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ISDA Definitions in case of Asset-backed Securities

Vinod Kothari

The June 2005 Confirmation to be used in case of Asset-backed Securities substantially amends the Credit Derivative Definitions 2003 in respect of asset-backed securities.

The most significant issue in a credit default trade is the definition of Credit Event, with reference to which protection payments under the swap are triggered. This definition, in case of ABS default swaps, will include the following events, and once again, parties may choose one or more of them at their discretion:

• Failure to pay
• Loss event
• Bankruptcy
• Rating downgrade

The definition of “failure to pay” is as under:

“Failure to Pay” means either:
(a) (i) after the expiration of any applicable Grace Period the occurrence of a non payment of an Expected Payment Amount on a Scheduled Distribution Date (a “Payment Shortfall”) which is in excess of the Payment Requirement where, for the avoidance of doubt, the occurrence of such a non-payment shall be determined taking into account any payment by or on behalf of the Insurer or Guarantor, if applicable; and
(ii) the satisfaction of one or more of the following conditions:
(A) the terms of the Reference Obligation do not provide for the reimbursement of the Payment Shortfall;
(B) [the terms of the Reference Obligation do not provide for interest to be paid on the Payment Shortfall at a rate equal to or greater than the Scheduled Interest Rate from the day of the Payment Shortfall until the day on which such Payment Shortfall is reimbursed in full; ] or
(C) such non-payment gives rise to an event of default (however described) under the terms of the Reference Obligation or other event allowing the holders (or a trustee acting on behalf of the holders) of the Reference Obligation to accelerate the Reference Obligation; or
(b) a failure to pay in full the outstanding principal balance of the Reference Obligation, without regard to any restructuring or writedown of the outstanding principal balance of the Reference Obligation whether or not in accordance with its terms occurring on or after the Trade Date, at the earlier of:
(i) the Maturity Date; and
(ii) the day on which the assets designated to fund the Reference Obligation have been disposed of (whether in accordance with the terms of the Reference Obligation or otherwise and whether pursuant to sale or liquidation or otherwise) and all proceeds of those assets have been fully distributed (whether in accordance with the terms of the Reference Obligation or otherwise and whether so distributed to holders of the Reference Obligation or any other person).

In short, an FTP event will be deemed to have taken place in case of asset-backed securities, if an “expected payment” has not been paid on a scheduled distribution date, or if the full outstanding principal has not been paid off by the maturity date, without taking into account any restructuring or write-off.

“Expected payment” has been defined as under:

“Expected Payment Amount” means a payment of interest or principal due or scheduled to be paid pursuant to the terms of the Reference Obligation or any financial guarantee insurance policy or similar financial guarantee in respect of the Reference Obligation as at the Trade Date without regard to any subsequent amendment, provided that if the terms of the Reference Obligation are amended such that a Scheduled Distribution Date occurs on a New Scheduled Distribution Date and as a result of such amendment the amount of interest or principal due or scheduled to be paid on such New Scheduled Distribution Date is reduced, then the Expected Payment Amount in respect of such interest or principal shall be such reduced amount. The Expected Payment Amount shall not include any amount properly withheld from a payment in respect of the Reference Obligation or any additional amount required to be paid in respect of the Reference Obligation in each case because of any withholding tax. The Expected Payment Amount shall be determined without regard to the effect of any provisions of the Reference Obligation that permit or provide for the limitation of payments or distributions of funds in accordance with the terms of the Reference Obligation pursuant to an available funds cap or otherwise, that provide for the capitalization or deferral of interest on the Reference Obligation, or that provide for the extinguishing or reduction of such payments or distributions.

“Loss event”, briefly speaking, is allocation of losses to the ABS investor. The definition runs as under:

“Loss Event” means:
(a) the occurrence of a Principal Reduction pursuant to the terms of the Reference Obligation; and
(b) the satisfaction of one or more of the following conditions:

(i) the terms of the Reference Obligation do not provide for the reinstatement or reimbursement of the Principal Reduction;
(ii) the terms of the Reference Obligation do not provide for interest to be paid, at the Scheduled Interest Rate, on the Principal Reduction, from the day of the Principal Reduction until the day on which such Principal Reduction is reinstated or reimbursed in full; or
(iii) [the terms of the Reference Obligation do not provide for interest to be paid, at a rate at least equal to the Scheduled Interest Rate, on the interest which would have accrued on the Principal Reduction, from the day of the Principal Reduction until the day on which such Principal Reduction is reinstated or reimbursed in full].

The word “bankruptcy” has also been re-defined. This is obviously important because the issuers of asset backed securities are special purpose vehicles which do not go bankrupt as such. The definition of bankruptcy in case of asset-backed securities goes as under:

[“Bankruptcy” means both (i) a Reference Entity (a) is dissolved (other than pursuant to a consolidation, amalgamation or merger); (b) makes a general assignment, arrangement or composition with or for the benefit of its creditors; (c) institutes or has instituted against it a proceeding seeking a judgment of insolvency of bankruptcy or any other relief under any bankruptcy or insolvency law or other similar law affecting creditors’ rights, or a petition is presented for its winding-up or liquidation, and, in the case of any such proceeding or petition instituted or presented against it, such proceeding or petition (A) results in a judgment of insolvency or bankruptcy or the entry of an order for relief or the making of an order for its winding-up or liquidation or (B) is not dismissed, discharged, stayed or restrained in each case within thirty calendar days of the institution or presentation thereof; (d) has a resolution passed for its winding-up, official management or liquidation (other than pursuant to a consolidation amalgamation or merger); (e) seeks or becomes subject to the appointment of an administrator, provisional liquidator, conservator, receiver, trustee, custodian or other similar official for its or for all or substantially all its assets (excluding, for the avoidance of doubt, the appointment by the Reference Entity of a trustee, custodian, fiscal agent or similar representative solely for the purposes of an issue of securities by the Reference Entity) (f) has a secured party take possession of all or substantially all its assets or has a distress, execution, attachment, sequestration or other legal process levied, enforced or sued on or against all or substantially all its assets and such secured party maintains possession or any such process is not dismissed, discharged, stayed or restrained, in each case within thirty calendar days thereafter; or (g) causes or is subject to any event with respect to it which, under the applicable laws of any jurisdiction, has an analogous effect to any of the events specified in clauses (a) to (f) (inclusive) and (ii) the occurrence of any of the events described in clauses (a) to (g) (inclusive) has given rise to an event of default (howsoever described) under the terms of the Reference Obligation.]

The other unique credit event in case of asset-backed securities is rating downgrade. The definition of rating downgrade runs as under:

[“Rating Downgrade” means the occurrence of one or more of the following:
(a) the Reference Obligation is rated by Fitch only and has been downgraded to [CC] or lower;
(b) the Reference Obligation is rated by Moody’s only and has been downgraded to [Ca] or lower; or
(c) the Reference Obligation is rated by Standard & Poor’s only and has been downgraded to [CC] or lower
(d) the Reference Obligation is rated by two or more of Fitch, Moody’s and Standard & Poor’s and has been downgraded to [CC] or lower or [Ca] or lower, as applicable, by at least two of Fitch, Moody’s and Standard & Poor’s.]