abs cds

Global Structured Finance ResearchNew YorkMarch 7, 2005

Single Name CDS of ABS Next Step in the Evolution of the ABS Market

• The emergence of a single name ABS Credit Default Swap (ABCDS)market represents a major development in the evolution of the ABSmarket. To date, ABS has primarily been a long risk, cash only market.ABCDS will now enable ABS investors the ability to take on risksynthetically. More importantly, ABCDS will transform ABS away froma “long only” risk market and provide ABS investors, dealers, and issuers,the ability to short the market, hedge positions, or hedge loan pipelines.

• The unique attributes of ABS mean that standard corporate CDSdocumentation and settlement procedures must be modified to create aviable single name ABCDS market.

• Synthetic ABS trades have been completed in the past, but havetypically been negative basis trades that used trade-specificdocumentation. Examples include “new issue” negative basis tradesand portfolio trades in synthetic CDOs of ABS.

• In the past, the lack of standard documentation, a conservative ratingagency approach to ABCDS settlement issues, and a lack of protectionbuyers for the product have been obstacles to the development of aliquid single name market. Over the past few months, documentationacross dealers has become much more consistent. ISDA standarddocumentation is expected to be finalized in the near future. However,finding protection buyers in size will still represent a key challenge forthe future growth of the market.

• CDOs of ABS, whether purely synthetic or cash deals with syntheticbuckets, and correlation books represent a potentially large source ofdemand for the product. Single name ABCDS represent a buildingblock for these players, but it is unclear whether the single nameABCDS market will ever offer the type of liquidity available in thecorporate CDS market. This is primarily due to the relative complexityof ABCDS, as discussed in this report.

Contents Introduction 2ABCDS market participants 6ABCDS contracts and mechanics

ABCDS versus Corporate CDS 8Reference entities 9Credit events 9Valuation and settlement 11Other considerations 14

Conclusion 15Single Name CDS of ABS is available on theJPMorganChase web site:www.morganmarkets.com

Christopher FlanaganAC

(1-212) [email protected]

Ryan Asato(1-212) [email protected]

Edward Reardon(44-207) [email protected]

North AmericaChristopher Muth(1-212) [email protected]

Glenn Schultz, CFA(1-312) [email protected]

Amy Sze, CFA(1-212) [email protected]

Tracy Van Voorhis(1-212) [email protected]

LondonRishad Ahluwalia(44-207) [email protected]

Ting Ko(44-207) [email protected]

www.morganmarkets.comThe certifying analyst(s) is indicated by a superscript AC. See last page of the report foranalyst certification and important legal and regulatory disclosures.

Christopher FlanaganAC (1-212) 270-6515Ryan Asato (1-212) 270-0317Edward Reardon (44-207) 777-1260

2

IntroductionThe emergence of a single name ABS Credit Default Swap (ABCDS) marketrepresents a major development in the evolution of the ABS market. To date, ABShas primarily been a long risk, cash only market. ABCDS will now enable ABSinvestors the ability to take on risk synthetically (sell protection). More importantly,ABCDS will transform ABS away from a “long only” risk market and provide ABSinvestors, dealers and issuers, the ability to short the market, hedge existingpositions, or hedge loan pipelines (buy protection).

In the past, two major obstacles have hindered the growth of the market.

• First, no standard documentation exists for the product. To date, the majority ofsynthetic CDS risk has been transferred via “negative basis trades” (as discussedlater in this section) using trade-specific documentation (i.e., an investor purchasescash ABS and buys protection on the tranche).

• Second, the ABS market has had a relatively undeveloped investor base forhedging/shorting ABS risk.

More recently, liquidity in ABCDS has started to expand as the market has begun toaddress these obstacles. Currently, dealers and investors are close to standardizingcredit event definitions and settlement procedures that are acceptable to both buyersand sellers of protection. Over the past few months, documentation across dealershas become much more consistent. ISDA standard documentation is also expectedto be finalized in the near future. In addition, protection buyers have begun toemerge as the market has developed. However, finding protection buyers in sizewill still represent a key challenge for the future growth of the market.

Brief review of CDS basicsA credit derivative is a financial contract that allows one to take or reduce defaultexposure, generally on bonds or loans, of a sovereign, a corporate entity, andincreasingly, asset backed securities. Credit default swaps (CDS) are thecornerstone of the credit derivatives market. CDS are an agreement between twoparties to exchange the credit risk of an issuer (reference entity) and does notdirectly involve the issuer itself. CDS are primarily used to 1) reduce risk arisingfrom ownership of bonds or loans, 2) take exposure to an entity, as one might do bybuying a bond or loan issued by that entity, and 3) express a positive or negativecredit view on a single entity or a group of entities, independent of any otherexposures to the entity that one might have.

The seller under the credit default swap is said to sell protection. The seller usuallycollects a periodic fee and profits if the credit of the reference entity remains stableor improves while the swap is outstanding. Selling protection has a similar creditrisk position to owning a bond or loan, or “going long risk.” The buyer under thecredit default swap is said to buy protection. The buyer usually pays a periodic feeand profits if the reference entity has a credit event, or if the credit worsens whilethe swap is outstanding. Buying protection has a similar credit risk position toselling a bond short, or “going short risk.” (Chart 1)

Global Structured Finance ResearchSingle Name CDS of ABS March 7, 2005

3

In the corporate CDS market, credit events include bankruptcy, failing to payoutstanding debt obligations, or in some CDS contracts, a restructuring of aborrowed money obligation. Following one of these credit events, the buyer ofprotection can deliver to the seller of protection defaulted bonds and/or loans with aface amount equal to the notional amount of the credit default swap contract. Theseller of the protection then delivers the notional amount on the CDS contract incash to the buyer of protection. The buyer can deliver any bond or loan, meetingcertain criteria, issued by the reference entity that is at the same level of seniority asthe specific bond referenced in the contract. This is called “physical settlement.”Alternatively, the buyer and seller can agree to unwind the trade based on the marketprice of the defaulted bond. This is called “cash settlement1.”

Due to unique attributes of ABS, both credit events and settlement mechanics havebeen modified to better fit these securities. These will be discussed in greater detailin the following sections.

Evolution of synthetic ABS risk transferenceAlthough the single name ABCDS market is in its development phase, ABS risk has,for some time, been transferred synthetically through negative basis trades.Negative basis trades entail the purchase of a cash bond and simultaneously buyingprotection on the bond using CDS. Many synthetic CDOs of ABS use negative basistrades, and we briefly review both of these below.

New issue “negative basis” trades“New issue” negative basis trades have been completed in structured products forsome time. In these trades, a bank (the “funder”) purchases the senior-most CDOtranche (already AAA rated) at the time the CDO prices. As part of the negativebasis trade, the bank also buys protection typically from a monoline insurer (the



Chart 1: Single name credit default swaps

Source: JPMorgan.

1. For more information, please refer to Credit Derivatives: A Primer, Beinstein/McGinty, January 2005.

ReferenceEntity

ProtectionBuyer

ProtectionSeller

Risk(Notional)

Fee/premium

Contingent payment upon a Credit Event

Credit Risk Profile of shorting a bond Credit Risk Profile of owning a bond

• Buy CDS• Buy Protection• “Short risk”• Pay periodic payments

• Sell CDS• Sell Protection (against default)• “Long risk”• Receive periodic payments


4

“wrapper”), and pays the monoline a running premium to protect against defaults.The bank and the monoline each receive a portion of the CDO tranche spread -determined through a negotiation prior to the deal pricing (Chart 2). From thefunding bank’s perspective, it has a “super-AAA” asset (i.e., a AAA-rated CDOtranche, with an additional “wrap” from the monoline). From the monoline’sperspective, it earns a running spread for taking an acceptable level of risk that istypically a big part of its financial guarantee business.

New issue negative basis trades are distinct from single name ABCDS because 1)monolines are extensively involved in the CDO and CDS documentation before thedeal is printed, 2) the trade normally takes place at new issue, and 3) the trade isusually based on the entire tranche.

Currently, many single name ABCDS are completed via negative basis trades(although not at new issue). An investor purchases the cash ABS and buysprotection, and earns the difference between the cash bond spread received and theCDS premium paid.

Synthetic CDOs of ABSSynthetic CDOs of ABS reference a large percentage of ABS synthetically (80-100%), and examples include BNP’s Thunderbird Investments and AXA’s TempoCDO programs. However, in part, due to the lack of a liquid single name ABCDSmarket, these CDOs also rely on negative basis trades and trade specific CDS tosource risk.

The bank, usually the CDO arranger, purchases cash ABS assets on its balance sheetand then buys protection on a portfolio basis from the CDO. The arranging bank(the swap counterparty) pays the CDO a running premium to take the credit risk ofthe ABS portfolio (Chart 3). In this negative basis trade, the CDO arranging bankmay not retain any spread for its funding role. We typically assume that anarranging bank provides LIBOR flat funding, so the CDS premium paid to the CDOis equal to the spread on the cash ABS. The documentation is trade-specific, butallows the CDO to reference the ABS portfolio synthetically.


Chart 2: New issue negative basis trade

Source: JPMorgan.

CDO Tranche

Receivesbond spread

Pays CDSpremium

Protection

Seller

“Funder”Buys

Protection

“Funder”Buys

Protection ParBuys Bond

Bond

5

Arranging banks for these CDOs are among those pushing for standardized ABCDSdocumentation. A liquid single name ABCDS market will allow these arrangers to1) source/hedge risk in a single name market, rather than through negative basistrades, and 2) manage any residual risks from single tranche synthetic CDOs of ABSif the entire synthetic CDO capital structure is not distributed.



Chart 3: Synthetic CDO of ABS

Source: JPMorgan, Fitch

Super-senior swap

AA

BBB

First Loss

SF Security Reference Portfolio

AAA Collateral

Trust (protection seller)

A

ProceedsPrincipal & Interest

Proceeds

Principal & Interest

Swap counterparty

CDS premiums

Protection payments

Protection payments

Spread on Cash ABS


6

ABCDS market participantsProtection sellersWe expect a diverse group of investors to use single name ABCDS as protectionsellers, primarily those that currently invest in cash ABS. Given that in someperiods, the primary market has failed to meet strong investor demand, we believe anumber of investors would source additional ABS risk using ABCDS. CDOs shouldprovide a large source of demand as ABCDS would allow them to quickly ramp uptheir portfolio and potentially give them the ability to diversify into different sectors,issuers, or even vintages. In addition, unfunded ABCDS should appeal to investorswith smaller capital bases (e.g., hedge funds, monolines).

Protection buyersA key challenge for a liquid single name market will be continuing to find newbuyers of protection, which we attribute to a variety of factors. To begin, structuralfeatures in ABS (e.g., credit enhancement, performance-based triggers, etc.) aredesigned to avoid default - even in highly stressed scenarios. Furthermore, ABSdeals tend to be primarily investment grade rated (AAAs alone represent 85-97% ofmost deals). Given these structural protections and the high ratings, investors maynot want to pay a CDS premium to protect against such low expected losses,especially higher up in the capital structure. Finally, few investors/ institutions have“natural” credit exposures to ABS issues compared to corporates (e.g., throughloans, swaps, counterparty credit, etc). As a result, there is less potential demandfrom institutions seeking to hedge ABS risk. Nevertheless, market participants mayseek to use ABCDS for a variety of reasons.

Relative value trades• Short the market. Historically, an inefficient ABS repo market has made

shorting ABS challenging. ABCDS may become the easiest way to express anegative view. We see hedge funds as an investor class that may become moreactive in the ABS market given the ability to execute short strategies. However,hedge funds typically are “fast money” oriented and will likely be much moresensitive to spread movements. As a result, they may be in-and-out of the marketand may not always be a stable source of demand.

• Put on capital structure trades. Investors can exploit perceived inefficiencieswithin a deal’s capital structure by going long risk in areas of the capital structurethey consider cheap and sell protection in areas they feel are rich. For example,investors could buy lower rated tranches and hedge their exposure by buyingprotection on a higher rated tranche from the same transaction.

Hedging• Manage counterparty credit exposure. Some institutions do have counterparty

credit exposure to ABS transactions via interest rate or currency swaps. Theseinstitutions can reduce/hedge some of their risk to the ABS issuer using CDS.However, this type of hedge would only be a proxy for the underlying risk, since theactual swap payment risk would not typically be directly referenced in the contract.

• Hedge issuer pipelines or CDO warehouse risk. Many ABS issuers originateassets in a warehouse and use securitization as their exit strategy or long-termfunding source. Buying protection using ABCDS (with a similar credit profile)


7

allows an originator the ability to hedge the risk that securitization spreads widenduring the warehouse period. Similarly, facilities warehousing CDOs in theirramp-up period can hedge the risk of potential spread widening of the assetspurchased into the warehouse prior to the CDO funding.

• Allow CDO mezzanine or equity investors the ability to hedge against positions held by the CDO. To the extent that a CDO investor has a negative view on a specific bond in a deal, the investor can buy protection against thesespecific positions.

• Delta hedging. Credit hybrids desks will find a liquid single name marketattractive because they can use this market to manage correlation risks of CDOtrades (both buying and selling protection).




8

ABCDS contracts and mechanicsFirst, we examine the differences between Corporates and ABS and how those needto be reflected in ABCDS contracts and credit events. Next, we discuss the variouscomponents of ABCDS, including reference entities/obligations, credit eventdefinitions, and valuation and settlement procedures.

ABCDS versus Corporate CDSThe ABCDS market has been able to leverage off the considerable development thathas already been done in the Corporate CDS market. However, the unique attributesof ABS mean that standard Corporate CDS documentation and settlementprocedures must be modified. Some of these differences include:

• Corporations may have more flexibility to avoid a credit event. With respectto Corporates, a company’s management can modify its capital structure,expenses, etc. to continue as a “going concern” or avoid default. In contrast, ABSrely on the asset cash flows for repayment of principal and interest, which are paidaccording to specific bond documentation. There is no (or comparatively, verylittle) management option that can increase or reduce the risks to ABS investors.

• Deliverable obligations. In typical corporate CDS, credit events occur in respectof a reference entity and its borrowed money obligations. If a credit event occurs,a variety of deliverable obligations may be delivered. The range of deliverableobligations typically includes bonds and loans, and may include other specifiedobligations. The ability to deliver various obligations may create a “cheapest-to-deliver option.” By contrast, because performance in ABS can vary across deals,most ABCDS contracts will be “reference obligation specific.”

• Accrued Interest / Payment-In-Kind (PIK). In stressed circumstances, cashflows received from the assets may be insufficient to repay bond interest. Some ABStransactions may use structural mechanisms to alter cash flows to prevent a defaultsince interest shortfalls may be a short-term liquidity issue. For example, somebonds may accrue interest (pay-in-kind), or use principal payments to pay interest.

• Principal writedowns. ABS principal may be reduced if losses exceed theavailable credit enhancement, or if principal is used to cover an interest shortfall(a debit to a principal deficiency ledger, or PDL). In some cases, the principalreduction may be reimbursed if performance recovers.

• Prepayment uncertainty. The majority of corporate bonds have a “bulletmaturity” — a single payment of principal on a specified legal maturity date. Ifprincipal is not paid at that time, a credit event occurs (“failure to pay”). Incontrast, most ABS amortize over time, and ABS “average life” estimates arebased on specific prepayment assumptions. As a result, failure to pay accordingto the assumed prepayment schedule would not constitute a credit event.

• Declining notional. Also due to prepayments and principal paydowns on theunderlying receivables, depending on the structure, the outstanding balance of thereference obligation may decline over time. As a result, the notional amount ofthe ABCDS contract should also decline in line with reductions to the outstandingprincipal on the reference obligation.

• Long legal final. ABCDS will feature long legal final maturities that match thecash assets. The legal final maturity of ABS typically reflects the tenor of the


9

longest maturity asset in the pool (e.g., roughly 30 years for mortgages, 10 yearsfor auto loans, etc). Using a shorter CDS maturity would be equivalent towriting/buying a put option on the reference obligation if it extends beyond theexpected maturity. However, this could be problematic for ABCDS on HomeEquities, for example, since a credit event, if one was to occur, is more likely tohappen later in a deal due to the timing of underlying collateral losses. Thus, ifthe contract were to terminate before the maturity of the underlying bond, thebuyer of protection may lose their coverage when they need it the most.

Reference entities/obligationsABCDS transactions are “reference obligation specific.” In most ABCDS, creditevents occur with respect to the reference entity (the issuer of the ABS) and aspecific security issued by that reference entity. With certain exceptions, settlementof the transactions is affected either by delivery of that specific security or byreference to the payment performance or market value of that specific security. Therationale for referencing a specific tranche is that ABS performance can vary fromdeal-to-deal, for a variety or reasons.

• Vintage. Credit performance can vary depending on the year of origination.Relaxed underwriting standards in a period of intense competition, for example,may lead to higher losses in a particular vintage. Poor economic conditions (e.g.,rising rates and higher unemployment) may also impact a specific origination yearmore acutely.

• Range of asset quality. Issuers frequently originate and securitize a broad rangeof assets, and the underlying borrowers can have different credit profiles. Sellersof protection seek to isolate credit risks, and therefore would not allow a defaultof any issue to qualify as a credit event.

• Senior and subordinate tranches. ABS transactions typically comprise seniorand subordinate bonds. By design, subordinate tranches absorb losses first (oncecredit enhancement has eroded), and are thus more likely to default than moresenior tranches.

For these reasons, a protection seller does not want a default on any bond of anissuer to trigger a credit event.

Credit EventsCredit events and settlement mechanisms in ABCDS may depend on the referencedcollateral type, and/or who the seller of protection is. For example, the ratingagencies may require different credit events and settlement mechanisms for cash-settled contracts that are placed in a rated CDO. There may also be regionalvariations in credti event definitions and settelement procedures, driven in part bycorresponding regional variations in the ABS cash market.

The following, are types of credit events that may be defined in ABCDS contracts.

BankruptcyABS issuers achieve “bankruptcy-remoteness” from an originator/seller bytransferring assets into a special purpose vehicle (in other words, ring-fencing the




10

assets from the balance sheet of the issuer). If the originator/seller defaults, ABSinvestors will continue to receive cash flows from the segregated assets, and theseassets do not form part of the bankrupt originator’s estate for unsecured creditors.In ABCDS, bankruptcy refers to a bankruptcy of the special purpose vehicle, adissolution of the SPV, or any lien/assignment against the assets such that ABSinvestors no longer have an exclusive claim on the assets.

Some buyers of protection need bankruptcy to be included as a credit event in orderto qualify for regulatory capital relief.

Failure to payFailure to pay interest or principal on a scheduled payment date is a standardcorporate credit event definition. However, as discussed, in some cases, ABS can 1)experience temporary interest deficiencies without defaulting, and 2) have principalrepayment profiles that do not typically follow a specific schedule.

In the context of ABCDS, failure to pay refers to the failure to pay required interestor principal due on a scheduled distribution date. In some markets, in order for acredit event to be deemed to have occurred, the ABS must also meet one or more ofthe following conditions:

• The failure to pay has occurred over an extended period (e.g., 24 months)indicating the shortfall is no longer temporary.

• The reference obligation does not allow for reimbursement of payment shortfalls.

• The nonpayment of interest or principal is a default according to the terms of theunderlying ABS.

Failure to pay can also represent the failure to pay all principal on the referenceentity by the legal final maturity date or the date when all assets backing the ABShave been sold and the proceeds distributed.

In order to ensure that the failure to pay is not due to any temporary technical issue,this event may include a minimum grade period.

Loss or writedown eventUnder certain circumstances, ABS permit a reduction to the principal amount of atranche. For example, if losses have eroded credit enhancement, or principal is usedto pay a temporary interest deficiency (i.e., principal deficiency ledger), the tranchenotional may be temporarily reduced. However, in some deals, a principal reductioncan be cured once performance improves. Therefore, in ABCDS trades that do notprovide for the buyer of protection to reimburse the seller in the event that there arewritedown reimbursements in the underlying ABS deal, a principal reduction mustoften meet one or more of the following conditions to qualify as a credit event:

• The underlying ABS does not provide for reimbursement of the principal reduction.

• The underlying ABS does not provide for interest to be paid on the principalreduction, or for any interest that would have accrued on the unpaid interest on aprincipal reduction.


11

Some contracts require the calculation agent or an independent third party todetermine that it is “mathematically impossible” for a future reimbursement tooccur. This calculation would have to include assumptions about futureperformance and may be difficult to put into practice.

Ratings-based triggersUnder a ratings-based trigger, a credit event would occur if one or more publicratings falls below a specified threshold. The threshold is somewhat dependent onthe type of settlement and whether or not the ABCDS is placed into a rated CDO.For physically settled contracts, downgrade triggers can be set higher; somecontracts specify a Caa1/CCC+ (Moody’s/S&P) threshold. For cash settledcontracts, Moody’s currently requires triggers be set at Ca for a minimum of sixmonths or C for any period while S&P requires a CCC- on negative watch or a CC+rating. In addition, the rating agencies generally prefer to have ratings-basedtriggers coupled with some other credit event. However, we believe that stand-aloneratings triggers not linked with other credit events can provide a “catch all” forunforeseen credit issues not captured in other events. Ratings-based triggers mayalso include withdrawn ratings.

Valuation and settlementABCDS may be physically or cash settled or settled on a “pay-as-you-go” basis. Thedefined settlement mechanism depends on the type of reference obligation. ABCDSreferencing Credit Card Master Note Trusts will most likely be structured withphysical settlement. Contracts executed in Europe will likely favor physicalsettlement with a cash settlement “fall back,” in part to prevent a documentationmismatch for existing CDOs of ABS. “Pay-as-you-go” combined with a physicalsettle option is the settlement mechanism of choice for ABCDS referencing HomeEquity ABS in the United States.

Physical settlementIn physical settlement, the protection buyer delivers the cash bond (or eligible asset)and receives par. In turn, the protection seller receives the cash bond and pays par(Chart 4). However, given the small size of some ABS tranches, protection buyersmay find it difficult to purchase and deliver bonds. As a result, physical settlementwill mainly be used for ABCDS referencing tranches issued from Credit CardMaster Note Trusts which could allow for multiple reference obligations to bedelivered. Since Credit Card Master Note Trusts are structured such that excess



Chart 4: ABCDS physical settlement

Source: JPMorgan.

Protection

Seller

Protection

Seller

CDSPremium

CDSPremium

Protection

Buyer

Protection

BuyerJPMorganJPMorgan

BondBond

Par Par


12

spread is allocated using a “socialist” methodology, and since writedowns areapplied pro-rata to all outstanding tranches with the same priority, if a credit event istriggered, the buyer of protection would be able to deliver any tranche from theCredit Card Master Note Trust with the same seniority as the reference entity.

Cash SettlementIn cash settlement, a minimum number of dealer bids, together with a specifiedvaluation method are used to attain a single settlement value. Cash settlement canuse a single valuation date or multiple valuation dates. On a determined number ofbusiness days after a credit event, dealers will be asked to submit firm bids for thedefaulted ABS. While not yet finalized, current documentation frequently requiresfive approved dealers to be solicited for quotes, and at least two full quotes to bereceived. If the required number of quotes is received, the contract will settleaccording to the agreed valuation method and settlement period. The valuationmethod may be an average of bids, the highest bid, an average omitting the highestand lowest bid, etc., and is determined at the outset of the contract. Once thevaluation is determined, the protection seller pays the protection buyer par less thedealer poll price (Chart 5).

If the minimum number of bids is not received, settlement will not take place, andthe bidding process will be conducted at defined intervals until completedsuccessfully (e.g., once every 30 days for six months). This process will continueuntil 1) the minimum number of bids are received or 2) a final bidding date, whereif still unsuccessful, the recovery value will be deemed to be zero.

However, cash settlement may pose additional challenges because of the valuationprocess. When ABS performance deteriorates significantly, market participantsgenerally agree that accurate valuation is difficult for a variety of reasons (e.g., lackof information, uncertainty about further defaults/prepayments, a small investor basefor distressed ABS, negative performance momentum). In distressed ABS valuation,the market expects that 1) fewer dealers will bid distressed paper, 2) bids will not beaggressive, and 3) there will be considerable dispersion of valuations among dealers.

Market participants also generally agree that over time, valuation accuracy is likelyto improve, as more information is received, and potential buyers emerge. However,finding a minimum number of bids for distressed ABS may still be difficult. Incontrast to the corporate market, there is a less active market for trading distressed


Chart 5: ABCDS cash settlement

Source: JPMorgan.

Protection

Seller

Protection

Seller

CDSPremium

CDSPremium

Protection

Buyer

Protection

Buyer JPMorganJPMorgan(1 – Dealer poll price)

(1 – Dealer poll price)

13

ABS names (in part, because there are relatively few distressed names),comparatively little research on distressed ABS, and frequently greater uncertaintyon the timing and amount of final recoveries.

Another key question for cash settlement is whether dealers will bid (at all), and/orat realistic levels in order to make the settlement process work. In order to protectagainst dealers bidding too low, some contracts allow the protection seller to alsosubmit a bid. To guard against bids being too high, the protection buyer may beable to hit the highest bid with a funded total return swap.

For cash settled ABCDS, these issues will present some challenges once a creditevent has occurred.

“Pay As You Go” / Physical SettleUS HEL ABS settlement will most likely be defined as “Pay As You Go” (PAYG)with a physical settlement option. PAYG differs from cash and physical settlementin that a single payment (or exchange of bond for par) may not take place. UnderPAYG, protection sellers make contingent cash payments equivalent to anywritedowns on the bond as the writedowns on the bond occur. The rationale forPAYG settlement is that HEL losses are reversible, can occur over an extendedperiod of time, and there is also the potential for “short squeezes” if contracts couldonly be physically settled given the relatively small sizes of mezzanine HELtranches. PAYG contracts also typically give the protection buyer the right, but notthe obligation, to physically settle the contract. In addition, PAYG does allow forpartial physical settlement if the protection buyer is unable to secure the full contractamount in the cash bond market.

PAYG settlement presents some operational challenges because writedowns arelikely to occur over an extended period of time. Furthermore, a reduction in thewritedown amount (e.g., a “writeup”) can also take place. In some contracts, a“writeup” would require the protection buyer to pay the subsequent “writeup” backto the seller.



Chart 6: ABCDS “pay as you go” / physical settle

Source: JPMorgan.

Protection

Seller

Protection

Seller

CDSPremium

CDSPremium

Protection

Buyer

Protection

BuyerJPMorgan WriteupsWriteups

PAYGWritedowns

PAYGWritedowns

BondBond

PhysicalPar

PhysicalPar


14

Other ConsiderationsHome Equity Available Funds CapThe available funds cap embedded in Home Equity ABS pose additionalrequirements for ABCDS contracts. The issue arises since the underlying cash bond’spass-through rate is defined as the lesser of the available funds cap, which is theweighted average expense adjusted net mortgage rate, and the bond’s spread plus itsindex (for floating rate securities). In the event that the available funds cap is hit, thecash bond holder’s effective spread over its benchmark would be reduced. Toaccount for this in an ABCDS, if the underlying bond were to hit the available fundscap, the protection buyer’s fixed payments would be haircut, reflecting the actualcoupon received on the cash ABS. The implication of this haircut is that ABCDScontracts will not strip out the available funds cap risk embedded in the underlyingcash bonds. In the event that the available funds cap shortfall is reimbursed in futureperiods, the protection buyer’s fixed payments would be increased by that amount.

The issue becomes more complicated when the cash bond is trading at a discount orpremium when the ABCDS is executed. In either case, the coupon being paid on thecash bond is different than the ABCDS premium which is expected to be initiallyexecuted as a par contract. For example, if the cash bond is trading at a premium,the cash bond would hit the available funds cap before the theoretical strike youwould have if you were using the lower ABCDS premium. In this example, oncethe cash bond hits the available funds cap, the fixed payments would be reduced bythe shortfall amount.

For simplicity of trading, the market is gravitating towards making the syntheticslook as close to the cash bonds as possible. At this point, the exact mechanics ofhow to handle the available funds cap remain under discussion.

CDOs of ABSFor ABCDS put into CDOs, the rating agencies have concerns about accuratevaluations in a cash settlement. To address these concerns, the rating agencies“haircut” recovery value estimates for ABCDS that use a short settlement period.Moody’s scales its recovery value based on the type of security, the perceivedliquidity in that sector and the length of the settlement period (Table 2). S&Preduces recovery values based on the length of the settlement period.

Most synthetic CDO trades use a long cash settlement period to avoid rating agencyhaircuts in order to reduce their required credit enhancement. If ABCDSdocumentation uses shorter settlement periods, existing CDOs will have adocumentation mismatch (short settlement in single name ABCDS, versus a twoyear settlement in existing CDO ABCDS).


Table 2: Moody’s Recovery Values by Settlement PeriodTime to Settlement Liquid Securities Illiquid Securities3 Months 25% 15%6 Months 75% 50%1 Year 95% 65%2 Year 100% 90%Source: Moody’s. Liquid securities include senior tranches of Automobile ABS, CF CBOs/CLOs, CMBS, Cards, Consumer Loan ABS,HEL ABS, RMBS, Italian Government ABS, Student Loan ABS, all tranches of static CDOs, wrapped tranches depend on underlying.

15



The authors would like to thank Paul Glasgow for his knowledge andinsights on the CDS market.

In synthetic CDOs of ABS, a minimum recovery rate may be stated for each asset inthe portfolio. If dealer quotes are below this stated recovery rate, the asset managermay defer settlement until the next quotation period. If the asset manager deferssettlement, the valuation process will extend in a similar way to that describedabove, and the asset manager deferment option will continue over a defined period(e.g., 1 year). Typically, the asset manager may accept a valuation below theminimum recover rate after a specified period.

ConclusionThe ABCDS market will continue to grow as documentation becomes standardizedand more buyers of protection emerge. ABCDS will help to transform the ABSmarket and not only increase the scope of the market but also its depth as newplayers enter. A liquid ABCDS market represents an important building block for anincreased flow of complex trades, such as ABCDS indices, first-to-default baskets,etc. and the development of ABS correlation books. However, due to the relativecomplexity of ABCDS and the underlying referenced entities, at this point it remainsunclear whether the single name ABCDS market will ever offer the size and liquidityavailable in Corporate CDS.

Analyst CertificationThe analyst(s) denoted by an “AC” certifies that: (1) all of the views expressed in this research accurately reflect his or herpersonal views about any and all of the subject securities or issuers; and (2) no part of any of the analyst’s compensation was,is, or will be directly or indirectly related to the specific recommendations or views expressed by the analyst(s) in this research.

Research DistributionTo amend research distribution please

contact Kathryn Burfitt, Research Administration, (212) 270-0740,

[email protected]

Analysts’ Compensation: The research analysts responsible for the preparation of this report receive compensation based upon various factors, including the quality and accuracy of research, client feedback, competitive factorsand overall firm revenues. The firm’s overall revenues include revenues from its investment banking and fixed income business units.

Principal Trading: JPMorgan and/or its affiliates normally make a market and trade as principal in fixed income securities discussed in this report.

Legal Entities: JPMorgan is the marketing name for JPMorgan Chase & Co. and its subsidiaries and affiliates worldwide. J.P. Morgan Securities Inc. is a member of NYSE and SIPC. JPMorgan Chase Bank, N.A. is a member ofFDIC and is authorized and regulated in the UK by the Financial Services Authority. J.P. Morgan Futures Inc., is a member of the NFA. J.P. Morgan Securities Ltd. (JPMSL) is a member of the London Stock Exchange and isauthorized and regulated by the Financial Services Authority. J.P. Morgan Equities Limited is a member of the Johannesburg Securities Exchange and is regulated by the FSB. J.P. Morgan Securities (Asia Pacific) Limited (CEnumber AAJ321) is regulated by the Hong Kong Monetary Authority. JPMorgan Chase Bank, Singapore branch is regulated by the Monetary Authority of Singapore (“MAS”). J.P. Morgan Securities Asia Private Limited is regulatedby the MAS and the Financial Services Agency in Japan. J.P. Morgan Australia Limited (ABN 52 002 888 011/AFS Licence No: 238188) (JPMSAL) is a licensed securities dealer.

General: Information has been obtained from sources believed to be reliable but JPMorgan does not warrant its completeness or accuracy except with respect to any disclosures relative to JPMSI and/or its affiliates and theanalyst’s involvement with the issuer. Opinions and estimates constitute our judgment as at the date of this material and are subject to change without notice. Past performance is not indicative of future results. The investmentsand strategies discussed here may not be suitable for all investors; if you have any doubts you should consult your investment advisor. The investments discussed may fluctuate in price or value. Changes in rates of exchangemay have an adverse effect on the value of investments. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. JPMorgan and/or its affiliates and employees may act as placementagent, advisor or lender with respect to securities or issuers referenced in this report. Clients should contact analysts at and execute transactions through a JPMorgan entity in their home jurisdiction unless governing law permitsotherwise. This report should not be distributed to others or replicated in any form without prior consent of JPMorgan.

U.K. and European Economic Area (EEA): Investment research issued by JPMSL has been prepared in accordance with JPMSL’s Policies for Managing Conflicts of Interest in Connection with Investment Research. This reporthas been issued in the U.K. only to persons of a kind described in Article 19 (5), 38, 47 and 49 of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 (all such persons being referred to as “relevantpersons”). This document must not be acted on or relied on by persons who are not relevant persons. Any investment or investment activity to which this document relates is only available to relevant persons and will be engagedin only with relevant persons. In other EEA countries, the report has been issued to persons regarded as professional investors (or equivalent) in their home jurisdiction.

Australia: This material is issued and distributed by JPMSAL in Australia to “wholesale clients” only. JPMSAL does not issue or distribute this material to “retail clients.” The recipient of this material must not distribute it to any thirdparty or outside Australia without the prior written consent of JPMSAL. For the purposes of this paragraph the terms “wholesale client” and “retail client” have the meanings given to them in section 761G of the Corporations Act 2001.

Korea: This report may have been edited or contributed to from time to time by affiliates of J.P. Morgan Securities (Far East) Ltd, Seoul branch.

Revised November 12, 2004

Copyright 2004 JPMorgan Chase & Co. All rights reserved. Additional information available upon request.

JPMorgan uses the following rating system: Overweight (we expect the bond to outperform the average total return of the bonds in the analyst’s (or analyst’s team’s) relevant sector), Neutral (we expect the bond to perform thesame as the average total return of the bonds in the analyst’s (or analyst’s team’s) relevant sector), and Underweight (we expect the bond to underperform the average total return of the bonds in the analyst’s (or analyst’s team’s)relevant sector).

*JPMSI or an affiliate has managed or co-managed an offering of securities within the past twelve months.^A senior employee, executive officer, or director of JPMSI and/or its affiliates is a director of the company.

J.P. Morgan Securities Inc.270 Park Avenue

New York, N.Y. 10017Tel. (212) 270-0740

J.P. Morgan Europe Ltd.125 London Wall

London EC2Y 5AJTel. (44 20) 7777-1821

J.P. Morgan Securities(Asia Pacific) Ltd. Chater House, 26/F8 Connaught RoadCentral, Hong Kong

Tel. (852) 2800-7000

J.P. Morgan Securities Ltd.60 Victoria Embankment

London EC4Y 0JPTel. (44 20) 7600-2300

J.P. Morgan Securities AsiaPte. Ltd.

Akasaka Park Building2-20 Akasaka 5-chome

Minato-ku, Tokyo 107-6151,Japan

Tel. (813) 5573-1185

abs cds

Documents