Imagine the embarrassment of a synthetic CDO manager when, forced to purchase the par amount of a referenced asset gone bad, also has to suck up nearly the entire amount of the deal's excess credit enhancement in order to fund the purchase, consequently causing a rash of downgrades.

While that scenario is not likely due to upfront contract modifications made on such deals, as more and more synthetic ABS transactions come to the market utilizing the International Swaps & Derivatives Association's relatively new pay-as-you-go (PAUG) template, along with variations of it, investors will now need to pay close attention to the nuances within contracts, according to a recent report by Fitch Ratings.

In particular, synthetic CDOs generally need to modify the contracts, which seek to mirror the economics of cash instruments, in order to avoid logistical problems in regard to settlement procedures. ISDA's June release of the PAUG form, created to help two-way settlement of credit events for non-corporate synthetics, is likely to be followed by additional settlement forms for CDOs and "more traditional" structured finance deals, according to Fitch. In the meantime, certain aspects of the settlement procedures should warrant special attention.

For example, in contrast to non-PAUG contracts, the PAUG contract issued by ISDA mimics cash assets by incorporating two-way credit events. The events allow the protection buyer an overriding option to physically settle all or a part of the reference asset, instead of simply settling the asset on an ongoing two-way basis, according to Fitch. That means that if the protection buyer is able to deliver the reference asset, the seller could be subject to a physical settlement process. The protection buyer in this case is charged with paying the par amount in exchange for the actual physical reference asset, consequently removing that asset from the deal's reference portfolio.

Fitch points out that the actual physical settlement procedure could be logistically impossible, given that more than one party is likely to reference the same asset. As well, structured finance credit default swaps are able to reference any dollar amount of the portfolio, say, $400 million, even though only $20 million of the portfolio may still be outstanding.

While CDO managers typically modify PAUG contracts in order to avoid mandatory cash settlement of distressed ratings downgrades and maturity extensions, they are technically listed as two-way credit events within the ISDA form contract. Other credit events often used, which allow for a physical settlement option, include failure to pay principal, writedown, distressed ratings downgrade - typically to the triple-C level - and maturity extension.

In order to avoid consuming the excess credit enhancement for the wrong reason, where physical settlement procedures are allowed in synthetic CDOs, the contracts should be modified so that the manager could sell the reference asset it was required to purchase, or, that additional liquidity could be applied in such a scenario. "Physical settlement is a more complicated option for synthetic CDOs using the PAUG template," Fitch wrote, explaining that it may not be the best method for determining when or if a synthetic CDO has eaten through an unfunded first-loss piece or breached an attachment point.

Also, instead of allowing a protection buyer to enjoy the liberty of heading up the valuation process, the best bet is to include stipulations that settlement not occur until unfunded first-loss pieces are eaten away or attachment points are in fact breached. If two-way settlement procedures are used for credit events within synthetic CDOs, the settlements should be based on actual losses to the reference obligation, without the need for valuation.

(c) 2005 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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