In June 2005, the International Swaps and Derivatives Association published two template confirmations for credit-default swaps on asset-backed securities:
1. Confirmation of credit-default swaps on asset-backed securities with cash or physical settlement, referred to as the cash/physical confirmation; and
2. Confirmation of credit-default swaps on asset-backed securities with pay as you go or physical settlement, dealer form, referred to as the Pay-As-You-Go confirmation.
In this Learning Curve we outline the key similarities and differences between the two dealer confirmations.
Two Confirmations, Many Different ABS
The two forms of confirmations have been created with different classes of ABS in mind, and demonstrate different approaches in reflecting the risk profile of the ABS.
Cash/Physical Confirmation
The cash/physical confirmation is designed to not be limited in its application to any particular class of ABS and can be used with a wide range of ABS such as repackaged securities, residential mortgage-backed securities and collateralized debt obligations. Of the two confirmations, it is closest in form to confirmations of standard credit-default swaps. Conceptually too, it is close to a standard CDS in that the occurrence of a specified credit event triggers a cash or physical settlement amount payable by the seller of protection: the document designates cash settlement but with an option by the buyer to specify physical settlement. It differs, however, from standard CDS in the focus on the ABS instead of the issuer of it and the credit events are substantially different.
PAYG Confirmation
The PAYG confirmation was primarily designed for use with the form of RMBS and CMBS common in the U.S. markets, but it can be adapted for use with other forms of ABS if required. Like the cash/physical confirmation, the PAYG confirmation differs from the confirmation of a standard CDS in that it focuses on the ABS instead of its issuer and uses different credit events. The PAYG confirmation also has a significant conceptual difference with both the confirmation of a standard CDS and the cash/physical confirmation. This is because under the PAYG confirmation, the occurrence of some events will lead to payments by the parties on an ongoing basis, instead of termination of the transaction by a single cash or physical settlement. This difference in approach is intended to result in the PAYG Confirmation providing a risk profile closer to that obtained by holding the ABS through its term.
Common Feature: Focus On ABS As Reference Obligation
In an ordinary CDS confirmation, the identified reference entity is the key to the drafting mechanics. Obligations for credit events and deliverable obligations which can be delivered at settlement are determined by reference to their connection with the reference entity. In both ABS confirmations, the reference obligation plays this defining role instead of the reference entity. It is the only obligation for determining credit events and the only deliverable obligation for settlement. In the cash/physical confirmation, the switch in focus is complete as the reference entity itself is defined as being the primary obligor of the reference obligation from time to time. This focus on the ABS as reference obligation results in the protection seller's risk profile being closer to a holder of the ABS than it would under a standard CDS confirmation (which results in a risk profile closer to being a general creditor of the reference entity).
Key Differences
1. Credit Events Used
ABS are dependant on cash flows from the underlying asset. They have inherent risks, such as unpredictable repayment schedules, that may be less clear-cut than the risks associated with corporate securities. Many ABS have distressed scenarios that may or may not be events of default under their own terms. For example, home equity loans--non-conforming loans in the US market--contemplate what is known as an available funds cap whereby, if the collateral pool hits a certain limit, no interest is paid at that time on the securities, although it may be paid in the future. Other ABS contemplate what is known as a payment in kind or PIK event, which is the deferral of interest or payment of interest out of principal if insufficient funds are available. In CDOs the breach of certain credit enhancement/collateral tests can trigger a permanent writedown of principal. The credit events commonly used in standard CDS do not clearly reflect these risks. The revised credit events in both ABS CDS confirmations have been drafted with these ABS features in mind, although each handles them slightly differently.
2. Manner Of Settlement After Credit Event
Each of the two confirmations allows for physical settlement following the occurrence of a credit event. Each, however, also allows an alternative:
1. The cash/physical confirmation allows for cash settlement as an alternative. This is determined in a similar manner to corporate credit-default swaps.
2. The PAYG confirmation allows for certain credit events to trigger additional payment exchanges between the parties. Those are:
Principal shortfall payments. If a failure to pay principal credit event occurs then instead of requiring physical settlement, the protection buyer may require the protection seller to pay an amount based on the shortfall between the principal expected to be paid and the principal which was actually paid under the ABS. If the issuer of the ABS subsequently makes a payment of the principal shortfall then the protection buyer must make a reimbursement payment.
Writedown payments. If a writedown credit event occurs then, instead of requiring physical settlement, the protection buyer may require the protection seller to pay an amount based on the amount of the writedown. If the issuer of the ABS subsequently makes a payment of the writedown or the writedown is otherwise reversed then the protection buyer must make a reimbursement payment.
3. Connection With Interest Under The ABS
Under the cash/physical confirmation, if there is a failure to pay interest on the ABS then it is a credit event if the requirements of a failure-to-pay credit event are met. Under the PAYG confirmation, a separate settlement mechanism is provided for interest shortfalls which does not involve a credit event.
Under PAYG, if there is a shortfall between the amount of interest expected to be paid on the ABS and the amount actually paid on the ABS, then the protection buyer may require the protection seller to pay an amount based on the interest not paid. If the issuer of the ABS subsequently pays interest which is greater than the expected amount, then the protection buyer must make a reimbursement payment.
A further distinction between the two confirmations in relation to interest is that the PAYG confirmation allows the parties to choose whether certain step-up provisions apply. These provisions are triggered if the interest payable on the ABS steps up during its term. If this happens then the protection buyer has the option of terminating the transaction early. If the transaction is not terminated then the fixed amount is adjusted upward by the amount of the step-up.
A final distinction between the confirmations in relation to the interest on the ABS is the initial payment which can be included in the PAYG confirmation. This is an adjusting payment made between the parties in order to enable them to set the fixed rate under the CDS at an amount equal to the margin over the base rate payable on the underlying ABS.
Conclusion
The two different styles of confirmations are the result of different drafting and conceptual approaches. There are key similarities and differences between each. These need to be kept in mind when considering which of the two is best suited to a particular CDS of ABS transaction.
This week's Learning Curve was written by Scott Farrell, partner, and Dan O'Connor, lawyer atMallesons Stephen Jaques in Sydney.
