LOS ANGELES - As industry representatives work to form a standardized framework for trading credit default swaps that reference CDOs, perhaps the biggest roadblock to completion is how to handle the write-down provision of the swaps. A CDO is not immediately written down following a credit event, making it difficult for parties betting on the deal's performance to either collect or make payments in a timely matter, said speakers at the Asset Securitization Forum's Sunset Seminar held here last week.
Much anticipation surrounds the release of standardized documentation for CDO CDS trades, yet the push and pull between various sides of the CDO sector has left the documentation unfinished thus far. In large part, market participants are looking forward to the opportunity to short the CDO sector. According to JPMorgan Securities, increased CDO CDS liquidity could result in increased CDO spread volatility. Groups that were coordinated by International Swaps and Derivitives Association have been meeting for months in order to develop a set of rules for the trades.
Under the ISDA's initial template for trading CDS of ABS using the pay-as-you-go settlement procedure, the seller of protection pays the buyer when events such as an interest shortfall, a write-down, or a principal shortfall occur with respect to the underlying instrument. However, a CDO is typically not written down until right before the end of its life, according to Josh Anderson, senior vice president and portfolio manager at Pacific Investment Management Co. Credit default swap protection buyers, he said, are not going to want to wait between 20 and 30 years to receive a credit event-related payment from their swap counterparty.
So the ISDA, according to Anderson, is gravitating toward adding a toggle for the implied write-down feature in CDS of CDOs based off the CDO's overcollateralization ratio. If a given tranche were undercollateralized based on pre-determined standards, the seller of protection would need to make a payment. The undercollateralization, however, could cure itself down the road, making for a sticky situation, he pointed out. Additionally, explaining toggles to potential clients is not an ideal scenario, he said.
"I can't tell you, trading this stuff, how difficult these toggles are," Anderson said. As participating firms weigh in on which kind of confirmation they'd like, PIMCO is fighting for an implied write-down with a fixed cap, he said.
Roland Ho, a managing director at Trust Company of the West, would not comment on the developing confirm other than to say TCW is using total return swaps for now when synthetically referencing CDOs because there are so many problems with the continued efforts to create the ISDA CDO CDS documentation.
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