With the increasing number of collateralized bond obligations of asset-backed securities (CBOs of ABS), market participants are finding new ways of addressing liquidity and liability issues.
A fairly recent development in this area is the introduction of cashflow or liquidity swaps to CBOs of ABS.
"What we've seen so far and some of the recent deals suggest that there's a higher percentage of CBOs of ABS with a significant concentration of CBOs, making it necessary for these deals to have a liquidity swap," said Phillip Mack, vice president and senior analyst at Moody's Investors Service.
The liquidity swap provides a temporary source of funds whenever there is a shortfall in the payments of interests to the senior note holders.
A shortfall in funds may occur because a CBO containing collateral with ratings A3 and below is allowed to "PIK" (Pay in Kind). PIKing means that the CBO can defer interest payments on these assets and capitalize them in the future. In cases like this, the CBO can miss a coupon payment and would not be considered in default because as the coupon accumulates, there is the chance that the capitalized coupon will be paid at the end of the deal.
So, if for instance 20% of a CBO's underlying collateral is "PIKable," and they all "PIK" - meaning the assets are accruing interest and not paying - this might affect the ability of the collateral to pay the senior and junior note holders. When this happens, a liquidity swap can step in and be applied to the "non-PIKable" portions of the liability, which are liabilities rated better than A3.
Morever, the introduction of liquidity swaps to recent CBOs of ABS transactions has allowed these CBOs to buy up to 30% of "PIKable assets," said David Wolf, vice president at West LB.
"With a cashflow swap we can essentially advance interest so that the CBO can make current payments on the triple-A notes, though interest is coming in currently to pay the notes that the CBO is issuing," he added.
West LB served as a cashflow and interest rate swap provider on two recent deals: PPM America Structured Finance CBO I Ltd. and Talon Funding I Ltd.
The PPM deal, which was rated by Moody's, was worth $300 million. Credit Suisse First Boston led the offering.
Meanwhile, the $375 million Talon deal was rated by Moody's and Standard and Poor's Ratings Services. The offering was led by Lehman Brothers.