Advancing Structured Finance

Editor's Award For Advancing Structured Finance - Revolution in the Streets

CDS IndexCo, International Index Co, International Swaps and Derivatives Association, Markit

Few if any developments have generated more excitement in the securitisation market in the last year than the arrival of credit default swaps (CDS) and derivatives products for asset backed securities.

The emergence of single name credit default swaps has been perhaps the most important development in the plain vanilla credit markets of the past fifteen years.

Similarly a liquid derivatives market for ABS could revolutionise the way risk is sourced and priced, and open up an array of new trading opportunities, including shorting and correlation trading.

International Swaps and Derivatives Association (ISDA) first began to work on documentation for CDS on asset backed securities at the end of 2004 and start of 2005, when it formed a working group to develop a standardised template for the product in response to requests from both European and US traders.

Over the next six months the group, which contained both lawyers and traders, worked to flesh out a fully fledged template for CDS of mortgage backed bonds.

Or to be more precise, two templates. One template allowed for so-called "pay as you go" settlement, whereby the protection seller makes good any shortfalls as and when they happen. The other — cash or physical settlement — either requires the protection seller to deliver cash equivalent to the difference between the trading price of the reference obligation and par, or the buyer to deliver the reference obligation, in return for which it receives the notional value of the CDS contract.

The two separate templates were needed because while dealers in the US wanted a pay as you go model, citing the way home equity cashflows work and the unreliability of cash/physical settlement for relatively illiquid and non-fungible ABS, dealers in Europe were even more insistent on a cash/physical settlement one. This is because the PAUG template did not include as credit events bankruptcy or restructuring, which banks need in order to obtain capital benefits from a CDS hedge. Whereas the US market is dominated by asset managers and mutual funds, banks form a large part of the European CDS market, so the PAUG template was unacceptable to European dealers. As a matter of fact, there are now two versions of the Pay As You Go template, "Form I" used for contracts between dealers and end users, and "Form II" — launched in December — for monolines. Essentially the monoline version adds two credit events — the available funds cap event and the temporary writedown — and that do not appear in the dealer version, because monoline protection sellers are not willing to absorb the related risks.

These events are not normally considered credit events in the ABS world, such that they would trigger a downgrade. Nevertheless they could cause an economic loss to a holder of the security relative to expected performance.

While some end users hoped for a compromise, the two markets are relatively discrete — monolines primarily operate in the triple-A arena while dealers handle with mezzanine risk.

For the rest of the year ISDA worked with dealers to see how the templates were used in practice and what improvements could be made. During this time the US market exploded — as one trader put it the CDS of ABS market grew from zero to $150bn in a year. Since January that figure has risen dramatically, following the launch by the CDS IndexCo and Markit of the first index of asset default swaps, known as ABX.HE and referencing 20 home equity ABS deals. By offering standardised tranches and independent pricing, the index should boost investor confidence in the integrity of the ADS. According to Markit, some $10bn of ABX trades were executed in its first two days, and that in the two weeks after its launch several hundred transactions have occurred. As an example of how the index can boost liquidity, bid offer spreads on some ABX constituents are currently under a basis point.

In Europe meanwhile the International Index Company, better known as iBoxx, put together a cash index of the most liquid ABS tranches, the ABS 50, with pricing data provided by Markit. Launched at the beginning of February 2006, the index will be used to structure options such as contracts for difference.

None of the joint winners is resting on its laurels. ISDA is working on still other templates. The next, a "bolt on" for the existing European template, should appear in final form by the end of February, and will allow for the "synthetic delivery" of reference ABS obligations through the use of total return swaps. This should make trading of small, illiquid tranches much easier and more reliable.

The organisation is also working on a confirmation template and/or definitional booklet for reference obligations in note form, for example CDOs or credit card ABS. This should greatly expand the scope of CDS of ABS, allowing investors easily to take a view on most asset classes.

In a similar vein, CDS IndexCo and Markit will be adding new CDS of ABS indices. First to launch, in a matter of months, will be CMBX, referencing 25 US CMBS deals.

Following that will be sister indices of ABX covering credit card ABS, student loans and other liquid asset classes. The credit for the emergence of CDS and derivatives of ABS must be shared by many — not least the traders in London and the US that first developed the concept. However, these bodies, CDS IndexCo, ISDA, iBoxx and Markit have between them provided the nascent market with the structural rigour and transparency to allow the product to really develop. ABS may never be the same.