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Fixed Income Research

ABS Credit Default Swaps–A Primer

December 9, 2005 SUMMARY
Credit default swap technology has arrived in the ABS market, opening up new ways to
Strategy acquire ABS exposure, hedge risks, and express relative value views. The market for asset-
212-526-8312 backed credit default swaps (ABCDS) is expanding at an exponential pace. Leveraging off
David Covey recently standardized ISDA documentation and the considerable development that occurred
Michael Koss in corporate credit default swaps (CDS), investors have jumped right in, pushing trading
Akhil Mago
volumes in subordinate home equity loans ABS beyond those of cash instruments. We
Sihan Shu
Jasraj Vaidya provide an introduction to the ABCDS market and discuss the mechanics, pricing, and
Brian Zola applications of ABCDS.

Quantitative Research The Nuts and Bolts: Mechanics of ABS CDS

Dick Kazarian Asset-backed securities are unique in a number of ways. Among the unique features of asset-
Dan Mingelgrin backed securities that CDS on ABS must handle are amortizations and prepayments, AFC
Stefano Risa risk, timing of principal writedowns, and reversible writedowns and interest shortfalls.
Vivien Huang ABCDS address these characteristics through a combination of a “pay-as-you-go” (PAUG)
Gaetan Ciampini
structure, a physical settlement option, and some uniquely defined terms in the contract.
Omer Brav
While the contracts have been standardized for the most part, some components, including
the treatment of interest shortfalls, may vary from swap to swap.

The Basics on the Basis: Valuation Considerations

An asset-backed security and the CDS on it provide investors with very similar exposures.
There are, however, both fundamental and technical factors that can keep the CDS basis, the
difference between the CDS premium and the spread of the underlying bond, from finding a
home at zero. These include bond funding costs, interest shortfall caps, and prepayment risk.
Higher bond funding costs should result in a lower (or more negative) basis, as CDS
investors do not explicitly fund their positions. Higher premiums and repo “haircuts” also
pressure the basis downward, while ABS CDO liability spreads may push it higher or lower.

A Whole New World: Applications of ABCDS

The extension of CDS technology to ABS products provides new opportunities for
investment and credit risk management. By transforming ABS away from a long-only
market, ABCDS allow investors to take short positions, hedge exposures, and engage in
relative value tranche, vintage, and issuer trading, which were heretofore impossible.

Looking into the Crystal Ball: Concluding Thoughts

ABCDS will certainly help broaden the investor universe of ABS and enhance liquidity in
the market. Things to look out for in the future are the launch of the ABX, a series of basket
ABCDS products, growth in synthetic CDO activity, and “bespoke” or customized synthetic
ABCDS trading.


Lehman Brothers | MBS & ABS Research ABS Credit Default Swaps—A Primer


Summary ..............................................................................................................................1
Introduction ..........................................................................................................................3
A Brief Review of CDS Basics ............................................................................................3
Unique Features of ABS.......................................................................................................4
The Nuts and Bolts: Mechanics of ABCDS .........................................................................5
The Basics on the Basis: Valuation Considerations ...........................................................10
A Whole New World: Applications of ABCDS.................................................................17
Looking into the Crystal Ball: Concluding Thoughts.........................................................17
Appendix: Asset-backed CDS vs. Corporate CDS.............................................................19

Acknowledgements and Recommendations for Further Reading

The ABS Research team would like to thank all of our colleagues who helped in the development of this
publication, including Jeong Gu Lee, Jeff Mudrick, Ashish Shah, and the MBS and CMBS strategy teams.

Additional sources of information on home equity loan ABS and credit derivatives include the following,
which are available on

• Credit Default Swaps in CMBS: An Introduction, Barve and Lee, November 2005
• The ABCs of HELs, Heike and Mago, December 2004.
• Valuation of Credit Default Swaps, O’Kane and Turnbull, April 2003
• Explaining the Basis: Cash versus Default Swaps, O’Kane and McAdie, May 2001
• Credit Derivatives Explained, O’Kane, March 2001

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Lehman Brothers | MBS & ABS Research ABS Credit Default Swaps—A Primer

The arrival of credit default swap technology to the ABS market provides investors with
both new opportunities to acquire ABS exposure and better mechanisms to manage risk.
The market for asset-backed credit default swaps (ABCDS) has grown rapidly. Leveraging
off recently standardized ISDA documentation and utilizing expertise developed in the
market for corporate credit default swaps (CDS), investors have jumped right in, pushing
trading volumes in subordinate home equity loan ABS beyond those of cash instruments.

As is the case with issuance, home equity loans (HEL) currently dominate the ABCDS
market. The vast majority of swaps have been single-name contracts referencing
subordinate HELs. The landscape is likely to change, not only due to greater awareness of
the new investment tool, but also due to the introduction of indices known as the ABX.
Currently under development by a consortium of dealers, the ABX indices will allow for
trading in benchmark baskets of CDS, through which investors can gain or short exposure
to a number of securities in one contract. It is scheduled for an early 2006 launch date.

In this primer, we provide an introduction to ABCDS and discuss the mechanics, pricing,
and applications of ABCDS. While we highlight through examples CDS on floating-rate
home equity loan ABS, the structures, valuation issues, and applications are very much
applicable to all ABCDS. For those familiar with corporate CDS, we review the key
differences between corporate and ABS CDS in the appendix.


A CDS is an insurance A credit default swap is essentially an insurance contract, providing the buyer with protection
contract, providing the buyer against specific risks. The “protection buyer” pays a periodic premium to the “protection
with protection against seller,” and in return, receives payments to cover losses from default on a reference bond
specific risks. (Figure 1). The protection seller is in a similar position to a buyer of the bond itself, as they
takes on the bond’s credit risk through the CDS, without having to fund it, or for that matter,
find it. The protection buyer has an exposure similar to that of a short position in the bond.

Figure 1. Basic CDS Structure

CDS Premium
Protection Buyer Protection Seller
"Short" the credit risk "Long" the credit risk
Payments only if credit event occurs

When a credit event occurs, In the most plain-vanilla CDS, the protection seller makes a payment to the buyer only when
CDS can be settled with cash a “credit event,” such as issuer bankruptcy or failure to pay principal, occurs. When a credit
or physical delivery. event does occur, the contract usually terminates in one of two ways: physical settlement or
cash settlement (Figure 2). In a physical settlement, the buyer of protection delivers the
defaulted bond to the seller and receives par in return. In a cash settlement, the buyer of
protection receives the net difference between par and the market price (also known as the
recovery value) of the defaulted security. In this case, a process involving multiple dealer
bids is often used to determine the market price of the bond. Investors have similar economic
exposure under either type of settlement.

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Lehman Brothers | MBS & ABS Research ABS Credit Default Swaps—A Primer

Figure 2. Physical versus Cash Settlement upon a CDS Credit Event

Physical Settlement
Protection Buyer Protection Seller
Par value of bond

Cash Settlement
100- Recovery Rate
Protection Buyer Protection Seller


ABS have several unique From a bird’s-eye view, the mechanics of ABCDS are very much in line with those of
features that ABCDS generic CDS. There are, however, several unique features of the asset-backed securities that
must handle. CDS on ABS must handle, and which make the swaps unique themselves. We briefly discuss
these features below.

• Amortization and Prepayments: Most ABS have principal that is paid over time and
are subject to some amount of prepayment uncertainty. The outstanding notional of an
ABS declines with scheduled principal payments, voluntary prepayments, and defaults.

• AFC Risk: Most HEL securities have coupons that are capped at the net weighted-
average coupon (net WAC) of the collateral. This cap, known as the available funds cap
or AFC, can result in “interest shortfalls” on the bond equal to the difference between
the “expected” coupon (i.e., LIBOR + coupon spread) and the actual coupon received.

• Timing of Principal Writedowns: Principal losses on ABS occur over time, whenever
losses on the collateral in the trust exceed the credit enhancement available for the bond.
This contrasts with corporate or sovereign debt, where a failure to pay principal is a one-
time event of default.

• Reversible Writedowns and Shortfalls: In most structures, interest shortfalls and

principal writedowns in one month can be reimbursed or reversed at a later date. The
former can be repaid from excess spread in later months, usually with accrued interest
(this is known as the “interest carry-forward” feature in ABS). The latter can be reversed
if credit performance of the collateral improves, resulting in a “writeup” of principal
(without accrued interest).

• Clean-up Calls: Virtually all ABS transactions have a clean-up call feature, which gives
the issuer the right to purchase the collateral remaining in the trust when the deal balance
falls to 10% or less of the original amount. If the call option is not exercised, the coupon
spread on many HELs “steps up” to 1.5-2.0 times the original amount.

• Lack of Homogeneity: No two ABS bonds are truly alike. ABS vary due to
differences in collateral, seasoning, deal structure, servicer, and a host of other factors.
Additionally, non-AAA ABS are issued in relatively small sizes; the size of the BBB-
tranche of a $2 billion HEL transaction, for example, may not exceed $10 million. The
lack of homogeneity coupled with small tranche sizes keep the liquidity of some ABS
limited relative to other bonds.

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Lehman Brothers | MBS & ABS Research ABS Credit Default Swaps—A Primer


ABCDS address these characteristics through a combination of a “pay-as-you-go”
structure and some uniquely defined terms in the contract. For example, to address
amortizations and prepayments, the notional amount used to calculate premiums decreases
over time, in line with that of the underlying bond. As with many derivative products,
understanding the nuances of ABCDS is critical—the devil is in the details, as they say.
Below, we define some key terms of ABCDS, and then follow with the details of ABCDS
payment mechanics and an illustrative example.

Reference Entity
The reference entity of Because each ABS is unique, the referenced entity in each ABCDS is a single ABS security.
ABCDS is a single This is in contrast to corporate CDS, where the reference entity is effectively an issuer rather
ABS security. than an issuer’s bond. Each ABCDS is written on a specific security, and only the status of
that bond (e.g., prepayments, writedowns, interest shortfalls, etc.) is relevant to the parties in
the contract.

Maturity Date
The scheduled maturity of The scheduled maturity date of ABCDS is the legal final maturity date of the reference bond.
ABCDS is the legal final The effective maturity date of ABCDS is the earlier of the legal final maturity date and the
maturity of the date when the reference cash bond is fully paid off or written down. The strictly defined
reference bond. maturity addresses the issues regarding prepayment uncertainty and the timing of losses.

Credit Events
There are generally four “credit events” as defined in ABCDS:

• Failure-to-pay: The reference cash bond fails to pay all principal by the legal final
maturity date.
• Writedown: The balance of the reference cash bond is written down.
• Distressed rating downgrade: One of the three major rating agencies downgrades the
reference cash bond to Caa2/CCC or below.
• Maturity extension: The legal final maturity date of the reference cash bond is

Failure to pay and writedowns are common in all ABCDS, but some contracts may not
include distressed rating downgrade or maturity extensions as credit events. In any case,
when a credit event occurs, the protection seller is typically required to make a payment to
the protection buyer, who, as discussed below, has the right to terminate the CDS through a
physical settlement.

It is important to note that non-payment of interest is not a credit event in ABCDS, although
it does trigger a payment to the protection buyer. Additionally, ABCDS do not include
bankruptcy as a credit event, since ABS bonds are issued by a bankruptcy-remote special
purpose vehicle.1

The Pay-As-You-Go System

ABCDS are structured as To handle principal writedowns that occur over time and relatively limited liquidity in some
“pay as you go” with a ABS bonds, ABCDS are structured as “pay-as-you-go” (PAUG) contracts with a physical
physical settlement option. settlement option. If a credit event occurs, the buyer of protection has the option, in whole or

The bankruptcy of the collateral servicer or any guarantor insuring bond investors against losses would not
constitute a credit event in an ABCDS, but may lead to a rating downgrade credit event.

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Lehman Brothers | MBS & ABS Research ABS Credit Default Swaps—A Primer

in part, to terminate the CDS contract by physical settlement, delivering the bond to the
protection seller in exchange for par in return. This may be an option for investors who own
the bond or can find it in the secondary market, but in practice, this will often prove
challenging. Allowing investors to use the PAUG alternative mitigates issues that can arise
when many investors (e.g., protection buyers) try to source bonds that are in short supply.

As the term implies, under PAUG, the CDS contract remains outstanding, and the protection
seller makes payments equal to the writedown amount and, to some extent, interest shortfalls.
The buyer continues to make premium payments based on the notional of the ABCDS
contract adjusted for writedowns and paydowns.

There are three payment “legs” to each ABCDS contract: a fixed payment leg, a floating
payment leg, and an additional fixed payment leg (Figure 3). The “fixed” payment is simply
the premium paid by the buyer of protection, a fixed percentage of notional. The “floating”
payments are made by the protection seller, representing writedown amounts, interest
shortfall amounts, and principal shortfall amounts (principal shortfalls are defined as unpaid
principal at the legal final maturity of the reference bond). The “additional fixed” payments
are made by the buyer, and consist of any reimbursements for reversed writedowns and
shortfalls. Of course, such payments are not truly “fixed,” but are labeled as such because
they flow in the same direction as the “fixed” leg CDS premium.

Figure 3. Pay-As-You-Go Payment Mechanics

Payment To / From Amount(s)

Fixed payments Buyer to Seller CDS Premium
Floating payments Seller to Buyer Principal writedowns
Interest shortfalls (up to cap)
Principal shortfalls
Additional fixed payments Buyer to Seller Reversed principal writedowns
Reimbursements of interest shortfall payments
Reimbursements of principal shortfalls

Interest Shortfall Mechanics

ABCDS offer three ways to ABCDS typically handle interest shortfalls (e.g., AFC risk) through one of three shortfall cap
deal with interest structures: no cap, fixed cap, and variable cap. The cap structure determines how much of
shortfall risk. each interest shortfall the protection seller must pay to the protection buyer when a shortfall

• No Cap: The seller’s obligation is equal to the full interest shortfall in each period.
• Fixed Cap: The seller’s maximum exposure is capped at the CDS premium.
• Variable Cap: The seller’s obligation is limited to LIBOR plus the CDS premium.

The most common structure is the fixed cap, due in no small part to the fact that many
protection sellers—CDOs in particular—prefer to avoid making net payments in the event of a
shortfall. In these CDS, the seller’s floating payment to the buyer due to interest shortfall is
limited to the premium the seller receives in that period, so on a net basis, the seller will not
make any “out-of-pocket” payments. Because the coverage of losses varies with cap structure,

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Lehman Brothers | MBS & ABS Research ABS Credit Default Swaps—A Primer

buyers of protection would need to pay a higher premium for no cap or variable cap protection
relative to fixed cap protection (we discuss this in detail in the section on valuation
considerations). We illustrate the different methods of treating interest shortfalls in Figure 4.

Figure 4. Alternative ABCDS Treatments of Interest Shortfalls

- The reference bond is a BBB HEL bond with a coupon of LIBOR+160 bp.
- The CDS premium on the underlying bond is 150 bp.
- LIBOR is 4.5%.
- The underlying bond fails to make any interest payments in the month evaluated
i.e. 100% of interest shortfall of LIBOR+160 or 6.1% annualized.
- All values are annualized.

1. Fixed cap
CDS premium = 150 bp
Protection Buyer Protection Seller
Interest shortfall covered = 150 bp

Net payment from the seller to the buyer is zero.

2. Variable cap
CDS premium = 150 bp
Protection Buyer Protection Seller
Interest shortfall covered = L+150 bp

Net payment from the seller to the buyer is LIBOR flat, or 4.5% annualized.

3. No cap
CDS premium = 150 bp
Protection Buyer Protection Seller
Interest shortfall covered = L+160 bp

Net payment from the seller to the buyer is LIBOR+10 bp, or 4.6% annualized.

As mentioned earlier, most HELs have a carry-forward feature that mitigates AFC risk by
allowing accumulated shortfalls to be paid in later months from any excess spread available
in the deal. Because shortfalls on the bond are repaid with interest when reimbursed, reversed
shortfalls in ABCDS are also repaid with interest.2 In the case of CDS, however, shortfall
payments accrue at LIBOR plus the CDS premium rather than at the bond’s coupon rate.

Clean-up Call & Implied Writedowns

The now-standardized ISDA documentation also includes provisions to deal with clean-up
calls, step-up coupon spreads, and implied principal writedowns. If the underlying bond is
not called, the buyer of protection has the option to terminate the contract or keep it
outstanding under the PAUG mechanics. If the CDS remains in effect and the coupon spread
steps up, however, the ABCDS premium steps up by the same factor (e.g., 50% or 100%),
mimicking the exposure of the bond. We note that the termination option is a one-time
option: it can be exercised only at the time the premium is scheduled to step up.

Certain deals, often HELs issued by REITs, do not have a writedown provision. For these
deals, principal writedown for purposes of ABCDS is based on an implied writedown
equal to the amount by which the reference obligation is under-collateralized.

Unlike shortfalls reimbursements, reimbursements of writedowns in ABS and CDS are not repaid with interest.

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Lehman Brothers | MBS & ABS Research ABS Credit Default Swaps—A Primer

I Want Out! Unwinding an ABCDS

Investors can unwind Investors in ABCDS can always maintain their positions until the underlying bond is called,
positions through paid off, or fully written down. Alternatively, they can unwind or monetize their position
termination, novation or an prior to maturity through termination, novation, and entering an offsetting position. Each one
offsetting position. of these alternatives should result in a gain or loss equal to the market value of the contract.

• Termination: One investor pays his counterparty the current market value of the CDS to
terminate the CDS contract.
• Novation: An investor transfers his obligations under the CDS to a third-party, receiving
or making a payment depending on the market value of the investor’s position.3
• Offsetting Position: An investor hedges his exposure by entering into an offsetting
position in a new-issue CDS with similar terms. The investor is exposed to new
counterparty risk, and gains/losses are effectively spread out over time rather than
realized upfront.

An Illustrative Example
The features of ABCDS may be best understood through an illustrative example. We construct a
hypothetical $5 million contract on a floating rate BBB- HEL bond, with a premium of 240 bp. The
underlying bond is priced at par and has a total outstanding of $10 million. For simplicity, we assume
constant LIBOR of 4.5%, no principal payments on the bond until maturity, and a day count
convention of 30/360. (The day count convention is usually actual/360 in HELs and HEL-based
ABCDS.) The terms of the contract and the assumed payments and writedowns on the reference bond
are shown in Figure 5 and 6.
Note that in this example, the “applicable percentage” of the CDS—the ratio of the CDS notional to
the total outstanding of the underlying bond—is 50%, ($5 million/$10 million). This factor is used to
calculate the CDS premiums as well as shortfall and writedown payments.4 Also note the interest
shortfall of $30,000 in month 18 for the ABCDS. Because the contract has a fixed cap on interest
shortfall payments, and the premium is less than the shortfall amount, the buyer of protection neither
receives nor makes a net payment in that month. The interest shortfall payment received is capped at
$10,000, the amount of premium paid. Furthermore, when the interest shortfall is reimbursed 12
months later, the buyer of protection pays $10,690, reflecting the original $10,000 received with
accumulated interest (accrued at LIBOR + the CDS premium rate).
There are three points of interest (no pun intended!) with respect to the writedown in month 32. First, the
writedown gives the buyer of protection the option to deliver $5 million in notional of bonds in
exchange for $5 million in cash, or continue under the pay-as-you-go structure. Second, the writedown
in month 32 reduces the ABCDS notional by $500,000, resulting in a smaller CDS premium in dollar
terms in month 33. Third, the partial reversal of the writedown in month 33 requires the protection buyer
to return $250,000 to the protection seller, but there is no accrual adjustment to the payment as there was
with the interest shortfall.

Figure 5. ABCDS Illustrative Example - Contract Terms

Terms of ABCDS Contract

Notional $5 million
Premium 240 bp
Maturity To life of the reference bond
Reference Bond Notional $10 million
Reference Bond Coupon LIBOR+200 bp (6.5% with LIBOR at 4.5%)
Interest Shortfall Cap Fixed Cap
Day Count Convention 30/360
Applicable % (ABCDS/Bond) 50%

To limit unfair changes in counterparty credit risk, novation typically requires consent from the investor’s
counterparty in the CDS.
For example, the monthly ABCDS premium is equal to $10 million bond notional x 50% x 240 bp/12, or $10,000.
Similarly, ABCDS writedown payments are equal to the reference bond writedowns times the applicable percentage.

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Lehman Brothers | MBS & ABS Research ABS Credit Default Swaps—A Primer

Figure 6. ABCDS Mechanics: An Illustrative Example

Reference bond events

Month 18 Interest shortfall of $30,000 on the reference bond
Month 30 Full recovery of interest shortfall from month 18
Month 32 Principal writedown of $1 mn on the reference bond
Month 33 50% recovery of principal writedown.

CDS Payments In Selected Months

• Month 1-17: No interest shortfall or writedown.

CDS premium = $10,000
Protection Buyer Protection Seller

The protection buyer makes a fixed payment of $10,000 ($5,000,000*240 bp/12) every month.

• Month 18: Interest shortfall of $30,000 on the reference bond

CDS premium = $10,000
Protection Buyer Protection Seller
Interest rate shortfall covered = $10,000

Interest shortfall on CDS is $15,000 ($30,000*50%), but fixed cap results in zero net payment.

• Month 30: 100% of interest shortfall is reimbursed

Reimbursement of shortfall w/ accrued = $10,690 ($10,000*(1+LIBOR+240 bp)
CDS premium = $10,000
Protection Buyer Protection Seller

The protection buyer makes a net payment of $20,690 to the seller.

• Month 32: Principal writedown of $1,000,000 on the reference bond

CDS premium = $10,000
Protection Buyer Protection Seller
Principal writedown covered = $500,000

Principal writedown on CDS is $500,000 ($1,000,000*50%).

The protection seller makes a net payment of $490,000 to the buyer.
The buyer has the option to terminate the CDS contract on the occurrence of the writedown.

• Month 33: Writedown reimbursements of $500,000 on the reference bond

Reimbursements of principal writedown = $250,000 ($500,000*50%)
CDS premium = $9,000 ($4,500,000*240bp/12)
Protection Buyer Protection Seller

The protection buyer makes a net payment of $259,000 to the seller in month 33.

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Lehman Brothers | MBS & ABS Research ABS Credit Default Swaps—A Primer


The difference between the CDS premium and the cash spread (e.g., discount margin) of the
underlying bond is known as the “CDS basis.” For purposes of this publication, we define
the basis as:

CDS Basis = CDS Premium – Cash Spread of the Reference Bond

In a perfect world, the basis In a perfect world, the basis should be close to zero since the credit exposure of a protection
should be zero... seller in a CDS is very similar to that of an investor in the underlying bond—both the timing
and amount of principal losses, for example, are the same. In a simplified world in which an
investor can either 1) buy a par-priced ABS and fund the position at LIBOR flat, or 2) sell
protection in a CDS on the same bond, they would earn identical returns if the bond’s
discount margin was equal to the CDS premium (Figure 7).

Figure 7. Going Long Credit Risk: Cash Bond versus ABS CDS
Cash Market CDS Market
Bond CDS Protection Buyer

$ LIBOR+DM Losses CDS Premium Losses

Investor Investor



Investor Receives = DM - Losses Investor Receives = Premium - Losses

*Assume the funding cost is LIBOR

*Assumes investor funds at LIBOR flat and the bond is priced at par. DM is the bond’s discount margin, or
cash spread.

… but fundamental and In the real world, however, both fundamental and technical factors can keep the basis from
technical reasons can keep finding a home at zero. These include cash funding costs, interest shortfall caps, and
the basis from finding a prepayment risk and the clean-up call termination option. We summarize these factors in
home at zero. Figure 8 and discuss each of these in detail below.

Figure 8. Key Factors Affecting the CDS-cash Basis

Factor Effect on the CDS Basis
Funding cost of cash positions above LIBOR ↓
Fixed cap on interest shortfalls ↓
Underlying bond priced at a premium ↓
Underlying bond priced at a discount ↑
Clean-up call termination option on CDS ↓
*Assumes bonds are floating rate.

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Lehman Brothers | MBS & ABS Research ABS Credit Default Swaps—A Primer

Funding Cost
Funding is required for long As seen in Figure 7, funding is required for long cash positions but not for investors in CDS.
cash positions, but not for An investor’s funding cost, therefore, plays a significant role in determining which strategy
investors in CDS. is preferable—buying a bond or selling protection on it. When the CDS basis is zero,
investors should find the CDS more attractive to the extent they fund cash bonds at rates
above LIBOR. All else equal, higher bond funding costs will result in a lower (or more
negative) basis.

Consider the case in which a hedge fund seeking to take on the credit risk of a par-priced
BBB bond is faced with the following two alternatives:

1) Borrow funds at L + 50 bp and purchase the bond at L+250, or

2) Sell protection on the bond in CDS with no margin requirement at 200 bp.

Since the investor earns a spread of 200 bp in both cases, neither one of these strategies is
economically more attractive than the other. The fair basis in this case would be -50 bp,
(200 bp – 250 bp). If the basis were lower, investors would simultaneously buy the bond and
buy protection on it, pushing the basis higher. If the basis were higher, investors in the bond
would sell it and sell protection on it, pushing the basis lower.

Repo haircuts, margin In practice, other factors, including funding “haircuts,” margin requirements, and funding
requirements and funding costs that vary for different investors, complicate this approach to determining the fair value
costs that vary for different of the basis. To deal with these factors, we assume that the marginal investor uses the repo
investors can affect the fair market for funding and estimate the fair basis that provides investors in the cash bonds and in
value of the basis. CDS identical returns on equity (ROE). When using this approach, we find that both funding
costs and repo leverage amounts have significant effect on the basis for securities across the
capital structure. We show the indicative bond funding costs, repo haircuts, and implied
leverage amounts on three generic HELs in Figure 9. A detailed example illustrating the
approach and results using a BBB-rated security is in Figure 10.

Figure 9. Fair Basis Values Given Cash Bond Funding Costs and Haircuts
Discount Repo Sprd Repo Implied Est. Fair CDS Fair Basis
Margin (bp) (bp) Haircut Leverage Premium (bp) Value (bp)
AA 43 5 5% 20 23 -20
A 63 15 10% 10 25 -38
BBB 180 40 15% 7 97 -83

CDO spreads can also affect Just as the repo spread can affect the fair value basis when the marginal investor funds via
the basis in sectors where repo, the spreads on cash CDOs can affect the basis in sectors where CDOs are dominant
CDOs are dominant investors. Higher CDO spreads (e.g., higher CDO funding costs) will pressure the basis
investors. downward. Moreover, the relationship between cash and synthetic CDO spreads can affect
the basis. Higher synthetic CDO funding spreads relative to cash CDO spreads will result in
upward pressure on the basis, as CDO managers will issue the type of deals that provide the
highest returns on equity.

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Lehman Brothers | MBS & ABS Research ABS Credit Default Swaps—A Primer

Calculating the Effect of Funding Costs on the Basis

Below, we illustrate how the fair value of the basis can be determined by equating the ROEs of a cash
investment to a synthetic one. We make the following assumptions:

• The reference bond is a par-priced BBB-rated HEL with a 180 bp cash spread.
• A cash investor in the bond must pay a repo funding spread of 40 bp, and incur a haircut of 20%
(i.e., 20% equity investment required or maximum leverage of 5x)
• The CDS investor must post 10% margin to the protection buyer.
• LIBOR is 4.5%.

Figure 10 illustrates both the position of the bond investor and that of the CDS protection seller. When
funding through repo, the cash bond investor will earn a ROE of 11.9%, assuming no losses on the bond.5 To
get the same ROE in the CDS market, the investor would require a premium of 74 bp, implying a basis of –
106 bp. This sizeable difference results from both the CDS funding advantage (40 bp) and the greater
leverage CDS provides (10x versus 5x). The sensitivity of the implied fair value basis to different funding
spreads and leverage amounts in this illustrative example is in Figure 11.

Figure 10. Comparing CDS versus Cash BBB Bond from a ROE Perspective
Cash Market
ROE of 11.9% LIBOR+180bp
Investor Cash Bond Levered Portfolio ABS Bond
$20 Capital $100
Repo Funding
$80 (20% Haircut) LIBOR+40bp

Repo Lender

CDS Market
ROE of 11.9% CDS Premium of 74bp
Investor CDS Levered Portfolio Protection Buyer
$10 Capital $10 Margin

Assumes no losses on underlying bond, and LIBOR of 4.5%.

Figure 11. Comparing CDS vs. Cash: Fair Value Basis from a ROE Perspective

BBB CDS Premium (bp) BBB CDS Basis (bp)

Sprd 5% 10% 15% 20% 5% 10% 15% 20%
(bp) Haircut Haircut Haircut Haircut Haircut Haircut Haircut Haircut
0 360 180 120 90 180 0 -60 -90
20 322 162 109 82 142 -18 -71 -98
40 284 144 97 74 104 -36 -83 -106

*Assumes 1 mo LIBOR of 4.5%,a discount margin on the BBB HEL of 180 bp, and a 10% margin
requirementt on the CDS.

ROE = Leverage * (cash spread – funding spread) + (LIBOR + funding spread) = 5 * (1.8%–0.4%) + (4.5%+0.4%)
December 9, 2005 12
Lehman Brothers | MBS & ABS Research ABS Credit Default Swaps—A Primer

Interest Shortfall Risk

CDS with a fixed shortfall In CDS with a fixed cap on interest shortfall payments, the protection seller only assumes
cap have a lower premium partial interest shortfall risk. The premium of a fixed-cap CDS should therefore be lower
than one with no cap. than that of no-cap and variable-cap structures, since the former gives the protection buyer
less protection against interest shortfalls. So all else equal, a CDS with a fixed cap on interest
shortfalls should have a negative basis. 6

The “shortfall cap basis We use two approaches to estimate this “shortfall cap basis impact” across the capital
impact” is usually relatively structure of recent deals. Overall, we found them to be relatively modest, usually in the
modest, between 0-10 bp. neighborhood of 0-10 bp. Not surprisingly, the impact is larger for lower-rated bonds, which
are more likely than AAAs to suffer interest shorfalls.

In one approach, we apply a variety of interest rate stresses to a generic HEL BBB- bond
(from LIBOR flat to LIBOR+400 bp) in order to assess the difference between no cap and
fixed cap CDS premiums. Using our model projections for fixed and hybrid collateral, we
forecast both no-cap and fixed-cap CDS cash flows under each scenario, calculating the
difference in interest shortfall payments in each swap. We then find the premium difference
between the CDS that equals the expected present value of the differences in interest shortfall
payments, which are based on probabilities (somewhat arbitrary in this example) of each
scenario occurring. As seen in Figure 12, we estimate the fair difference in CDS premium
between no-cap and fixed-cap BBB- CDS to be about 7 bp (29 bp in present value
difference/bond PV01 of 4 bp). Of course, these amounts will vary from bond to bond and
deal to deal.

Figure 12. Basis Value of Fixed-Cap versus No-Cap CDS on a Generic BBB- HEL Bond

PV Payment Difference - No-cap PV of 1bp in

Scenario Probability CDS vs. Fixed-cap CDS (bp) Additional CDS premium
L 85% 0 4.0
L+100 7% 0 3.9
L+200 5% 1 3.8
L+300 1% 277 3.7
L+400 1% 834 3.6
L+500 1% 1777 3.5
Total 100% 29 4.0

Additional CDS Premium in no-cap vs. fixed-cap CDS = 29/4 ~ 7bp

In another approach, we value the available funds cap itself on a given bond, which
provides an upper bound estimate of the fixed-cap basis impact. This is because the fixed-
cap protection seller is on the hook for some, but not all, of the AFC risk of the bond. They
therefore should be willing to accept a lower CDS premium versus a no-cap CDS, but the
difference should be no greater than the total value of the AFC. We used our HEL OAS
model to calculate the AFC value of 1500 HEL bonds issued in the second half year of
2005, isolating the cap risk component of bond spread from the credit risk and prepayment
risk components (Figure 13). The option cost due to AFC risk averages about 5 bp for
BBB- HEL bonds.

By a similar argument, a variable cap premium should be greater than that of a fixed cap structure, but less than or
equal to that of a no-cap structure.

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Lehman Brothers | MBS & ABS Research ABS Credit Default Swaps—A Primer

Figure 13. AFC Option Costs in 2H05 Home Equity Loan ABS (bp)
Upper Bound on Impact Upper Bound on Impact
Rating Average Across All Deals 98th Percentile
Aaa 2.0 9.0
Aa2 2.5 8.0
A2 2.5 9.0
Baa1 3.0 11.5
Baa2 4.0 15.0
Baa3 5.0 15.0

Prepayment Risk and Bond Price

Prepayment risk either adds While credit risk is typically the largest component of ABS spreads, it is by no means the
to or reduces spread only factor determining nominal spread levels. Prepayment risk in securities subject to
depending on the bond’s prepayment uncertainty also affects spreads, either adding to them in the case of negatively
convexity. convex securities, or reducing them in the case of positively convex assets. Consider two
mortgage backed securities (MBS) with virtually no credit risk exposure: a par-priced
GNMA passthrough and a FNMA principal-only (PO) security. Virtually all of the spread on
both can be attributed to prepayment risk. In the case of the GNMA, the spread is positive
due to the bond’s negative convexity. In the case of the PO, the spread is (typically) negative
since POs usually exhibit positive convexity.

In contrast to these MBS, a noncallable corporate bond has no prepayment risk, so all the
spread on a corporate issue is compensation for credit risk. Many ABS fall somewhere in
between corporates and agency MBS, with both credit and prepayment risks affecting
nominal spreads. Complicating the matter is the fact that the interaction between credit and
prepayments is critical to valuation, and isolating one risk from the other is often a challenge.

The CDS premium should be A buyer of protection in a CDS is compensated only for credit-related losses on the
lower than the cash spread if underlying bond. Thus, the CDS premium should be lower than the cash spread if the bond is
the bond is negatively negatively convex, and should be greater than the bond spread if it is positively convex, all
convex. else equal. This is intuitive if we look at the three extreme cases above: in the case of a
corporate with no prepayment risk, the CDS premium should be close to the bond spread.
The CDS premium on both the GNMA and the FNMA PO, in theory, would be close to zero,
implying a negative basis on the former (premium < nominal spread) and a positive basis on
the latter (premium > nominal spread).

Fixed-rate ABS are exposed to far greater prepayment risk than floaters, which currently
dominate HEL and CDS activity, but floaters trading at significant premiums or discounts
can be subject to prepayment risk that affects nominal spreads. Below we discuss why
prepayment uncertainty should have little effect on the basis for par-priced floating ABS but
could have a more meaningful effect on discounts or premiums.

Prepayment Risk on Par-Priced Floaters Is Minimal…

Prepay risk for a par priced For par-priced floating rate bonds with uncertain timing of principal payments, prepay risk
floater is almost non-existent. in a valuation sense is virtually non-existent. Consider a AA-rated floater priced at par
with a coupon of LIBOR + 50 bp and an average life of 4 years.7 If the AA spread curve is
flat at 50 bp across the maturity spectrum, what would happen to the bond’s price if it
extended by a year?

For valuation purposes, we ignore the impact of any AFC risk and liquidity risk in this section.
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Lehman Brothers | MBS & ABS Research ABS Credit Default Swaps—A Primer

The answer is “not much.” If cash spreads (i.e., discount margins) remain unchanged,
discounting the cash flows of a par-priced floater at market rates results in a present value
of par under any prepayment assumption. A par-priced 4-year bond extending in maturity
by one year would still be priced at 100 as long as its cash spread remains unchanged
(Figure 14).

Figure 14. Par-Priced Floating Rate Bond—Price Exposure to Prepayment Risk

4y WAL Bond with L+50 bp Coupon 5y WAL Bond w/ L+50 Coupon

Total PV @ Total PV @
Year Coupon Princ. Pmt L+50 Coupon Princ. Pmt L+50
1 5.00 5 4.76 5.00 5 4.76
2 5.00 5 4.54 5.00 5 4.54
3 5.00 5 4.32 5.00 5 4.32
4 5.00 100 105 86.38 5.00 5 4.11
5 5.00 100 105 82.27
Total Present Value (Price) 100.00 100.00

*Assumes constant LIBOR of 4.5%, a constant spread curve of 50 bp, and for simplicity, annual coupon

Since prepayment variability has little effect by itself on the price volatility of a par-priced
floater, we can conclude that the nominal spread on the bond largely reflects a return for
credit risk. The CDS premium on the bond represents compensation for the same risk, and
therefore should be theoretically close to the bond’s nominal spread. In other words,
prepayment variability should not materially affect the basis. This is intuitive, since after all,
each $1 in writedowns on the bond results in loss of 1% for both the cash and CDS investor.
This is not the case, however, when the underlying bond is priced well above or below par.8

…But Can Affect the Basis on Premium and Discount Bonds

Premium and discount While par-priced floaters have little risk exposure to prepays alone, the same cannot be said
floaters are exposed to for premium and discount securities. Consider a 4-year bond with a price of 102, a coupon of
prepay risk. L+110, and a discount margin of 50 bp (Figure 15). Unlike the par bond, the price is
sensitive to prepayments, with one year of extension resulting in a price appreciation of
almost 50 bp (as before, we assume a constant spread curve).

Figure 15. Premium Floating Rate Bond - Price Exposure to Prepayment Risk
4-year Bond, Coupon of L+110 bp 5-year Bond, Coupon of L+110 bp
Total PV @ Total PV @
Year Cpn Princ. CF L+50 Cpn Princ. CF L+50
1 5.60 5.6 5.33 5.60 5.6 5.33
2 5.60 5.6 5.08 5.60 5.6 5.08
3 5.60 5.6 4.84 5.60 5.6 4.84
4 5.60 100 105.6 86.88 5.60 5.6 4.61
5 5.60 100 105.6 82.74
Total Present Value (Price) 102.13 102.60
*Assumes LIBOR of 4.5%, a constant spread curve of 50bp, and for simplicity, annual coupon payments.

A premium bond can be We can look at this premium bond as the combination of two securities: 1) a bond with a
viewed as the combination of L+50 bp coupon priced at $100 and 2) a 60 bp interest only security (IO) worth $2 (Figure
a par-priced floater and an 16). The par-priced component is largely insensitive to prepay variability (for reasons
IO strip. 8
Note that we are not implying that par-priced floaters are not subject to any prepayment risk. Rather, the effect of
prepayments on these bonds depends on whether or not market spreads (which reflect credit risk) change when
bonds shorten or extend. It is through this interaction between prepays and credit risk that prepayments affect bond
December 9, 2005 15
Lehman Brothers | MBS & ABS Research ABS Credit Default Swaps—A Primer

described above), but the $2 IO is a negatively convex asset very much subject to prepay
risk. If prepays speed up, the IO quickly loses value, while if they slow down, the IO gains
in value.

Figure 16. A Premium Floater Decomposed: Par Bond + IO





1 2 3 4
Par bond payment (% of orig bal) IO strip (% of orig bal)

*Shows cashflows from $102 premium bond with L+110 bp coupon and 4-year maturity. Assumes annual
coupons and a constant LIBOR at 4.5%.

A protection seller in a CDS A protection seller in a CDS referencing this bond takes on the risk inherent in the par-priced
does not take on the risk of component of the bond but is essentially immune to the risk of the IO. In the extreme case in
the IO. which the bond prepays immediately, for example, the bond investor loses $2, but the CDS
protection seller loses nothing. However, each $1 of principal writedown the bond investor
suffers by maturity affects the CDS investor as well.

The cash-CDS basis on Due to the implicit IO exposure, premium ABS are typically more negatively convex than
premium bonds will be similar par bonds and therefore command a greater nominal spread in an efficient market. The
biased downward. cash-CDS basis on premium bonds will therefore be biased downward. By contrast, the basis
on discount ABS should be biased upward to the extent the bond exhibits positive convexity.

Clean-up Call Option

The buyer of protection has the right to terminate the CDS at the first possible call date if the
bond issuer decides not to call the deal. There are a number of reasons why an issuer may
choose to forgo calling a deal. In cases where the issuer does not call the deal for reasons not
related to performance (e.g., a short-term funding need, extra liquidity, etc.), the buyer of
protection may be better off terminating the CDS rather than paying a stepped-up premium
for insurance they no longer need. Although relatively small in terms of value, this option
value puts downward pressure on the basis at the margin.

Supply and Demand Imbalances

Supply and demand imbalances have a significant effect on the CDS basis. Many long-
only investors may be restricted from using CDS and therefore may acquire ABS exposure
only in the cash market. Many institutions, for example, are limited in their use of
derivatives due to investment policy restrictions or accounting concerns. All else equal, the
existence of such restrictions puts pressure on the basis to remain positive. In addition, in
periods of quickly deteriorating credit sentiment, investors may use CDS to express their
negative views on the market due to the difficulty of shorting cash bonds. The strong
demand for protection, when coupled with limited supply of protection sellers can, at least
temporarily, drive the basis upward.

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ABCDS provide investors The extension of CDS technology to ABS products provides new opportunities for
with new opportunities for investment and credit risk management. To say there are many ways ABCDS can be used is
investment and credit risk an understatement; we summarize a few of the more common ABCDS applications below.
Acquire Credit Risk
ABCDS provide investors access to credit risks and rewards they otherwise may not be able
to acquire due to scarcity of cash bonds. For example, ABCDS allow subordinate investors
such as CDOs ramp up their portfolios more quickly than is possible when only cash bonds
are available. CDS also allow investors to acquire more exposure to a specific bond than is
available in the cash market. An investor with a particularly strong view or with a larger
portfolio could, for example, sell protection in a $10 million CDS contract referencing a
BBB bond that has only $5 million outstanding.

Increase Leverage
Since CDS require no initial cash outlay (beyond any margin requirements), they provide an
efficient means of making leveraged credit investments. As discussed earlier, investors with
relatively high funding costs should find it more attractive to sell protection through ABCDS
than to buy the cash bond and fund it on balance sheet.

Short the Market

ABCDS have transformed ABS away from a long-only cash market. ABCDS allow investors
to express a bearish as well as bullish view on the credit quality of ABS collateral in general.
Investors seeking to profit from a housing market slowdown, for example, may buy
protection on a number of subordinate HEL bonds from a wide range of issuers.

Hedge Exposures
ABCDS can be used as hedging instruments for mortgage originators, banks, and other
investors. The subprime mortgage market has experienced an annualized growth rate of 50%
over the past four years. As the market has grown, bank and originator margins have
compressed, increasing their desire to hedge pipeline risk (i.e., the risk of spread widening
after loan rates are locked but before they are closed and sold or securitized).

Relative Value Tranche, Vintage and Issuer Trades

ABCDS can be used to reflect not only a bullish or bearish view on the market, but also a
relative value view on one issuer versus another, one part of the capital structure versus
another (e.g., BBB+ versus BBB-), one vintage versus another (e.g., 2003 versus 2005), or
even one product type versus another. CDS makes such “pairs trades,” in which an investor
goes long one risk while shorting another correlated risk, relatively easy to execute.


The development of the credit default swap market will transform the ABS market in a
number of important ways. Giving investors greater access to ABS exposure, the ability to
hedge exposures, and the ability to short the market or specific bonds will certainly broaden
the investor universe of ABS and enhance liquidity in general. While it is unclear whether or
not the ABCDS market will ultimately approach the size of the corporate CDS market—now
estimated at almost $12 trillion, nearly four times as large as the cash market—it is clear that
ABCDS have the potential to be an integral component, if not a dominant one, of the ABS
market in the not-too-distant future.

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Lehman Brothers | MBS & ABS Research ABS Credit Default Swaps—A Primer

New developments worth A liquid ABCDS market represents an important building block for an increased flow of
watching for include the more complex trades. Some developments worth watching for in this regard include the
ABX, growth in synthetic launch of the ABX, scheduled for 1Q06, growth in synthetic ABS CDO issuance, and trading
CDOs, and bespoke ABCDS. in “bespoke” or customized synthetic ABS.

Index CDS—The ABX

A series of index products for ABS CDS, which will be marketed under the name “ABX,” is
currently under development by a consortium of broker dealers and is scheduled to be
released in the first quarter of 2006. There will be five ABX sub-indices that will be traded,
each representing a different rating class (Aaa, Aa2, A2, Baa2 and Baa3). Each index will be
composed of about 20 single-name ABS CDS (each sub-index will be composed of the same
20 deals). To ensure liquidity, the dealer community has committed to providing daily marks
on each index. Ultimately, ABX trading should further improve the liquidity of the single-
name CDS market and could facilitate delta hedging and correlation trading.

Growth of Synthetic ABS CDOs

There are number of reasons why synthetic CDO issuance should continue to grow with the
ABCDS market. One is that CDOs remain a primary acquirer of subordinate ABS credit risk,
and CDO managers have few restrictions on their ability to gravitate toward synthetic
structures. More important, depending on their funding costs, synthetic CDOs may be more
attractive structures for managers and CDO equity holders. They also allow for more
efficient execution in that a synthetic portfolio can be created in far less time than a cash
portfolio. “Ramping” periods for cash CDOs can last as long as 9-12 months.

Bespoke CDS
Customized tranching of synthetic CDS has become feasible with the development of the
single-name market. “Bespoke” (i.e., customized) synthetics often provide CDO-like
exposures tailored to the risk appetite and credit expertise of the investor. In corporate CDS,
for example, an investor may buy protection against losses above 7% but below 10% on a
customized basket of high yield issuers. If losses on the pool are 8%, they receive a payment
of 1% of the pool’s notional. The investor can choose the underlying credits, the tranche
width, and/or implied rating.

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Lehman Brothers | MBS & ABS Research ABS Credit Default Swaps—A Primer


Corporate CDS have enjoyed widespread acceptance in a well-developed market and provide
a good point of comparison for their ABS brethren. While ABCDS are generally similar to
corporate CDS, there are significant differences between the two due to the unique nature
and structural mechanics of ABS products. Below we highlight these differences, which are
summarized in Figure 20.

Reference Entity
In corporate CDS, the reference entity is effectively a corporate issuer, while in ABCDS, it is
a single ABS security. The failure of a corporate issuer to pay principal or interest on any
debt obligation is typically a “credit event” for all of that issuer’s CDS. This “cross-default”
concept is absent from the ABS market.

Credit Events
Credit events in corporate CDS include bankruptcy of the reference corporation, failure to
pay principal or interest, and restructuring. Unlike corporate CDS, ABCDS do not include
bankruptcy or restructuring as credit events. In addition, non-payment of interest is not a
credit event in ABCDS, although it does trigger a payment to the protection buyer.9

Maturity Date
The maturity date of corporate CDS is largely independent of the maturity of the issuer’s
bonds, and tenors are typically 1-10 years, while the effective maturity date of ABCDS is
the earlier of the bond’s legal final maturity and the date when the it is fully paid off or
written down.

Most corporate CDS require physical settlement, while some contracts specify cash
settlement. In either case, the buyer does not have the option to choose one or the other.
ABCDS are structured as “pay-as-you-go” (PAUG) contracts, with the buyer retaining a
physical settlement option if a credit event occurs.

Principal Writedown
Principal loss is a one-time event for corporate bonds and results in settlement (and
termination) of the CDS. Under the PAUG structure, the protection seller in an ABCDS must
reimburse principal losses over time, until maturity of the contract. Furthermore, if principal
writedowns are later reversed, ABCDS provide for writeup of the CDS notional and
reimbursements to the protection seller.

Non-payment of Interest
Failure to make interest payments on the underlying bond is considered a credit event in
corporate CDS but not so in ABCDS. Interest shortfalls, defined in ABCDS as any non-
payment of expected interest, can occur due to an available funds cap (AFC), which limits
the bond coupon to the net WAC of the collateral. While not credit events in ABCDS, they
do trigger payments from the protection seller, which may be later reimbursed.

Prepayment Uncertainty
Corporate CDS are not subject to prepayment risk, since corporate bonds usually have bullet
maturities. However, ABS, and therefore ABCDS, are exposed to prepayment uncertainty.

A credit event can be distinguished from other contingent events in ABCDS triggering payments in that the former
allows the protection buyer to settle (and terminate) the contract.
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Lehman Brothers | MBS & ABS Research ABS Credit Default Swaps—A Primer

To handle this complication, the notional amount of ABCDS declines with reductions in the
balance of the reference cash bond.

Figure 20. Key Differences Between Corporate CDS and ABS CDS

Corporate CDS ABCDS

Reference Entity A corporation A single security
Credit Events Failure-to-pay, bankruptcy, restructuring Failure-to-pay, writedown, distressed downgrade, maturity extension
Maturity Date Typically 1-10 years Earlier of underlying bond legal final maturity or full paydown
Settlement Physical or cash settlement Pay-as-you-go with a physical settlement option
Principal Writedown One time event Losses occur over time, and can be reversed
Non-payment of Interest Is a credit event Not a credit event, but does trigger payment, can be reimbursed
Prepayment Uncertainty Not applicable Declining notional due to voluntary prepays and defaults

December 9, 2005 20
The views expressed in this report accurately reflect the personal views of David Covey, the primary analyst(s) responsible for this
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