Aside from one's long-term views on the U.S. housing market, the new and relatively untested nature of the ABS CDS market has some wondering whether investors will agree as to who owes what - along with when and how. While many strides are being made toward further standardization for the trades and their documentation, new types of players in the sector and the specter of counterparty risk are two often-voiced concerns. What's more, a case on appeal to the United States Court of Appeals for the Second Circuit could call into question whether the contracts actually stand up in court.
Market players emphasize maintaining stability and confidence in the burgeoning ABS CDS sector is in the best interest of everyone involved. The increasingly poor performance of the bonds referenced in many of the trades, however, has definitely drawn new participants to this complex sector, many of which are hedge funds. The ability for subprime mortgage borrowers to pay their monthly mortgage payments is crumbling in some cases, amid slowing home price appreciation and looser underwriting standards. Mortgages originated in 2005 and 2006 - the two most widely referenced vintages in ABS CDS contracts - are expected to bear the brunt of poor conditions (see article on page 1).
The ongoing two-way aspects of ABS CDS trades, according to industry experts, causes more of an emphasis on so-called counterparty risk - or the chance that one of the parties will either renege on, or dispute, their side of the contract. Under the increasingly popular pay-as-you-go (PAUG) CDS format, protection buyers and sellers exchange payments throughout the life of the contract - which generally has a matched maturity to the life of the underlying reference obligation. Also, in contrast to the corporate CDS market, protection buyers make a premium payment on the contract to the seller monthly, as opposed to quarterly.
Technical issues surrounding ABS CDS contracts are slowly being ironed out - such as standardizing the cash settlement option across a wide range of products, among other initiatives. And while it may take a while for agreements to be reached when creating standardized forms, it is in the industry's best interest. "People always want to dispute what is going to happen in terms of their interpretation of the language," said derivatives expert Janet Tavakoli, founder and president of Chicago-based consultancy Tavakoli Structured Finance. "We've had a lot of back-and-forth with CDS language when it comes to ABS. It is really only going to be a problem if people dispute the language." In fact, a lack of standardization could be more costly to investors, explained Richard Schetman, a capital markets partner in the New York office of Cadwalader, Wickersham & Taft LLP. "To the extent you start modifying things, your trade becomes different than other trades, and if there are dealers trying to hedge a book, they may charge you more," Schetman said.
Court battles over terms of the contracts would also likely be long, time consuming, and of uncertain outcome. "The more you can get reasonable people to come to an agreement and stay out of court, the more helpful it is to everybody," Tavakoli said. The two biggest risks when headed to court are that of a waste of time and money - along with the threat of a surprise ruling that could have lasting implications for the industry, she added.
Court can bring unintended consequences
What was called a complete misunderstanding by a district court judge of a credit derivatives contract is causing some to raise an eyebrow at the clarity of credit default swap documentation. The Southern District Court of New York in February ruled that the French bank Societe Generale, as a protection seller in a CDS transaction, pay the buyer and plaintiff Aon Financial Products, a division of Aon Corp. $10.1 million despite its failure to deliver bonds to SG - and according to industry professionals, the decision was based on an entirely separate derivatives contract and viewed SG as more of a guarantor than a CDS party. The case is pending decision on appeal in the second circuit court of New York, according to a spokesman for SG.
"If in fact the district decision is upheld, it will throw the whole settlement mechanic in CDS in disarray," said Anthony Nolan, a partner in the securitization and derivatives group at Goodwin Procter LLP. "You (would) have a real incentive on the part of anybody who gets the bad end of a deal to just ignore his contract."
In 1999, Aon had purchased $10 million in credit default protection from SG on $500 million of debt issued by the Republic of Philippines. Aon did so in order to hedge a separate transaction in which it sold $10 million in credit protection to Bear Stearns on a surety bond issued by the Philippines' Government Service Insurance System. Aon successfully managed to argue that because the SG transaction was made in connection with the Bear transaction in order to hedge against potential losses, the SG swap therefore guaranteed payment in the case that they did incur losses in the Bear transaction, according to court filings, despite two completely different CDS contracts. "The basic error," according to SG's appeal, was "the finding that the two swaps hedged against the same risk on the same terms."
The case, however, is being called more of an anomaly than a sign of things to come in terms of legal disputes in the sector. "I think that will be a very small segment of the market," Nolan said.
Efforts to maintain stability
In a move that could serve as a future model for ABS CDS dispute resolution, International Swaps and Derivatives Association (ISDA) is looking for a council of experts that could help to mitigate disagreements between credit default swap counterparties in one aspect of the trades - what constitutes a deliverable obligation. While the actual process that would guide counterparties through resolving disputes is already completed, the search for the right types of experts - namely, those not perceived to harbor a bias - could hold up the implementation of the new guidelines, which may or may not coincide with ISDA's 2007 credit definitions expected out late next year, Kimberly Summe, ISDA's general counsel, said. ISDA members had been working over the summer to draw up the set of standards to deal with dispute resolution in regard to deliverable obligations.
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