Professional Documents
Culture Documents
September 2005
September 2005
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W CDS enables more efficient trading of credit andlor spread risk and
identify value
- In a CDS transaction, a buyer of protection pays a protection
seller a premium in exchange for payments if certain credit
events occur
W Corporate CDS market primarily trades on two credit events:
- Bankruptcy
- Failure to Pay
The corporate CDS market has grown dramatically and
revolutionized the corporate bond market
W Index trading on corporate credit (i.e., CDX) has dramatically
increased liquidity in the sector
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Single tranche bespoke synthetic CDOs
Full capital structure synthetic CDOs jW'h *C
M3.
Tqn ~5
- H y b r i d C D O s j ~ U 3
Growth in Liquidity in the Structured Product
CDS Market
12+ dealers are making 2-way markets
- RMBS & CMBS have seen the majority of trading flow
- BidlOffer currently ranges from 3-5bps range on AAA and
10-25bp area on BBB and BB
- Trade Size = $5 to 50MM
- CDS notional typically exceeds 01s notional of cash
security
CDS will likely have a significant market impact on the pricing
of risk and ultimately on cash spreads
- Tiering among RMBS servicers is being witnessed
Liquidity continues to grow
- Numerous bid and offer lists have been executed upon
,=I
Primary Market Participants & ApplicationS l
&\\
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Buyers Sellers
Hedge Funds & Arbitrage CDOs
Dealers - 100% Synthetic
- Flow trading desks - Hybrid (cash &
synthetic)
- Proprietary desks
Whole loan originator
- Synthetic Bucket
traders Hedge Funds & Arbitrage
Banks I Funders - LonglShort
- Negative Basis Trades - Synthetic 110
Insurance Companies - Term Funding
Portfolio Managers Insurance Companies
Portfolio Managers
Development of Index Products
September 2005
lSDA CDS c S Confirmation with
Pay-As-You-Go or Physical Settlement
Designed to be used for RMBS and CMBS reference obligations:
Provides for "pay-as-you-go" methodology whereby the seller of protection
('Seller") will make "Floating Payments" to the buyer of protection ("Buyer") on a
current basis (i.e.. principal writedowns and principal and interest shortfalls, in each
case, with respect to the reference obligation);
= To the extent Seller makes a Floating Payment to Buyer and such amount is
"reversed," Buyer will pay such reversed amount back to Seller;
With respect to interest shortfall coverage. Seller will cover interest shortfalls in one
of three ways: (i) Seller will pay interest shortfalls up to an amount equal to the
fixed rate (i.e., fixed cap). (ii) Seller will pay interest shortfalls up to an amount
equal to LlBOR plus the fixed rate (i.e., variable cap) or (iii) Seller will pay the entire
amount of the interest shortfall (i.e., interest shortfall cap not applicable);
Credit events include (i) failure to pay principal, (ii) principal writedown. (iii) ratings
downgrade and (iv) maturity extension;
Upon a credit event, Buyer may physically settle all or a portion of the notional
amount of the trade by delivering the reference obligation (or a portion thereof) to
X Seller in return for par; if Buyer settles only a portion of the trade, the trade will
continue and the notional amount thereof will be reduced by the physically settled
portion;
The term of the trade will match the legal final of the underlying reference
obligation.
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- The payment obligations of the Buyer fall into two categories: (i) the Fixed Amount and
(ii) Additional Fixed Amounts.
The Fixed Amount is the protection premium payable by Buyer to Seller and is equal to
the product of the Fixed Rate and the Reference Obligation Notional Amount.
The Reference Obligation Notional Amount is adjusted throughout the life of the trade
as follows: (i) decreased by (a) principal payments on the reference obligation, (b)
principal writedowns on the reference obligation. (c) principal shortfalls on the
reference obligation and (d) any portion of the reference obligation that is physically
1\
The payment obligations o f t e Seller are called 'Floating Payments" and fall
into three categories: (i) Writedown Amounts; (ii) Principal Shortfall Amounts
- obligation is undercollateralized;
Princ~pnlShodfall Amounts - if a scheduled principal payment is not made
when legally due, a principal shortfall will result and Seller will make a
Floating Amount payment to Buyer equal to such principal shortfall.
- If there is an lnterest Shortfall on the reference obligation, Seller will (subject to the
. lnterest Shortfall Cap) pay Buyer the amount of the lnterest Shortfall;
An lnterest Shortfall will occur on a given payment date if the Actual lnterest Amount is
less than the Expected lnterest Amount in each case, on such payment date;
The Actual lnterest Amount is defined as the actual amount of interest paid in respect of
the reference obligation on a given payment date;
The Expected lnterest Amount is defined as the amount of interest acmed on the
reference obligation for the relevant calculation period and expressly provides that such
amount will be determined without regard to the applicability of any available funds cap
("AFC"); this has the effect of transferringthe AFC risk to the Seller;
= Notwithstanding this transfer of AFC risk to the Seller, a the parties elect the Fixed Cap
with respect to lnterest Shortfall coverage, the amount of the lnterest Shortfall payable by
Seller to Buyer for a given payment period will be capped at the protection premium
payable for such payment period;
If the parties elect the Variable Cap with respect to lnterest Shortfall coverage, the
amount of the lnterest Shortfall payable by Seller to Buyer for a given payment period will
be capped at the protection premium for the applicable period plus LIBOR;
If the parties provide that the lnterest Shortfall Cap is not applicable. Seller will pay the
entire amount of the lnterest Shortfall to Buyer.
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Assumptions
W Reference Obligation Coupon is the lesser of (i) L+400 and (ii) 10% (i.e.,
10% is the AFC);
3
Reference Obligation is trading at 2d0bps at the time of the trade;
Buyer and Seller set the fixed rate (i.e., the protection premium payable
from Seller to Buver) at (i) 200bos (if the lnterest Shortfall Cao is
applicable) or (ii)b00bps (if the interest Shortfall C -
~ isP not aLplicable);
and
W The Reference Obligation fails to pay interest on a given payment date
(i.e., an lnterest Shortfall equal to L+400bps)
Credit Events
PAYGo
Guarantees payment of interest and principal during life of ABS
Long-term relationship
Available funds cap risk - not consistent with European ABS structures
Can trade with fixed cap
CashlPhysical
Looks like a corporate CDS
Trigger results in payout
Follows less closely the terms of the ABS
Can be used for all ABS types, not just CMBSIRMBS (although modifications
mav be appropriate)
. . .
Current volumes FOR CashlPhysical
2005 - EUR 7-10bn
2006 - EUR 75-100bn
Portfolio managers slow to approve the document
The Confirmation CashlPhysical -
= Looks like a corporate CDS
= Shorter than PAYGo form
= Very helpful footnotes in both forms
Buyer pays Fixed Amounts, calculated by reference to an
initial notional amount which fluctuates depending
- upon
amortization etc. (average)
= Seller pays Floating Amount on day Final Price is
deterrnined1Delivery Date
-
Credit Events CashlPhysical
Failure to Pay
Payment Requirement: USD 100,000
Loss Event
(Writedown)
m, Failure to Pay
-
BankruptcylRestructurin
Rating Downgrade
=
"CC" "default"
PAYGo - "CCC" =allows Physical Settlement
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Settlement CashIPhysical \
Cash Settlement, unless Seller receives NOPS prior to first Valuation Date
Valuation Date
Seller selects a Business Day 120-140 calendar days after Event
Determination Date
An amended Section 7.7 applies--
Settlement Diagram
120 r
-
-
r
Subs.quanlPhy.tcal
Buyer Deliveo sand
Seller pays Par
Dsllv.ry I
NO
t
C m h Vai~atIon Subsequlnl P h p h a l De1lv.w
(Dealer Poll1 - Buyer Deiven sand
-
180
1 Seller pay, Par
J
Final Price No Flnal Price
Days
Highsl Bid 3Oc - PIIce Deemed Oc
Buyer 6 Selleragn. wllh Final Price Seller pmpo. AIt Flnal Prls. 6oc Seller do. mt propose AI Final ~ d c a
- Seller pay$ Buyer 7Oc - Seller p a p Buyer Par
I
4
Buyer pmpwms All F i n d Price tOc Seller pmpose.An
* Flnal Price 60s
vla TRS
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