The Art of Credit Derivatives: Demystifying the Black Swan

16

ABCDS and PAUG

The big guys are the status quo, not the innovators.

Kenneth Fisher

16.1 INTRODUCTION

In Chapter 4 we discussed the synthetic single name CDS and described models to price it. We have outlined the importance of a CDS by itself and as an essential component of the corporate synthetic CDO asset class. We have also seen the fundamental role played by single name CDSs on the pricing algorithms for not only the corporate standardized credit indices but also for the bespoke corporate CDOs, via the correlation mapping techniques presented in Chapter 12.

In this chapter we describe the CDS of ABS, also known as ABCDS. The instrument has existed since at least 1998 and its purpose was to provide a synthetic form of assets for CDOs of ABSs. Those first ABS CDO transactions were balance sheet CDOs, and the protection buyers realized a reduction of regulatory capital costs. Other protection buyers were engaged on negative basis trade deals, in which the investor buys an ABS bond and an ABCDS, realizing a gain as the spread of the bond was higher than the premium paid on the CDS plus its cost of funding the ABS bond. As expected, the documentation was nonstandard and based on the templates for corporate CDSs. The growth of subprime mortgages and interest of investors, especially hedge funds interested in taking a short position on subprime mortgages, brought up the necessity of a specific dealer transaction template for the instrument that indeed became available by mid ...