Hedging considerations in CDO transactions.
Many CDO structures use swap agreements to transform the cash flow characteristics of the issuer's assets into payment terms sought by investors. Most commonly, the CDO will use some combination of interest rate swap and cap agreements to hedge its risks against interest rate mismatches between fixed rate assets and floating rate liabilities, or visa-versa. Similarly, it may be necessary to employ a basis-risk swap where the collateral consists of floating-rate assets linked to one index, while the liabilities pay interest based on another.
In addition to these interest-rate and basis-risk swaps, a transaction may employ currency hedges where assets and liabilities are paid in different currencies to protect against foreign-exchange risk. The overwhelming majority of these hedges are documented using the master agreement prepared by the International Swap Dealers Association, Inc. (ISDA). Set forth below is a discussion of the criteria that Standard and Poor's applies in transactions with "AAA" rated tranches for determining which parties are eligible to be swap counterparties and the provisions that are acceptable under the ISDA documentation.
II. INTEREST RATE AND BASIS RISK SWAPS
A. HEDGE COUNTERPARTIES RATINGS REQUIREMENTS
Entities rated with a short-term rating of 'A-1' or better may serve as swap counterparties in interest-rate and basis-risk hedges. To the extent that a potential counterparty does not have a short-term rating (or prefers to use a long-term rating to satisfy the ratings requirement), the entity must have a long-term rating of 'A+' or higher to be an acceptable interest-rate and basis-risk hedge counterparty. (These rating requirements may be satisfied by the rating of a guarantor of the swap counterparty's obligations under the hedge agreement, provided that such guarantor is identified under the ISDA documentation as a Credit Support Provider.)
B. REQUIREMENTS UPON DOWNGRADE
Should the rating of the counterparty (or the rating of its guarantor, if satisfaction of the ratings requirement is dependent upon the rating of such guarantor) fall below the 'A-1' or the 'A+' thresholds discussed above, the swap counterparty will then have an obligation to find a substitute counterparty that satisfies these rating requirements, All costs associated with finding such a replacement and assigning the agreement shall be borne by the "downgraded" swap counterparty. In the event that the agreement has not been assigned to a new counterparty within 30 days, the swap counterparty will be required to post collateral in amount equal to the greater of the market-to-market value of the swap, the amount of the next payment due, or 1% of the outstanding notional amount of the hedge agreement. These amounts should be posted in accordance with the collateral posting requirement set forth below.
Regardless of the fact that the counterparty may have posted such collateral in accordance with Standard & Poor's criteria after 30 days, the obligation of the swap counterparty is to find a replacement swap counterparty to which it may assign its rights and obligations under the agreement, which will remain in effect. In the event the swap is not replaced within this 30-day period, then a rating action may be taken. Standard & Poor's will weigh the following: the swap maturity; the market value of the swap; the market for similar swaps; the current rating of the transaction; and the rating outlook of the swap provider.
C. COLLATERAL POSTING REQUIREMENTS
All collateral should be pledged to the trustee or other independent third party acting as agent for investors. The collateral should be segregated and pledged under normal ISDA requirements and in the possession of the trustee or some other fiduciary third party.
Collateral is to be invested in eligible investments (other than debt of the counterparty) in the currency of the rated securities and should be deposited in an account in the name of the trustee or issuer. The funds should be invested with an eligible institution other than the swap provider. If the funds do not mature before the next interest payment due on the rated securities, additional collateral may be required. The costs associated with posting the collateral should be borne by the swap provider.
Swap providers will have to mark the swap to market and post collateral on a weekly basis, with a cure period of three days. The mark-to-market valuation should reflect the higher of two bids from counterparties that would be eligible and willing to provide the swap in the absence of the current provider. Annual audits should be amended to specifically verify a sample of swap calculations and collateral postings.
First loss classes should absorb any loss due to the failure of a swap counterparty. Transactions will need to explicitly state that all subordinated cash flows will be diverted to make up any shortfalls. Claims resulting from insufficient swap payments, a counterparty default, or insufficient collateral necessary to find a replacement counterparty will be the obligation of the first loss class.
III. FOREIGN CURRENCY SWAPS
A. Hedge Counterparties Ratings Requirements
For currency hedges, entities with short-term ratings of 'A-1+' may serve as counterparties in 'AAA' -rated transactions if they agree to post collateral or replace themselves upon downgrade to a rating of 'A-1'. Similarly, entities with a short-term rating of 'A-1' (or 'A+' if a long-term rating threshold is used) may participate in a 'AAA' -rated transaction if they agree to post collateral at the beginning of the transaction and agree to replace themselves upon downgrade from the 'A-1' or 'A+' threshold.
The collateral posting triggers for currency hedges are more stringent than those for interest rate and basis risk hedges. Standard & Poor's believes that the market for interest rate and basis risk hedges enjoys less price volatility and has more liquidity, thus allowing for a lower-rated counterparty without increasing the overall risk to the transactions. The thresholds and the collateral posting requirements set forth herein are limited to those currencies recognized by ISDA.
B. CALCULATION OF REQUIRED COLLATERAL POSTING AMOUNTS
For currency swaps in permitted currencies, 'A-1+' rated counterparties do not have to post collateral. For 'A-1' and 'A+' rated entities, the new collateral levels will equal the greater of zero or the mark to market of the swap plus the amount equal to the appropriate value as a percentage of the notional value of the swap.
The specifics of calculating the required collateral posting amount for foreign currency swap counterparties is presented in Appendix B. The required collateral amounts should be posted in the manner discussed above under "Interest-Rate and Basis-Risk Hedges, Collateral Posting Requirements".
C. REQUIREMENTS FOR 'AAAT' RATED SWAP TRANSACTIONS
As a result of the growing and increasingly liquid market for swaps, Standard & Poor's will rate structured finance transactions with swaps from 'AAAt' rated derivative product companies. The derivative product company will be required to post additional collateral with the trustee to ensure sufficient funds are available to replace the swap during market swings.
Terminating derivative product companies are rated based on their ability to pay the mark to market at termination. Structured financings, however, need additional protection against movement in swap values between termination and replacement. These collateral amounts should be posted in the manner discussed above under "Interest-Rate and Basis Risk Hedges, Collateral Posting Requirements".
IV. SWAP AGREEMENT CRITERIA FOR CDOS
This section substantively restates the swap criteria for structured finance transactions that were originally published in Standard & Poor's 1995 publication Global Synthetic Securities Criteria. Structured finance transactions frequently include swap agreements that transform the cash flow characteristics of an issuing special-purpose entity's (SPE's) assets into payment terms desired by investors. The swap agreement criteria for a particular issue depend on the applicable rating approach. There are three rating approaches that reflect the differing roles of swap agreements in transaction structures: the swap-dependent approach, the asset-independent approach, and the swap-independent approach.
A majority of the swap agreements reviewed by Standard & Poor's are contracted under the ISDA agreement forms. The ISDA documentation for a swap transaction consists of a swap toaster agreement and a schedule and confirmation that modify the terms of the master agreement. The schedule and confirmation should modify the master agreement to reflect Standard & Poor's swap agreement criteria based on the applicable rating approach.
This section discusses specific sections of the 1992 ISDA multi-currency Cross Border Master Agreement as it pertains to Standard & Poor's swap agreement criteria. This '1992 agreement' updates the 1987 ISDA form documents. The discussions of criteria that follow are cross-referenced to the appropriate section of the 1992 agreement. Separate comments are provided when the "1987 agreement" treats a topic differently. Although the ISDA form agreements are most frequently used to document a swap transaction, other forms of agreements may be used provided that the comparable sections incorporate Standard & Poor's swap agreement criteria.
V. RATING APPROACHES
In both the swap-dependent rating approach and the asset-independent rating approach, the issuer's credit rating of the swap counterparty, or its guarantor, is a supporting rating and may be the weak-link rating if its rating is the lowest of all the supporting ratings in the transaction. In addition to evaluating the creditworthiness of the swap counterparty or its guarantor, the swap-dependent approach reflects the creditworthiness of the issuing SPE's other assets. The asset-independent approach reflects only the creditworthiness of the swap counterparty or its guarantor.
A. SWAP-DEPENDENT APPROACH
When the issuing SPE's other assets also are a supporting rating, the issue credit rating addresses the credit risk of the swap counterparty, the other assets, and the transaction's structure. Each element affects the issuing SPE's ability to provide transformed cash flows to holders of the rated securities in a full and timely manner.
In many of these transactions, as well as in most asset-and mortgage-backed issues, the counterparty does not expect to take the credit risk of the issuing SPE's other assets. Therefore, the counterparty desires a swap contract that deviates as little as possible from the market standard. Investors in rated securities, however, also need reasonable assurance that the swap counterparty will not cause an early termination of the swap. An early termination of the swap may result in a termination payment by the issuing SPE to the swap counterparty out of funds that otherwise would be payable to the holders of the rated securities. A list of acceptable default and termination events that would enable the swap counterparty to terminate the swap agreement in securities in which the swap counterparty and the issuing SPE's other assets are supporting ratings is included here.
Analysts will assume that the issuing SPE would not have an incentive, or the ability, to terminate the swap agreement absent a default on its other assets, and then only if it is in the best interests of investors and is generally subject to their vote. The criteria for securities in which the swap counterparty and the issuing SPE's other assets are supporting ratings, as the criteria apply to specific sections of the 1992 agreement, are discussed below. These criteria are applicable to synthetic securities and asset- and mortgage-backed transactions. The provisions of the 1992 agreement that are not referenced below are acceptable provided that they are not modified. The swap dependent ISDA Cross References are presented in Appendix D.
B. ASSET-INDEPENDENT APPROACH
Rated securities can be structured so that the issuing SPE's other assets will not be a supporting rating and thus achieve a rating that is higher than, or irrespective of, the issuer credit rating of these other assets. This can be accomplished by including a swap agreement that commits the counterparty to make payments to the issuing SPE even if there has been a default on the issuing SPE's other assets. In effect, the swap agreement becomes the issuing SPE's only asset from a rating perspective. The swap counterparty is still a supporting rating, but the other assets are not.
Default and termination events for swaps in these transactions are more flexible than they are in transactions in which the issuing SPE's other assets are also a supporting rating. Recent structures have included the following default and termination events under the swap agreement:
* Failure to pay,
* Merger without assumption,
* Illegality, or
* Events of default under the indenture.
Events of default under the indenture include failure to pay interest on any note when due, failure to pay principal on any note when due, an event of default or early termination of the swap agreement, and the bankruptcy of the issuing SPE.
If the swap is terminated for any of the above reasons, however, the swap counterparty would make a termination payment to the issuing SPE equal to the principal of and accrued interest on the rated securities minus proceeds from sale of the issuing SPE's other assets, In other words, investors in the rated securities are paid full principal and interest up to the redemption date even if the swap is terminated. In this structure, the formula for calculating the termination payment will have to be amended accordingly.
If no withholding tax currently applies to swap payments by the swap counterparty and its guarantor, if any, Standard & Poor's will generally request legal opinions from counsel confirming that under current law no such tax applies, and that there is no pending legislation to create such a tax.
C. SWAP-INDEPENDENT APPROACH
These types of securities also use swaps to transform the cash flows generated by the assets as an accommodation to investors. A Standard & Poor's issue credit rating, however, does not address the swapped cash flow, only the likelihood of payment on the issuing SPE's other assets. If the swap counterparty defaults for any reason, either the transaction terminates and investors receive their pro rata share of the assets, or the investors agree to accept the cash flows on the other assets without the benefit of the swap and the transaction continues.
The swap counterparty's issuer credit rating is not a supporting rating. Therefore, default and termination events under the swap agreement are more flexible than those for swap-dependent securities in which the issuing SPE's other assets are also a supporting rating. The following events have been included in swap-independent structures:
* Failure to pay,
* Breach of agreement,
* Credit support default,
* Default under specified transaction or swaps,
* Cross default,
* Merger without assumption,
* Trust termination, and
* Default on the issuer's other assets.
If the swap terminates, neither party would be owed a termination payment or swap breakage fees. Generally, the 'r' symbol is attached to the ratings of these transactions to indicate that investors may be subject to market risk upon termination of the swap.
VI. ADDITIONAL CRITERIA
Section 11 of the 1992 agreement provides that the defaulting party will pay certain reasonable out-of-pocket expenses incurred by the other party related to the enforcement and protection of that party's rights under the swap agreement or any credit support document. This section should not apply to the issuing SPE for asset-independent or swap-independent structures because swap agreements employed by these structures may terminate as a result of non-credit events. The occurrence of an event of default under the swap agreement for an asset-independent transaction should not create a liability for the issuing SPE that will result in payment shortfalls to investors. In the case of swap-independent structures, since the swap provider is not a supporting rating, the occurrence of an event of default should be transparent to the issuing SPE and not result in the creation of an expense under this section.
For all swap agreements, the swap counterparty should agree that it will not petition the issuing SPE into bankruptcy, or join in any petition to file the issuing SPE, during the term of the rated securities and for a period equal to the preference period plus one day applicable to the issuing SPE after all outstanding rated securities have matured.
In transactions where the issue credit rating is dependent on a swap agreement and guarantee, if any, Standard & Poor's generally requests the following legal opinions for the swap counterparty and guarantor, as applicable, under the law of the jurisdiction of organization of the relevant entity and under the governing law of the swap agreement and guarantee, as applicable:
* An enforceability opinion in connection with the swap agreement and guarantee against the swap counterparty and the guarantor, as applicable, according to their respective terms;
* A pari passu opinion stating that payments due under the swap agreement and the guarantee, as applicable, rank at least pari passu with the unsecured and unsubordinated obligations of the swap counterparty and the guarantor, as the case may be;
* A choice of law opinion stating that local courts in the jurisdictions of the swap counterparty and the guarantor, as applicable, would recognize the choice of law in the swap agreement and the guarantee, as the case may be, and the choice of law is prima facie valid and binding under such local law;
* A recognition of claim opinion stating that local courts in the jurisdictions of the swap counterparty and the guarantor, as applicable, would recognize and enforce as a valid judgment any final and conclusive civil judgment of a court of competent jurisdiction for monetary claims under the swap agreement and the guarantee, as the case may be; and
* Relevant withholding tax opinions on payments under the swap agreement and the guarantee, as applicable. Standard & Poor's will also typically request from counsel for the issuer the relevant withholding tax opinions on payments by the issuer under the swap agreement.
Standard & Poor's may waive the enforceability opinion described above for swap counterparties and guarantors if Standard & Poor's previously has received similar opinions under the same governing law in similar transactions. (For a fuller discussion of these rating approaches, see Standard & Poor's Legal Issues In Rating Structured Finance Transactions, "Criteria Related to Global Synthetic Securities.")
In addition, for CDO transactions and given the nature of the asset pool and transaction specifics, Standard & Poor's allows the termination of the swap with the SPE being at fault. This could occur if the majority noteholders of each class of notes vote to materially amend the indenture or other transaction documents once they are notified that the swap counterparty has not consented to the change, and by them voting "yes" proceed with the amendments, causing the swap to terminate. Such material amendments typically are changes to the rights of the swap counterparty, changes to the priority of payments above the swap counterparty's position, and changes to the reinvestment criteria.
A. TERMINATION PAYMENTS IN THE PRIORITY OF PAYMENTS
Given the uncertainty associated with precisely predicting future interest rates, and the fact that structure finance SPEs are special purpose vehicles that only have a limited amount of assets and no borrowing power, it is not feasible to accurately model termination payments or require the SPE to pay such an amount above the rated noteholders, should the swap counterparty default. For these reasons Standard & Poor's requires the swap counterparty to subordinate its claim of termination payments below investment grade rated tranches should the cause of the termination be due to its own default.
If the SPE defaults, Standard & Poor's allows the swap counterparty to get termination payments pari passu with the senior noteholders. In such cases, one of the abovementioned events of default has occurred and the rating of the senior notes has already been compromised.
Standard & Poor's
BRIAN O'KEEFE is a director in the Structured Finance Group at Standard & Poor's. He is a member of the Global CDO Group. Prior to joining Standard & Poor's in 2000, Brian was an attorney working on securitization transactions at the law firms of Clifford, Chance, Rogers & Wells and Jones, Day, Reavis & Pogue. Brian earned a J.D. from the University of Pennsylvania in 1994.
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|Title Annotation:||collateralized debt obligations|
|Publication:||The Securitization Conduit|
|Date:||Mar 22, 2002|
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