum probable exposure also cannot be the loss the issuing entity would suffer if the derivatives contract were terminated early. This number will also be smaller than maximum probable exposure.
On the other hand, the statistical approach embodied in the maximum probable exposure concept arguably comes closer to reflecting, on a conservative basis, the ABS investor's credit exposure to the derivatives counterparty during the term of the ABS securities than does using the cap purchase price.
The ASR comment letter contains an example that assumes a five-year interest-rate swap, with LIBOR exchanged for fixed-rate payments at a then current market rate, with a non-declining notional amount of USD100 million. The letter notes that because the obligations of the floating rate paying counterparty are uncapped, under very extreme scenarios, the maximum possible exposure of the issuer to that counterparty could be in excess of even the notional amount.
As long as the maximum probable exposure to the counterparty for at-the-market interest-rate swap contracts supporting asset-backed securities remains below 10% of the aggregate principal balance of the pool assets or the classes of asset-backed securities to which the derivative relates, as applicable, Item 1115 will have a very modest effect on the scope of disclosure by providers of these contracts in ABS. In light of the difficulty that derivatives providers that are not U.S. Exchange Act reporting companies would have in supplying the financial statement disclosure required by Item 1115, many market participants are probably counting on the 10% level never being hit.
As it happens, ABS are supported by currency swaps as well as interest rate swaps--think of USD-denominated Australian MBS backed by AUD mortgage loans, or EUR-denominated MBS backed by USD or sterling-denominated mortgages. For currency swaps, the maximum probable exposure may often exceed the 20% threshold. For this and other reasons, ISDA, The Bond Market Association and the American Securitization Forum have readied a joint submission to the SEC containing interpretive suggestions to improve the workability of Reg AB's new financial information requirements for swap providers, smoothing the application of this important regulatory initiative.
This week's Learning Curve was written by Adam Glass, partner at Linklatersin New York.
