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Derivatives

Loose Documentation Raises Specter of Settlement Failure In Synthetic ABS

A combination of soaring volumes in the synthetic asset-backed securities market and bankers looking to structure deals further down the ratings scale could lead to settlement problems because the documentation is not designed for these types of trades.

A combination of soaring volumes in the synthetic asset-backed securities market and bankers looking to structure deals further down the ratings scale could lead to settlement problems because the documentation is not designed for these types of trades.

Shin Yukawa, an associate director of credit products at Fitch Ratings in New York, is concerned about whether the mechanics of these trades will work if the ABS default. This is because market players are structuring synthetic collateralized debt obligations and credit-default swaps on ABS based on documents originally designed for derivatives referencing corporates.

One of the problems of using the corporate documents for asset-backed transactions is the settlement process. In the event of a corporate default, there will likely be a multitude of bonds and loans that qualify as a deliverable obligation, which is not the case in ABS, according to Yukawa. In the ABS arena, the number of eligible bonds is likely to be far smaller and could result in parties not being able to deliver a default asset and forfeiting the protection.

In the case of cash settled transactions, the concern lies in the valuations. "[This] may be much more difficult because of the magnitude of difference in the availability of the referenced obligation versus the corporate universe," said Michael Gerity, senior director of credit products with Fitch.

So far there have been no credit events to test synthetic ABS. This is largely because deals have referenced AAA assets, noted Yuri Yoshizawa, managing director in the derivatives group at Moody's Investors Service. But that's changing. "We are seeing more transactions coming down the rating scale," she said.

Yoshizawa is more optimistic about the advances market participants have already made and thinks the remaining glitches will be ironed out with the forthcoming International Swaps and Derivatives Association documentation. Still, she said delta hedging these trades may be a little more concerning because it's a less liquid market.

For now the situation remains stable because of limited activity and because it's unlikely that any assets have, as of yet, been referenced multiple times. But the volume of ABS on CDS is expected to grow, in large part due to ISDA's documentation, which it expects to finish by spring.

Structured finance default swaps have only been around for a year or two, but bankers are predicting it could develop into a liquid market. Gerity noted this will be difficult if these issues are not dealt with. Until now, no alternatives have been developed, Gerity said, but credit proffesionals are recognizing there may be problems as these kinds of trades increase.

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