An ABS is a transaction in which the financial institution that originated a portfolio of, say, car loans borrows money using the car loans as collateral. The financial institution sells the portfolio of car loans to a special purpose vehicle, which pays for the assets by issuing tranches of sequentially ranking debt – the asset backed securities. However, similar to balance sheet CDOs, the originating financial institution generally retains the equity (first loss) tranche. These ABS tranches are always rated, as most investors require a rating, and most deals comprise a cascade of liabilities rated from triple A down to double or triple B.
Unlike credit default swaps on corporates or financials which reference the issuer or reference entity, credit default swaps on ABS reference a particular class of notes from a particular ABS issuer. This is because the issuer of ABS – the special purpose vehicle – is bankruptcy remote. More importantly, all the different tranches of the securitisation have very different probabilities of experiencing a loss.
Asset-backed securities also have other characteristics that need to be taken into account in the credit derivative documentation. For example, asset-backed securities generally amortise the principal over time rather than making a bullet payment at maturity. This feature can leave a protection buyer holding a contract on a bond that no longer exists.
Also, some asset-backed securities, unlike most corporate bonds, are permitted to miss interest payments if there are insufficient funds to make the payment – this is generally called interest shortfall. In addition, asset-backed securities can be written down (have their face value reduced) if they are affected by losses in the portfolio. This is referred to as a loss allocation or a principal writedown. But in many cases the principal can be written back up again if the performance of the underlying portfolio subsequently improves.
These characteristics and others mean that an ABCDS contract needs to have a unique set of definitions for credit events, a unique settlement process and also needs to take into account principal amortisation among other things. Given the differences between ABS on different asset classes, it is unlikely there will ever be one standard contract for all ABS credit default swaps. However, by early 2006 identifiable standards were beginning to emerge for different types of ABCDS, such as those on US ABS, European ABS and US CMBS.
The contract to date that has received the most attention is the one primarily used for US home equities, called pay-as-you-go or PAUG/PAYG. Unlike with a corporate credit default swap – where the protection seller only ever makes a single payment, following a single credit event – in a pay-as-you-go ABCDS, the protection seller compensates the protection buyer for losses on principal as they are allocated to the reference ABS, as well as interest shortfalls. However, if principal or interest is reimbursed, the protection buyer has to pay this amount back to the protection seller, and in the case of interest reimbursements, generally with interest as well.
Payments can be exchanged between the two counterparties in this way throughout the life of the trade. However, anytime there is a principal writedown, the protection buyer can choose to physically settle the credit default swap by delivering the ABS to the protection seller and receiving par in return.
This potential two-way exchange of payments throughout the life of the trade means that the protection seller needs to worry about the counterparty risk of the protection buyer. This is another big difference from a corporate credit default swap, where generally only the protection buyer is worried about the risk that the counterparty will default. (The protection seller’s only risk to the protection buyer is the relatively small amount of premium.)
ABS credit default swaps also differ from corporate contracts in that protection payments are usually made monthly rather than quarterly. In addition, the maturity of the ABS contract is usually the same as the term of the bond, which means that ABS credit default swaps can have very long maturities, of as much as 80 years.