Handbook of Finance: Financial Markets and Instruments

Chapter 36. Synthetic Asset-Backed Securities

MOORAD CHOUDHRY, PhD

Head of Treasury, KBC Financial Products, London

Abstract: The excess of demand over supply for specific tranches of structured finance transactions such as asset-backed securities and mortgage-backed securities has led to investors' accessing these assets via the credit default swap market. A credit default swap written on an asset-backed security possesses different contract mechanics to a standard credit default swap written on a corporate reference name. The main differences relate to the list of occurrences that constitute a credit event and the settlement mechanics whenever the underlying tranches of an asset-backed security or mortgage-backed security experience a paydown or other prepayment.

Keywords: asset-backed security (ABS), mortgage-backed securities (MBSs), cash settlement, credit default swaps (CDSs), credit event, pay-as-you-go, physical settlement, structured finance securities

Credit derivatives were first introduced during the 1990s, initially as a risk management tool for banks seeking to manage and transfer the credit exposure of their loan books. They have since developed into an asset class in their own right, in synthetic form, and in some cases are preferred to the cash version of an asset where the latter is in short supply or otherwise illiquid. The advent of a liquid and transparent market in credit derivatives has meant that investors are now looking at synthetic access to the asset-backed ...