Standardized Pay-As-You-Go CDS ON CDOs

June 29, 2006

Claude Laberge 212-526-5450 claberge@lehman.com Lorraine Fan 212-526-1929 lfan@lehman.com

OVERVIEW On June 7, ISDA released standard documentation for CDS on CDOs with pay-as-yougo (PAUG) or physical settlement, a template adapted from PAUG CDS on ABS. Paying special attention to the treatment of defaulted or deferred interest (PIK), in this report, we: Identify differences in the PAUG CDS format between CDOs and ABS; and Point out factors to be taken into account when valuing a cash security versus PAUG CDS.

PAY-AS-YOU-GO CDS: CDO VERSUS ABS As its name suggests, the PAUG approach differentiates itself from regular corporate CDS in that, rather than terminating a trade automatically upon the occurrence of a credit event, PAUG CDS grant the protection buyer a choice between continuing the trade and settling physically in part or in full. The mechanics of PAUG CDS on CDOs (see appendix) resemble those laid out in Form I of the PAUG CDS contract on RMBS and CMBS published by ISDA last year.1 CDS on CDOs have, however, some specific characteristics related to the treatment of interest shortfall and implied writedown, as highlighted below: Interest shortfall constitutes a credit event for CDOs. For ABS, a missed interest payment leads to a payment from the protection seller to the buyer. This is still true for CDOs, but it also triggers a credit event. To qualify for settlement, a PIKable tranche has to remain not fully cured 360 calendar days following an interest shortfall of at least $10,000. The compounding of the interest shortfall for reimbursement calculations is optional for both fixed- and variable-cap structures. Such compounding is mandatory for ABS. Should reimbursements become available, interest shortfall payments previously made by the protection seller are compounded (accrue interest) at [LIBOR + CDS premium]. Implied writedown is optional for CDOs. This provision is compulsory for ABS products without actual writedown clauses. The CDO template lists implied writedown as an option to measure the extent to which the reference tranche is undercollateralized. In general, this amount can be derived as: Max (0, Min [Tranche Notional, (Tranche + Senior Notional) - OC Numerator]) where the OC numerator is based on the most recent trustee report and therefore includes the appropriate treatment of defaulted, long-dated, and other assets subject

See ABS Credit Default SwapsA Primer, and Credit Default Swaps in CMBS: An Introduction.

Please see important analyst(s) certifications on the back cover of this report

Lehman Brothers | Standardized Pay-As-You-Go CDS ON CDOs

to haircuts as per the indenture.2 This approach is in contrast to how CDS on ABS treat the face value of performing and non-performing assets. Other provisions irrelevant to CDO mechanics are removed: These provisions include step-up coupons, clean-up calls, and WAC cap interest.

CDO: CASH FORM VERSUS PAY-AS-YOU-GO CDS The economics of PAUG CDS diverge from those of the underlying cash obligation in a number of ways. The considerations in valuing a cash security versus its PAUG CDS3 are presented below. Comparing Apples with Apples: PAUG CDS Spread and Cash Bond Price A PAUG CDS is a par-priced instrument quoted at a spread, while cash bonds are quoted at a price that can deviate significantly from par. Investors should evaluate the CDS premium against the discount margin of the cash position to measure the credit risk implied in each. Obviously, the derivation of the discount margin from the price requires the determination of a timeframe, which in turn involves taking views on asset defaults, recoveries and prepayments, and the likelihood that the CDO will be called or refinanced. Protection Seller Does Not Receive CDS Premium on PIK nor Reimbursements in Excess of Prior Interest Shortfall Payments (Aside from Payment Compounding) In cash CDOs, previously missed interest payments accrue current interest. PAUG CDS investors need to be aware that defaulted or deferred interest is not included in the outstanding notional for computing the CDS premium amount to which the protection buyer is liable (we will refer to all such interest as PIK for the sake of convenience) (see Appendix Figure 3). Since the protection seller compensates the protection buyer immediately upon an interest shortfall, no contractual amount remains to be owed. On the contrary, the underlying CDO has yet to repay the interest shortfall to the tranche holder and, therefore, should accrue interest on that uncured amount. The notional of a CDS contract adjusts downward with the amortization of the underlying bond, partial obligation deliveries in previous settlements, and optional implied writedown. It only adjust upwards upon implied writedown reimbursements. Because the counterparties are trading credit protection from the effective date of a PAUG CDS, reimbursement payments made to the protection seller, omitting the compounding component of such payments, cannot exceed the aggregate payments made in previous interest shortfalls. This mechanism marks a distinction from the entitlement of a cash bondholder for all PIK-curing and interest-on-PIK cash flows that occur on or after the trade effective date regardless of when the PIKs originally took place. Such difference in rights should be reflected in premium. Implied Writedown Represents a Potential Stream of Cash Flows Even though cash flow CDOs have no actual or implied writedown provisions, PAUG CDS contain an embedded implied writedown option. There are varying incentives and
Since the current period implied writedown can only be determined on a payment date, the OCs from interim trustee reports bear no effect on the implied writedown mechanism. We discuss the concept of implied writedown in more detail in a later section. 3 Many of these considerations, such as funding costs, are similar to those regarding single-name corporate CDS and PAUG CDS on ABS. See Explaning the Basis: Cash versus Default Swaps and ABS Credit Default SwapsA Primer.
2

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Lehman Brothers | Standardized Pay-As-You-Go CDS ON CDOs

disincentives for investors using the implied writedown option. Cash CDO owners looking for hedges that largely mimic the mechanics of the underlying securities may prefer not to use the implied writedown option. CDOs, which can sell protection to fill their CDO buckets, are usually barred from entering contracts that may result in future payments to counterparties. Nonetheless, there are also investors, especially protection buyers, who desire an opportunity to monetize portfolio deterioration from time to time. If this option is elected, it should be reflected in valuation not only because of the potential extra stream of cash flows but also because implied writedown is factored into the notional on which the CDS premium payment is calculated (see Appendix Figure 3). To some extent, for class As, implied writedown mirrors one type of event of default. Many CDOs regard the descent of the class A overcollateralization ratio below a specified percentage as an event of default. There are, however, two issues to be addressed. First, the corresponding percentage is always 100% for implied writedown in CDS, whereas the underlying CDOs typically set it at 100% or higher. Second, the ratio is based on the OC numerator from the relevant coverage test for CDS, but some indentures do not adopt the same numerator for the overcollateralization ratio used in the determination of an event of default.4 Caps on Interest Shortfall Payments Lead to Different Net Payments Without any interest shortfall, all PAUG CDS cap structures should result in the same economics. Nonetheless, the different payment schemes in an interest shortfall (see Appendix Figure 4) imply that the protection sellers net payments, which takes into account the CDS premium received from the buyer, should differ.
Figure 1. Net Payments of Cash Security Holder and PAUG CDS Protection Seller in Full Interest Shortfall
Trade Price * Notional * LIBOR Par * Notional * [Reference Obligations Coupon of (LIBOR + Spread) - CDS Premiumno-cap] Par * Notional * [CDS Premiumfixed-cap - CDS Premiumfixed-cap] = 0 Par * Notional * [LIBOR + CDS Premiumvar-cap - CDS Premiumvar-cap] = Par * Notional * LIBOR

Cash Position Funded at LIBOR PAUG CDS - No Cap PAUG CDS - Fixed Cap PAUG CDS - Variable Cap

Assume the caps are taking effect, i.e., the full interest shortfall is greater than or equal to the CDS Premiumfixed-cap and LIBOR plus CDS Premiumvar-cap.

In Figure 1, the difference between the out-of-pocket payments required from the floating-rate cash security holder and the protection seller is a function of the trade price of the cash position, the reference obligations spread, and CDS premiumno-cap. The two payments will be the same if CDS Premiumno-cap = LIBOR * (1 - Trade Price/Par) + Ref Obs Spread One such scenario is when CDS premiumno-cap equals the contractual coupon spread of the reference obligation and the cash position has been entered at par. A protection seller in a fixed-cap structure pays at most the CDS premium and receives the CDS premium and, therefore, will never result in a net payment with respect to an interest shortfall. It has been the most popular cap structure for synthetic and hybrid ABS CDOs selling protection on other ABS CDOs because of this feature. The sellers net payment in a variable-cap structure will equal that of a no-cap structure when CDS Premiumno-cap coincides with the reference obligations coupon spread. A
4 For clarification purposes, notice that an event of default for a reference CDO deal does not necessitate credit events in the CDS of all tranches within that deal. Whether credit events in the context of a CDS result depends on the actual interest/principal payment and implied writedown conditions for each individual tranche. However, there are overlapping instances for certain classes, such as interest shortfalls for the controlling and/or other non-PIKable classes, which can trigger both events of default for the entire deal and credit events for CDS referencing those particular classes.

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Lehman Brothers | Standardized Pay-As-You-Go CDS ON CDOs

variable cap can enforce its limitation function only if the CDS Premiumvar-cap is smaller than the reference obligations coupon spread. Under such circumstances, the net payment in the no-cap structure deviates from that of the variable-cap structure, which is at LIBOR, by [Reference Obligation Coupon Spread - CDS Premiumno-cap]. Cash Bond Price Induces Loss Disparity in Principal Shortfall If a principal shortfall occurs, the protection seller in a CDS loses [par - recovery], while the cash holders could lose less (more) if the trade was entered at a discounted (premium) price. For the same trade notional, a long position in a discount cash security should be compensated for less risk compared with such a position in a CDS from this perspective. The opposite applies to a cash trade priced above par. CONCLUSION PAUG CDS open up avenues for investors synthetically to obtain long or short exposure to cash CDOs. With some differences in economics, PAUG CDS can cater to particular risk appetites or hedging strategies and present arbitrage opportunities. They have also become the leading derivative for mezzanine ABS CDOs, largely because of their ties to the HEL market; but at this point, they have been less popular in the corporate CDO arena. Investors looking to replicate the exact economics of the cash security or trade equity classes, and those with concerns about trading distressed securities via the current form of CDS will find total return swaps (TRS) to be a more attractive vehicle.5

We encourage readers to refer to our May Monthly for a primer on TRS.

June 29, 2006

Lehman Brothers | Standardized Pay-As-You-Go CDS ON CDOs

APPENDIX: MECHANICS AT A GLANCE

Figure 2. Credit Events for PAUG CDS on CDOs
Refers to current interest on PIK-exclusive but implied-writedowninclusive principal notional; PIKable tranches need to remain uncured at least 360 calendar days following the PIK occurrence to qualify for settlement Only relevant at legal final maturity or the liquidation of all assets; the relevant face value is adjusted by any implied writedown amount Overcollateralization falls below 100% Downgraded to Caa2 or below by Moodys or CCC or below by S&P or Fitch; or withdrawn investment grade rating not reinstated at Caa1/CCC+ or above within three months

Failure to Pay Interest of $10,000 or More

Failure to Pay Principal Implied Writedown (Optional) Distressed Rating Downgrade

Figure 3.

PAUG CDS Treatment of Uncured PIKs and Implied Writedown

Uncured PIK Implied Writedown (Optional) Included Included Not Included Included Included Included

CDS Premium Computation: Outstanding Notional Interest Shortfall Computation: Expected Interest Interest Shortfall Computation: Actual Interest Interest Shortfall Reimbursement Computation: Cap Applicable Principal Shortfall Computation Settlement Computation

Not Included Not Included Payments for Current Interest on PIKs and Curing PIKs Included PIKs of Underlying Obligations Incur Interest if CDS is Compounded Not Included Not Paid for by Protection Seller

Figure 4.

Interest Shortfall Payment and Reimbursement Payment Amounts by Cap Structure

No Cap Fixed Cap Min [CDS Premium, Full Shortfall] Optional at LIBOR + CDS Premium Min [Reimbursement in No Cap, Net Cumulative Shortfall Payment Amount of CDS - Net Cumulative Interest Shortfall Amount of Underlying] Variable Cap Min [L+CDS Premium, Full Shortfall] Optional at LIBOR + CDS Premium Min [Reimbursement in No Cap, Net Cumulative Shortfall Payment Amount of CDS - Net Cumulative Interest Shortfall Amount of Underlying]

Interest Shortfall Payment Interest Shortfall Payment Compounding for Reimbursement

Full Expected Interest - Actual Interest N/A

Reimbursement Payment (If Any)

Full Actual Interest - Expected Interest

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Lehman Brothers | Standardized Pay-As-You-Go CDS ON CDOs

Figure 5.

Comparison of CDS and TRS on Corporate CDOs and PAUG CDS on CDOs
CDS on Corporate CDOs TRS on Corporate CDOs PIKable and Non-PIKable Total Return of Reference Security PIKs with Reference Security PAUG CDS PIKable and Non-PIKable Insurance Premium Depends on Cap Structure Interest Shortfall is Reversible Failure to Make Timely Interest Payment or Principal Payment N/A [Implied Writedown] Distressed Rating Downgrade PAUG (Option to Physically Settle) Reference Security Market Value Market Value Market Value Full Redemption/Maturity TRS Payer Exercises Put Option Full Redemption/Maturity Credit Event Occurs and Protection Buyer Exercises Put Option for Settlement

Tranche Type Return Treatment of Failure to Make Scheduled Interest Payments

Non-PIKable Insurance Premium

Physical Settlement

Credit Events

Failure to Make Timely Interest or Principal Payment

Typical Settlement Deliverable Obligation

Physical Reference Security

N/A Reference Security

Trade Termination

Full Redemption/Maturity Credit Event

Reprinted from Total Return Swaps on Cash Corporate CDOs in Structured Credit/CDO Monthly, May 2006.

June 29, 2006

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