Super senior tranches of synthetic collateralized debt obligations: part one

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1 Super senior tranches of synthetic collateralized debt obligations: part one, Partner 2 April 2001 In part one of this article, Adam Glass explains why insurers and banks approach documenting the super senior credit default swap in a synthetic collateralized debt obligation with different expectations, resulting in an epic battle of viewpoints he calls Swaps World vs Insurance World Many synthetic collateralized debt obligations (CDOs) have an insurer taking the ultimate risk on the super senior (above AAA) portion of the transaction s credit default swap. It would be a mistake, however, to conclude from this that the parties to the super senior swap come in with a well-established, consistent set of expectations. Generally, the intermediary bank will want to document the swap with the insurer s special purpose vehicle (SPV) with the same standard provisions the bank uses in its other credit default swaps. The insurer, on the other hand, will want to trim away all provisions that tend to make the substance of the transaction different from a typical financial guaranty transaction. Consistent with the foregoing, the insurer will want to minimize the role of the SPV, which it views as merely a formal prerequisite to writing insurance policies on credit default swaps. The intermediary bank, on the other hand, will tend to take the swap with the SPV seriously and will resist attempts to remove provisions (such as cross default, credit event upon merger, and so on) that it views as important to limiting its risk in swaps generally. This leads to certain topics being negotiated with predictable regularity in a battle of expectations I call Swaps World vs Insurance World. Payments on early termination The intermediary bank will generally want Section 6(e) of the International Swaps and Derivatives Association, Inc. (ISDA) Master Agreement to apply, so that if the swap is terminated according to its terms prior to its scheduled termination date, the party for whom the swap is an asset will receive a payment from the other party, more or less equal to the market value or replacement cost of the swap to the party for whom the swap is an asset. This approach is standard for swap agreements and will satisfy the internal policies of the bank and make the credit default swap function like the bank s other swaps. The intermediary bank will expect that termination payments owing from the SPV under Section 6(e) will be insured. The insurer, on the other hand, will have problems with this approach. First, the insurer will reject the notion that it may have to make a payment to the beneficiary even though no credit event has occurred and the beneficiary s default may have caused the early termination of the swap. Second, if the insurer

2 is exposed to the risk of changes in market value of the underlying credit default swap as well as the credit risk of the obligations to which the credit default swap refers (the reference obligations ), its accountants may require it to account for the insurance policy as a derivative under Financial Accounting Statement (FAS) 133, in which case its carrying value will have to be marked to market, possibly introducing unwelcome balance sheet volatility. Third, ISDA-style termination payments are not a standard feature of insurance policies, where the insurer will generally have only the single obligation to pay insured amounts under the policy in respect of nonpayment on the insured obligation. For these reasons, the insurer will attempt to negotiate walk away termination provisions. That is, in the event of an early termination of the swap agreement, the protection buyer will be liable for the accrued Fixed Amount (as such term is defined in the 1999 ISDA Credit Derivatives Definitions) to the date of the termination, and the protection seller will be liable for all credit protection payments that may become due with respect to credit events that have occurred prior to the date of termination, but no other amounts will be payable by either party in respect of the early termination. In terms of documentation, this result is accomplished by including language in the swap disapplying the provisions of Section 6(e) of the printed ISDA Master Agreement, and adding a provision to the effect set forth in the preceding sentence. If the business arrangement calls for it, the insurer may also be entitled to a make-whole payment in respect of the early termination if the early termination happens before a specified date. The insurer may agree to ISDA-style damages for early termination resulting from events that it considers extremely remote, such as bankruptcy or failure to pay by the insurer, and the beneficiary may be interested in having these termination events included to make the swap look more like a typical swap agreement. Events of default and early termination events The intermediary bank will usually start with the standard ISDA Events of Default and Early Termination Events set forth in Sections 5(a) and 5(b) of the ISDA Master Agreement as its wish list. It may add some additional termination events relating to regulatory factors or a credit rating downgrade of the insurer. The insurer, on the other hand, generally wants as few events of default and early termination events to apply as possible. From the insurer s point of view, its only obligation is to make a payment on the policy when a claim is made. If it fails to make the payment, the intermediary bank should sue. Other events of default relating to the SPV or the insurer are extraneous. The insurer will resist the inclusion of cross default as an event of default, as it believes that only its performance or nonperformance on the policy are relevant. The insurer will resist an additional termination agreement based on a rating downgrade (not a typical feature of financial guaranty insurance), and if it is required to agree to a downgrade additional termination event, it will insist that any replacement will not be at the insurer s cost. The insurer will also resist any provisions that could have the effect of requiring the payments under the policy to be grossed up for unanticipated taxes. While a standard ISDA Master Agreement requires each party to represent that no withholding taxes will be due on any payments to be made by it, and to gross up payments by it to eliminate the effect of any withholding taxes that are found to apply,

3 the insurer will generally take the position that it is not responsible for the tax risks of the structure, and should be able to pay net, not gross, of any withholding tax found to apply.

4 Super senior tranches of synthetic collateralized debt obligations: part two, Partner 9 April 2001 In part one of this article, Adam Glass explained why insurers and banks approach documenting the "super senior" credit default swap in a synthetic CDO from different perspectives. Part two sets out some further examples of points of disagreement and how they are typically resolved Collateral The provision of collateral in an amount linked to the replacement value of the transactions between the parties pursuant to an ISDA credit support annex (a specialized two-way security agreement used with swap agreements) has become increasingly popular among swap counterparties. An intermediary bank that generally requires the posting of collateral will also request this of an insurer that is guaranteeing a credit default swap, at least on any downgrade of the insurer. Like other New York insurance companies, financial guaranty insurance companies (monolines) appear to have the authority to pledge collateral to secure their obligations, including obligations under insurance policies. However, they may be reluctant to do so, because such pledges could affect the regulatory capital position of the company. The superintendent reserves the authority not to admit assets pledged to secure the performance of specific obligations. Assets that are not 'admitted assets' cannot be counted in determining regulatory surplus. As a result, an insurer may be reluctant to agree to enter into a credit support annex, preferring at most to allow a downgrade termination of the credit default swap in which the insurer can be replaced at the counterparty's cost if the counterparty so chooses. Oral contracts versus written contracts: formality of documentation procedures Swap agreements, especially standardized contracts such as interest rate swaps, currency swaps, and even single name credit default swaps documented on standard ISDA forms, are often concluded over the telephone. In this case, the "confirmation" for the transaction (as defined in the ISDA Master Agreement) really is a confirmation of an already existing agreement. To expedite the closing of transactions, parties to a swap agreement that have not previously transacted may enter into a confirmation that contains a covenant to negotiate in good faith to enter into a schedule to the ISDA Master Agreement. The confirmation may recite that until such time as a schedule has been agreed, the terms of the printed ISDA Master Agreement will apply. The insurer, on the other hand, will not want to issue the policy until the swap documents are final and fully executed. Entering into a policy insuring payments that are due under a credit default swap, where the confirmation has been executed but the schedule remains to be negotiated will seem, to the insurer, like issuing a policy on bonds issued under an indenture that has not been executed. Generally, the

5 insurer's insistence on having final, executed documents before its policy takes effect should carry the day. Insurance licensing issues for intermediaries The intermediary bank will generally want assurance that its back-to-back transaction with the bank that is the ultimate protection buyer cannot be recharacterized as insurance. To generalize further, banks (and other financial institutions that are not licensed insurers) will generally want this assurance when they enter into credit default swaps. To accomplish this result, credit default swaps generally recite language to the effect that "the parties agree and acknowledge that seller's payment obligation hereunder is not conditioned on buyer having suffered a loss, and therefore this contract is not a contract of insurance." While the author has worked on transactions where the monoline protection seller has attempted to structure the transaction so that the protection buyer is in fact required to have suffered a loss, generally the bank's desire not to be subject to recharacterization as an unlicensed insurer will carry the day. Insurance premium tax issues for protection buyers Just as non-insurer protection sellers will want to be assured that the contract they are executing is not the issuance of an insurance policy, protection buyers that would be subject to an excise tax on the payment of insurance premiums of the swap's insurance will want the same assurance. This risk arises under Internal Revenue Code section 4371 if the protection buyer is located in the US and the protection seller is a foreign insurer. Non-acceleration clause in insurance policy Under section 6905 of the New York Insurance Code, policy forms must be filed with the superintendent within 30 days of their use by the insurer, and each policy must provide that, in the event of a payment default by or insolvency of the obligor, there shall be no acceleration of the payment required to be made under such policy unless such acceleration is at the sole option of the financial guaranty insurance corporation. Swap counterparties will often object to this language on the ground that it does not apply to swaps. However, once they are informed that it is required by statute, and does not change the terms of the transaction, they are usually comfortable retaining the language.