Explaining the ISDA Pay as You Go or Physical Settlement ABS Credit Default Swap Template

Transcription

1 Explaining the ISDA Pay as You Go or Physical Settlement AS redit Default Swap Template Part I: An AS Trader s Document Makes Few oncessions to Laymen by Adam W. Glass, Partner November 2005 ISDA s PAYG DS confirm template has been described as not very user-friendly. It was written not to be easy to understand, but to match up to concepts used by AS traders in the cash markets. An example of this is the way in which the confirm implements the idea of scalability. onceptually, scalability simply means that protection may be written on a notional amount of AS greater than the principal amount actually issued. In theory, scalability also applies to allow protection to be written on a notional amount of AS less than the principal amount actually issued, but since the same result can be accomplished simply by referencing a smaller Outstanding Principal Amount of the Reference Obligation, the incremental effect of the scalability provisions in the PAYG confirm is only to provide upward flexibility. While the ability to write protection on more than the outstanding principal amount of a debt security exists in corporate credit default swaps, it is implemented simply by stating the notional amount of the DS as the desired greater amount. There is nothing in the 2003 ISDA redit Derivatives Definitions to prevent a regular DS being written on an identified notional amount of a Reference Obligation that is greater than the outstanding principal amount of that Reference Obligation (although a buyer of protection in that case would likely want to specify ash Settlement rather than Physical Settlement). More commonly, corporate DS are written against a Reference Entity rather than a particular Reference Obligation. In this case it is unlikely that a single protection buyer would be buying protection in an amount greater than the entire principal amount outstanding of the bonds and loans of the Reference Entity. It could certainly be the case, however, that the total amount of protection written exceeded the principal amount outstanding of the Reference Entity s obligations. ecause the PAYG confirm looks to put the protection seller in the same position as a holder of the cash bond, there is no way to write a PAYG confirm without referencing an actual principal amount of the AS that is the Reference Obligation. The measure of the payments that the buyer is entitled to protection on, and of even more relevance, the actual timing and amount of payments made on the AS, are necessarily keyed to an actual principal amount of the Reference Obligation. So, if a protection buyer wishes to buy protection on an amount of the AS greater than the issued amount, it becomes necessary to multiply the actual principal amount, actual expected payments, actual payments and actual subsequent reimbursements (proceeds of late payments on the AS applied to reimburse the protection seller for Floating Amounts previously paid) by a percentage that increases their amounts in

2 the same proportion as the Reference Obligation Notional Amount exceeds the Outstanding Principal Amount of the Reference Obligation. The simplest way do this would be simply to define an Applicable Percentage in the required amount 125%, for example -- and multiply all these amounts by 125% to gross them up properly to reflect that the Reference Obligation Notional Amount is bigger than the Outstanding Principal Amount of the Reference Obligation. Instead, the definition of Applicable Percentage in the PAYG confirm reads as follows: Applicable Percentage: On any day, a percentage equal to A divided by. A means the product of the Initial Face Amount and the Initial Factor and such amount shall be decreased on each Delivery Date by an amount equal to (a) (i) the outstanding principal balance of Deliverable Obligations Delivered to Seller divided by (ii) the urrent Factor on such day multiplied by (b) the Initial Factor. means the product of the Original Principal Amount and the Initial Factor and (a) such product shall be increased by the outstanding principal balance of any further issues by the Reference Entity that are fungible with and form part of the same legal series as the Reference Obligation; and (b) such product shall be decreased by any cancellations of some or all of the Outstanding Principal Amount resulting from purchases of the Reference Obligation by or on behalf of the Reference Entity.

3 Since some of the defined terms used in the definition of Applicable Percentage are themselves fractions (such as Initial Factor and urrent Factor), in exploded form, this definition actually describes the following complex fraction: A D + E [ F] [ G] where A = Initial Face Amount = Outstanding Principal Amount To = Original Principal Amount D = Outstanding principal balance of Deliverable Obligations Delivered Tn E = Outstanding Principal Amount Tn F = Outstanding Principal alance of Fungible Further Issues Tn G = ancellations of Principal alance of Reference Entity Tn Why does the PAYG confirm take the more complex approach? Two reasons. One, AS traders are used to thinking of AS principal balances in terms of initial factors and current factors (the standard way of describing pool balances in agency and private label RMS, for example). Thus, it is more straightforward, to an AS trader, to describe the current pool balance as [Original Principal alance x urrent Factor] than it is to simply give a number (for example, $100,425,389.21). Two, the PAYG confirm is very concerned not to let certain very rare, but possible, events upset the proper calculation of the Reference Obligation Notional Amount ( RONA ). One of these rare circumstances is the further issuance of subsequent fungible issues of AS (that is, securities identical in all respects and bearing the same USIP that are issued after the initial offering of AS of the issue). In my experience of structured finance and securitization, I have only seen this type of issuance in very specialized kinds of transactions, such as so-called institutional to retail SEregistered repackagings of corporate bonds, or single tranche credit-linked note offerings secured by bespoke collateral whose issue amount can be increased by fungible issuances. In the context of RMS and MS, which the PAYG confirm says it is specifically intended to reference, I really don t see how subsequent fungible issues can occur, since the raw material of these AS securities (the heterogenous residential or commercial mortgage loans that back them) cannot be increased pro rata in principal amount to allow the issuance of additional fungible securities. Yet the risk of issuance of additional fungible securities was thought significant enough that the definition of Applicable Percentage specifically incorporates a provision for the purpose of excluding the balance of such securities from the calculation of Applicable Percentage. Another similarly rare circumstance is a reduction in the outstanding principal amount of a Reference Obligation resulting from purchases of the Reference Obligation by or on behalf of the Reference Entity. It boggles the mind to think how this could occur in a U.S. RMS or MS transaction. For one thing, in the United States, mortgage-backed securities are generally classified as grantor trusts or REMIs for federal income tax purposes, and the issuing vehicles are required by the rules of those tax classifications to be essentially unmanaged, brain dead entities.

4 In a typical mortgage pass-through trust, there is no one home to make the decision to buy in a Reference Obligation, and if there were, there would be no available source of funds with which the Reference Entity could make the purchase. An RMS or MS is a complicated structure that is set in motion on the date of issuance, and thereafter operates like a pre-programmed machine according to the rules laid down in the pooling and servicing agreement or trust agreement. Discretion may be exercised in servicing decisions within the limits of an agreed servicing standard, but there is no discretion in the transaction trustee or any other party to make investment or financing decisions for the issuing entity, such as doing a debt buyback. I am not saying this has never happened the concept found its way into the PAYG confirm, so it must be based on something. ut if it occurs at all, it must be extremely rare. One possible exception is if the drafters of the PAYG confirm were thinking of cash MS DOs as the type of MS that the confirm would apply to. ut this is inconsistent with the other trappings of the PAYG confirm (use of Initial Factor and urrent Factor, for example). The result of including the two rare events of fungible securities issuance and issuer buyback of Reference Obligations in the definition of Applicable Percentage is to give the appearance that the Applicable Percentage is likely to change over the life of the credit default swap, when, in fact, 99 times out of a 100, the Applicable Percentage will be a simple fixed percentage that will remain the same for the life of a transaction, at least until a redit Event occurs. For this reader of the PAYG confirm, the inclusion of these terms was unfortunate. As a general drafting principle, it is undesirable to give equal prominence of place in a document to crucial concepts, on the one hand, and unimportant or extremely unlikely ones, on the other. This is because the human mind, unlike a computer, is confused by unnecessary complexity, and can only focus on a limited number of variables at a time. (Or is it just me?) If the likelihood of occurrence of an outcome (like the issuance of fungible securities or the buyback of RMS or MS by a U.S. REMI or grantor trust) falls somewhere between never and extremely rarely on the probability spectrum, do these possibilities really need to be part of the definition of Applicable Percentage? For example, Applicable Percentage could have been defined without reference to these unlikely events. The definition could then have been followed by a statement that in the event fungible securities were issued or Reference Obligations bought in, the Applicable Percentage would be adjusted to preserve the economic effect of the Transaction. This phrase used to worry me when I first encountered it as a stock way of dealing with contingencies in swap transactions. I was a junior lawyer drafting swap agreements for a bank, now not in business as an independent entity, that had a reputation for aggressiveness and pushing the envelope of complexity. The apparent lack of precision in the phrase, whose implementation was to be effected by the dealer, seemed to me to allow for the possibility of overreaching, leading to disputes. ut in this context, where the required adjustment would be simply to proportionately offset the effect of the unforeseen change, there wouldn t seem to be any room for argument over what the required adjustment would consist of. A similar approach could have used to deal with the reduction of the denominator of Applicable Percentage caused by Physical Settlement of less than 100% of a transaction on a Delivery Date.

5 To me, the increased simplicity of defining the Applicable Percentage as A rather than [ ] [ ] G F E D A + would have made this approach worthwhile.