MARCH 2007 ABCDS: CREDIT DEFAULT SWAPS ON ASSET BACKED SECURITIES

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1 MARCH 2007 NO. 1 ABCDS: CREDIT DEFAULT SWAPS ON ASSET BACKED SECURITIES

2 At PAAMCO, we recognize that active and continuous research is essential to identify alpha in a constantly changing hedge fund opportunity set. Beyond the manager selection and overall portfolio construction lie the underlying securities, asset classes and markets that drive the alpha generation. This is the first of a series of papers that will address the implications of emerging securities or assets classes for the hedge-fund industry, as well as broader conceptual issues. This paper is for informative purposes only. PAAMCO does not necessarily endorse or engage in these strategies.

3 ABCDS: CREDIT DEFAULT SWAPS ON ASSET BACKED SECURITIES by Mayer Cherem EXECUTIVE SUMMARY ABCDS are credit default swaps (CDS) on tranches of asset-backed securities (ABS), which are claims on cash flows from a specific pool of assets. Buying an ABCDS is equivalent to acquiring protection, or shorting the underlying security. The market for ABCDS is new but has been growing very fast since the creation of ISDA documentation standards in June 2005 and a new ABX index in January Because PAAMCO has full transparency for all its invested hedge funds, examination of the underlying positions can provide a unique window into changing patterns in the industry. In particular, we have seen an increasing number of credit and equity hedge funds using ABCDS and taking long or short positions in the underlying ABS. This allows them to implement both positive and negative views on various sectors of the mortgage market and to implement relative value trades. At the same time, the short positions decrease the systematic risk of the portfolio. Thus, the emergence of ABCDS creates new opportunities for alpha generation in this asset class. Mayer Cherem is an Associate Director based in PAAMCO s Irvine office. He is focused on researching new uncorrelated sources of alpha including complex fixed income strategies.

4 SUMMARY POINTS ABCDS are credit default (CDS) swaps on asset-backed securities (ABS), which are claims on cash flows from a specific pool of assets. The market for ABCDS is new but has been growing very fast since the creation of ISDA documentation standards in June ABCDS of non-conforming mortgage loans dominate the market. Daily trading is estimated to be $1 billion for single name ABCDS; total notional outstanding is more than $150 billion. New trading strategies are being used. ABCDS allow participants to take long or short positions on the underlying ABS, e.g. to implement views on various sectors of the mortgage market. Investors can take positions in specific tranches, as a result of detailed loan-level analysis, which can provide value relative to simple credit ratings. ABCDS are structured differently from corporate CDS, and pricing is much more complex. A new ABX index was launched in January This is a CDS on an index of ABSs. The liquidity on ABX is much better than that of individual ABCDSs. There are some risks however. Although liquidity is improving, some ABCDSs are still illiquid. Unwinding can be complicated. This is a new instrument and its behavior in extreme market conditions has not been tested. 2

5 INTRODUCTION Credit default swaps on asset backed securities ( ABCDS ) are new financial instruments, which are increasingly used by hedge funds. The underlying securities are ABS, which pool cash flow generating assets and direct those cash flows to different tranches. ABCDS are credit default swaps on these tranches, typically backed by home equity and commercial property loans. The market for these securities has been growing significantly in the last year, providing broad opportunities to savvy investors. This has been spurred by the creation of ISDA documentation standards in June 2005, and by a new ABX index launched in January Liquidity is increasing, with daily trading estimated at $1 billion for single name ABCDS. Total notional outstanding now exceeds $150 billion. This paper provides an introduction to the ABCDS market. It begins with a review of the fundamental and structural mechanics of these instruments, which are fairly complex. ABCDS differ significantly from corporate credit default swaps, both in terms of cash flows and definition of credit events. ABCDS use a periodic cash settlement method to better match the cash flows of the derivative with those of the reference obligation (commonly referred to as pay-as-you-go). In addition, this paper analyzes the risks and pricing issues associated with these securities. Pricing is complex because ABCDS are a derivative of ABS, an already complex instrument. The risks of ABCDS are also related to the risks of the reference obligations as well as to the technical forces created by the different market participants. While liquidity has improved, some trading strategies are best implemented in funds with longer horizons. The paper then provides an overview of some trading strategies we have observed in hedge fund portfolios. ABCDS allow participants to take long or short positions on the underlying ABS, e.g. to implement views on various sectors of the mortgage market, or in specific tranches. 3

6 I. DEVELOPMENT OF ABCDS MARKET A credit default swap based on an ABS instrument is a type of insurance against defaults on the underlying ABS. The protection buyer makes a regular payment in exchange of a profit if the value of the reference ABS falls. Before the appearance of credit default swaps on ABS, the ABS market was essentially a long-only market. Investors with a negative view of a market found it difficult and costly to short the bonds. Most investors acquired bonds and tranches at origination. Trading in the secondary market was limited. All of this is changed with the development of the ABCDS market. In general, Asset Backed Securities are claims on cash flows generated by pools of financial assets such as credit card receivables, auto loans, student loans, aircraft leases, home equity loans, non-agency residential and commercial mortgage backed securities. These cash flows get packaged and then redivided into different tranches. The cash flows, however, are affected by two types of risk: prepayment risk, which is the risk of early prepayment of principal, and credit risk, which is the risk of default on the payments and distributed according to a waterfall structure. Senior tranches have priority over cash flows but also get prepaid faster. Junior tranches will suffer principal losses earlier, protecting senior tranches from impairment. Insurance wraps and over-collateralization might protect junior tranches from losses up to certain point. Exhibit 1 shows a typical structure of asset backed securities. EXHIBIT 1. ABCDS STRUCTURE 4

7 ABCDS are credit default swaps on specific tranches of asset backed securities. By the end of 2003 the market for CDS of ABS was practically nonexistent. In 2004, banks began buying and writing protection on several ABS tranches. However these were non-standard, customized, over-the-counter instruments. As demand for the product increased, the major broker dealers collaborated and in June 2005 created an ISDA Master Document that set a standard for ABCDS. Since then, the market has grown very fast; by the end of 2005, total outstanding notional was estimated to be $ billion. ABCDS have since been trading actively, at a rate of $1 billion per day. ABCDS of non-conforming home mortgage loans now dominate the market. Liquidity has been further improved with the launch in January 2006 of a new ABCDS index for home equity loans, called ABX. Trading of this index has been very active, estimated at $ million daily. This is the most liquid product currently in this market. The ABX index is composed of a basket of ABCDS, using 20 equally weighted large (>$500M) securitizations of sub-prime mortgages. The index is subdivided into 5 sub-indices: AAA, AA, A, BBB, BBB-, using different tranches of the same 20 securitizations. Every six months, the ABX is rolled into a new series composed of 20 totally new securitizations. This is a key difference versus the CDX index for corporate CDS, which has more than 80% common names between series. This roll forces each series to remain current and liquid, as opposed to the CDX where pricing and liquidity change for older series 5

8 II. MECHANICS OF ABCDS Credit default swaps have two sides: the protection buyer and the protection seller. The protection buyer pays a spread on the amount of notional outstanding on a specific tranche of an ABS securitization to the protection seller, in exchange for a contingent payment in the event of write-downs or credit events. Note that unlike traditional CDS on bonds, there is a different design feature: as the principal is amortized and the notional becomes smaller, the actual payments decrease, even if the spread remains constant. There are several major differences between corporate and ABS credit default swaps. Most of these come from the inherent differences between the underlying securities but some are related to new market standards intended to facilitate execution. The first difference is the definition of a credit event. For a corporate CDS, the credit event is a one-time event with a clear-cut definition, e.g., bankruptcy of the underlying corporate entity. In contrast, ABS are structured as Special Purpose Vehicles (SPV), which are passive vehicles distributing the cash flows of underlying assets. The SPV itself cannot go bankrupt, unlike corporations. Even if the company originating the ABS went bankrupt, there should be no disruption in the cash flows received from the underlying loans. So, credit events must be defined differently from corporate CDS. In practice, credit events are defined as: (1) a failure to pay interest or principal by due date on the underlying loans, (2) a loss event involving a reduction of principal, also known as write-down, (3) a credit rating downgrade below a specified threshold, or (4) a dissolution of the Special Purpose Vehicle. ABCDS can have multiple events over the life of the contracts. Second, ABCDS are reference obligation-specific not issuer-specific. This means, for example, that an ABCDS on Countrywide s April 2005 senior tranche will be different from an ABCDS on Countrywide s April 2005 junior tranche, and different from a subsequent Countrywide July 2005 securitization. This is because the assets and the structure of the securitization shape the cash flows, not the issuer. In the case of corporate bonds, a bankruptcy or reorganization event will probably cause unsecured bonds of similar seniority to trade at a similar recovery values. Hence, corporate CDS are issuer-specific. Corporate CDS are also affected by cross-default provisions, unlike ABCDS. 6

9 Third, the settlement mechanism is different. Corporate credit default swaps involve cash settlement or physical settlement upon the credit event, with the latter involving delivery of the underlying obligation. ABCDS can also involve these two methods, but also use a pay-as-you-go PAUG systems. Under PAUG, the protection seller makes regular cash payments that correspond to the payment shortfall (i.e., a principal write-down, principal or interest shortfall). The trade keeps going, however. When shortfalls are reimbursed, the protection buyer reimburses the seller. Upon termination with physical settlement, the protection buyer delivers the asset, in exchange for the notional. For cash settlement, dealers are polled to determine a reference price. Exhibit 2 illustrates for a given event in one month the exchange of cash flows between the seller of protection or a buyer of protection. EXHIBIT 2. EXAMPLE OF ABCDS CASH FLOWS a.) Assumed events for underlying ABS tranche b.) Net CDS cash flow from protection seller to buyer. 7

10 A positive aspect of the cash settlement method is that it prevents the disruption of the physical bond market. In the Delphi case, for instance, the notional CDS positions were so large that when the company filed for bankruptcy, the bonds trended up as protection buyers looked for the paper to deliver in exchange for par. The drawback, however, is the need for getting an estimated recovery value from several dealers. Finally, in order to terminate an ABCDS contract prior to maturity the investors have three options: termination, assignment, or offsetting position. In a termination, the investor will pay the counterparty the current market value of the ABCDS whereas in an assignment the investor will transfer the obligation to another broker dealer making the payment to the later. In an offsetting position, the investor will enter into a new contract for a similar new issued ABCDS to lock in the gain or loss via the difference in spreads over time. III. PRICING ISSUES ABCDS are fairly complex instruments to price, for a number of reasons. First, the underlying asset backed securities have several risks that are inherently hard to model. This includes credit risk on a pool of assets, prepayment risk that is path dependent, interest rate risk if the securities are not floating, and liquidity risk, as junior tranches are significantly smaller than senior tranches. The performance of different tranches depends on the distribution of cash flows, combined with the priority structure. Modeling the major risks leads to a cash spread, which represents the theoretical price of the ABCDS. However, there is still some basis risk, defined as the difference between the (synthetic) CDS and cash spread. In theory, this basis should be zero. In practice, it is affected by both fundamental and technical factors. Fundamental factors include differences in financing costs. Due to margin requirements, financing costs for cash bond tends to be higher than the implicit CDS costs. Also, the CDS contract may include embedded options such as a cap on payments for interest rate shortfalls. Technical factors are directly linked to the main players in this market. Managers of Collateralized Debt Obligations (CDOs) have been large sellers of protection as it allows them to book premium, pushing ABCDS spreads, and the basis, down. On the other hand, global macro hedge funds jumped into this market when ABCDS provided a way to short the housing market, pushing the basis in the opposite direction. 8

11 Exhibit 3 describes the evolution of spreads for various tranches of Home Equity Loan (HEL) ABS, which is backed by sub-prime mortgages. The chart shows that ABS spreads fell sharply in early In November 2005, global macro managers massively bought protection on BBB tranches, anticipating a sharp slowdown of the housing market. Both ABS BBB spreads and ABCDS spreads widened. These volatile months were followed by a return to more normal levels after speculators realized that losses were still somewhat far away and after protection sellers (mainly CDOs) ramped up their portfolios, capturing wider yields. Most macro hedge funds did not make money but kept their trades in place, while some replaced the name specific ABCDS for the ABS index (ABX). EXHIBIT 3. ABCDS STRUCTURE HOME EQUITY LOANS (HEL) BBB- BB+ 9

12 The basis can also be affected by counterparty risk and liquidity risk. Pricing will be affected if there is a structural deterioration of the counterparty, especially if the contract is difficult to unwind. In addition, if cash bonds are hard to find, dealers will carry smaller inventories, which drives bid-ask spread higher. Even though bonds and ABCDS should be priced based on comparables, true value might not be reached until losses actually occur. Finally, two models are generally used to estimate the value of ABCDS: risk-neutral pricing and static replication pricing. Risk-neutral pricing starts with calibrating the option adjusted spread (OAS) to zero to find the cash flows that emulate a security with no risk. These cash flows are later used to price the credit spread of the risky security at its current market price. Static replication pricing constructs a replicating portfolio of securities to match the payoffs of the ABCDS. Both methods should, in theory, get the same prices. IV. ABCDS OPPORTUNITIES 3 The ABX market provides an ability to express global views on the ABS market, including shorting the market. Individual ABCDS allow more specific views on areas, groups of consumers or businesses. EXAMPLE 1 (DIRECTIONAL TRADE) Economics: Taking a view on the realized versus originally expected default rates. Implementation: Short $1 of 2003 Sub-Prime Home Equity Loans tranche rated AA (see Exhibit 1) This outright short relies on the nature of weak structures put in place in Basically, junior tranches (A and BBB) started getting paid back, removing the inherent layer of protection below the senior tranche (AA). Over time, what is left in the pool is slowly degrading, and losses are expected on the AA tranche. 2 For a full description of both methods, consult the Asset-Backed CDS pricing chapter of ABS Research, Bear Stearns, December The trade examples are provided for illustration purposes only. Short can only be achieved through a long protection position in the ABCDS. Proper security specific analysis is required to actually select the underlying pool and estimate expected losses at the loan level and project a cash flow distribution. 10

13 More generally, ABCDS create the ability to go long or short a specific tranche of an ABS. Most of securitizations today provide a record of loan level details that include data like credit scores of borrowers, loan to value vs. collateral, type of mortgage, value of the property, aggregation by zip code. For an investor willing to invest in modeling technology and spend the time analyzing the underlying data and the structure of the securitization, there is a lot of potential value to be extracted. For instance, ABCDS allow pairs trading. This includes the ABX index vs. a particular ABS, different vintages, or loans with same collateral quality trading at different spread because of different originator reputations can now be exploited. EXAMPLE 2 (PAIRS VINTAGE TRADE) Economics: Taking a view on the relative credit quality of one year s loans versus another. Implementation: Long $1 of 2004 Sub-Prime Home Equity Loans tranche rated BBB, Short $1 of 2006 Sub-Prime Home Equity Loans tranche rated BBB This trade captures the period when mortgage origination was most aggressive in terms of low documentation, consumer base, regions and technology. We would expect greater losses on the 2006 pool relative to the 2004 pool, as delinquencies are already ramping up on the 2006 pool. EXAMPLE 3 (PAIRS ISSUER TRADE) Economics: Taking a view on the relative likely default rate difference among home equity loans originated by different organizations. Implementation: Long $1 of WAMU (Washington Mutual) Home Equity Loans BBB tranche at LIBOR plus 160 bps, Short $1 of Countrywide Home Equity BBB tranche at LIBOR plus 140 bps. Two pools of very similar collateral trade at different spreads because the issuers are different. Note that the credit risk of the issuers is not a factor in this trade rather it is the performance of each pool s respective collateral. 11

14 EXAMPLE 4 (CAPITAL STRUCTURE TRADE, LEVERAGED) Economics: Owning higher quality loans (Prime) and hedging with much more sensitive lower quality loans. Implementation: Long $4 of a portfolio of Prime Home Equity Loans tranche AA at LIBOR plus 40 bps, Short $1 of a portfolio of Sub-Prime Home Equity Loans tranche BBB at LIBOR plus 150 bps. The pools have very different collateral. Trade has positive carry due to the leverage factor of 4, and is credit and/or interest rate duration neutral. Models show that a 3% to 5% depreciation in house prices will wipe out BBB first because collateral has lower quality and seniority. However, in a worse case scenario, losses could affect the long position and erase some of the gains. EXAMPLE 5 (CAPITAL STRUCTURE TRADE) Economics: Owning a portfolio of high yielding junior tranches while hedging with less sensitive senior tranches. Implementation: Long $1 of a portfolio of Prime Home Equity Loan tranches BB, BB- as well as the ABS s equity at an aggregate rate of LIBOR plus 500 bps; Short $3 of Sub-Prime Home Equity Loans tranche BBB at 150 bps spread. The pools have very different collateral (long prime and short sub-prime). Models show that a 3% to 5% depreciation of home prices may wipe out both the long and short positions. In general, this trade is structured such that the higher ABS position of sub-prime (BBB) is impaired before a large portion of the prime home equity loans which are higher quality in underlying credit but in a lower position in the ABS structure (BB, BB- and the equity piece). If both disappear, the net profit is $2 because of the larger weight of the short vs. the long position. If the market doesn t move and home prices don t depreciate, the trade will have positive carry ($1 x 500 bps less $3 x 150 bps equals a net positive carry of 50 bps). 12

15 This market creates an ability to trade corporate CDS vs ABCDS, or single names vs. CDOs. EXAMPLE 6 (ISSUER TRADE) Economics: Hedging Home Equity Loans with the credit of the originator. Implementation: Long $1 of Countrywide prime BBB at LIBOR plus 90 bps; Short $1 of Countrywide credit (long protection) at LIBOR plus 50 bps. As mortgage issuers keep what they cannot sell in their balance sheets, the corporation holds lower quality assets than those securitized. Thus defaults should hit first assets retained on the balance sheet. In addition, the ABCDS market opens up a number of other trades. Investors can exploit the basis trade on select issues when synthetic spreads are lower than cash spreads. This involves buying the bond and buying protection on the bond. The implied correlations of the ABX index vs. the individual ABCDS can be traded with a much larger granularity. There are thousands of underlying loans vs. only hundreds in the corporate correlation trade, creating a much better diversified portfolio. Finally, it is interesting to note that ABS structures de-lever by design gradually. Once the securitization takes place, the notional amount shrinks down over time as the loans amortize and prepay, in contrast to corporate bonds, where the company generally re-levers the balance sheet. This changing leverage affects the rating of various tranches: As senior tranches get repaid first and become thinner, the subordination level of junior tranches is reduced. However, rating agencies have historically been slow to respond to this changing leverage, creating opportunities to identify mispriced securities. Also, the natural deleveraging of ABS structures makes them expensive to short. 13

16 V. RISKS AND DRAWBACKS Like all complex financial instruments, ABCDS are subject to model risk. Credit losses on different tranches must be modeled from the entire distribution of credit losses for the underlying pool, combined with the waterfall structure. The shape of this distribution depends on the granularity of the pool, or default correlations. Changing estimates of these correlations will greatly affect the pricing of ABCDS. While the ABCDS market is now becoming more liquid, some structures, including some reference obligations, can be very illiquid. This can cause deviations from fair prices and create problems for settlements of these contracts. Finally, because ABCDS are new instruments, their behavior in extreme market conditions have not been tested yet. VI. ABCDS AND HEDGE FUNDS Hedge funds are becoming actively involved in the ABCDS market. In effect they are buying put options on the asset-backed markets. The first movers were the ABS-dedicated funds, who already have developed models to differentiate securities, using a bottom-up approach. Other credit and event-driven funds are investing opportunistically, often through a basket of ABCDS or index ABX to implement market views. More recently, these funds also have been taking positions through individual ABCDS. Hedge funds are attracted to ABCDS as an uncorrelated source of alpha in a new and rapidly expanding market. As is the case for long-short equity funds, much of the value added comes from the ability to implement both long and short positions. Not only do such long/short strategies reduce systematic risk, but they also have the potential to extract value from purchasing undervalued securities and selling overvalued securities. Putting these strategies in place, however, requires fairly substantial investments in human capital, modeling techniques, and risk management systems. Even so, ABCDS are permanently expanding the opportunity set for hedge fund investors. 14

17 VII. CONCLUSION ABCDS are new financial instruments that combine the innovation of the tranched asset backed securities market with the credit default swap market. They provide exposure to credit risks that are much more granular than pools of corporate bonds. In addition, payoffs on home mortgage loans are likely to have lower betas than corporate debt, which makes them well-suited to an alternative investment portfolio. This paper has documented several attractive ABCDS trades. These trades require short or leveraged positions, which require a hedge fund structure. At the same time, the illiquid nature of some of these securities requires a long-term commitment. Overall, ABCDS has the potential to provide a valuable source of alpha to a hedge fund portfolio. 15

18 BIBLIOGRAPHY Bear Stearns, ABS research. Introduction to Asset-Backed CDS, December 2005 Citigroup, Guide to Prospering in the ABS Market, December 2004 CSFB, 2003 Home equity deep dive: into the eye of the storm, November 2006 CSFB, The CDO Strategist: An Introduction and Comments on New ISDA Template for CDS of ABS, June 2005 Deutsche Bank, Pay-as-you-go CDS and New Frontiers in ABS CDOs, June 2006 Fabozzi et-al, The Handbook of Non-agency Mortgage-backed Securities, FJF, 2nd edition Fabozzi, The Handbook of Fixed Income Securities, McGraw Hill, 7th edition Hayre, Guide to Mortgage-backed and Asset-backed Securities, Wiley Finance, 2001 ISDA, ISDA Publishes Revised Pay-As-You-Go or Physical Settlement Form for CDS on ABS, January 2006 JP Morgan, ABCDS Market Update. Launching the ABX.HE Index, January 2006 JP Morgan, Single Name CDS of ABS, March 2005 Lehman Brothers, ABS Credit Default Swaps-A Primer, December 2005 Lehman Brothers, ABS Strategies Weekly Outlook October Lehman Brothers, CMBS Research November 21, 2005 Lehman Brothers, Introducing Credit OAS for RMBS, April 2006 Lehman Brothers, Introduction to the ABX, January 2006 Lehman Brothers, US ABS Floating Rate Index, April 12, 2005 Markit, New US ABS CDS Benchmark Indices, January 2006 Moody s, Structured Finance Rating Transitions: S&P, Ratings Transition 2004, February 2005 UBS, How Bad is 2006 Subprime Collateral, November 2006 Financial Times, 2005, Bond Shorting is as Easy as ABCDS, markets (December 9)

19 Pacific Alternative Asset Management Company, LLC ( PAAMCO ) is an institutional fund of hedge funds investment firm dedicated to offering strategic alternative investment solutions to the world s preeminent sophisticated investors. PAAMCO s clients include large public and private pension plans, foundations, endowments, and financial institutions. Located in Irvine, California, with a European office in London, Pacific Alternative Asset Management Company Europe, LLP ( PAAMCO Europe ), and an Asian office in Singapore, Pacific Alternative Asset Management Company Asia, Pte. Ltd. ( PAAMCO Asia ), the firm is committed to meeting the needs and demands of its global institutional client base both now and in the future. PAAMCO is registered with the U.S. Securities and Exchange Commission and the Commodities Futures Trading Commission, and is a member of the National Futures Association. PAAMCO Europe is registered with and authorized by the Financial Services Authority. PAAMCO Asia is listed with the Monetary Authority of Singapore.

20 Pacific Alternative Asset Management Company, LLC Jamboree Road, Suite 400 Irvine, CA United States Tel: Fax: Pacific Alternative Asset Management Company Europe, LLP 25 Victoria Street London SW1H 0EX United Kingdom Tel: Fax: Pacific Alternative Asset Management Company Asia, Pte. Ltd. 167/169C Telok Ayer Street Singapore Tel: Fax: