Subprime Mortgage Credit Derivatives

CHAPTER 6

Introduction to Credit Default Swap on ABS CDS

credit default swaps (CDS) on ABS have been around since at least 1998. The motivation back then was to provide synthetic assets to ABS CDOs; instead of buying cash bonds, the CDO took on the risk of referenced ABS assets by selling credit protection via credit default swaps. Documentation at that time was nonstandard, one-off, and closely based on corporate CDS templates. As subprime securitization production increased, dealers wanted a means to hedge their warehouse risk while subprime mortgages were being aggregated for securitization. At the same time, hedge funds became interested in shorting subprime mortgage risk. The dealer template for transacting credit default swaps on ABS was first published in June 2005 and the user or monoline template followed soon after. A comparison of these ABS CDS forms, and their differences to corporate CDS, provides insight into the credit issues underlying ABS CDS. We discuss the evolution of ABS CDS in this chapter and show how it allowed the ABS CDO market to grow so big so fast in 2006. We begin by giving enough of an overview of the terms, structure, and advantages of corporate CDS to help clarify issues in ABS CDS.

CORPORATE CDS FUNDAMENTALS AND TERMINOLOGY

The dramatis personae of a corporate CDS are: a credit protection buyer, a credit protection seller, a reference obligor, and reference obligations. These parties are tied together by notional amount, credit events, physical ...