Structured Finance Security CDS are credit default swaps where the underlying asset is a structured finance security such as an Asset-backed Security (ABS) or a Mortgage-backed Security (MBS).
A CDS on ABS/MBS can be used to transfer the credit risk away from an ABS/MBS and can also be used to short the credit risk of an ABS/MBS.
In case of a CDS on ABS/MBS the protection seller will generally pay periodic payments of interest/principal shortfalls or principal write-downs, and “Par” (written down) in exchange for Delivery of Reference Obligation. Alternatively, it will pay a reduction in market value (i.e., cash settlement). The payments are triggered by Credit Events, or Floating Amount events (Pay As You Go). In such CDS, the protection can continue for full life of the Reference Obligation.
The credit risk of these structured finance securities differs significantly from the other corporate credit because of which the documentation and settlement procedures of the CDS on ABS/MBS need to be modified. The differences arise from the applicability of the credit events and the process of settlement. Since the structured finance securities such as ABS/MBS are issued through a special purpose vehicle (SPV), which is bankruptcy-remote, credit events such as bankruptcy and debt restructuring does not apply. Also, in case of SPV, it is difficult to identify that there is a default of payment. Generally, corporate bonds have a bullet maturity — a single principal payment of principal on maturity date. If principal is not paid on time, it is considered as failure to pay (Credit event). However, ABS/MBS amortize over time, and the “average life” of these securities assumes a certain prepayment rate. So, a failure to pay according to the prepayment schedule will not constitute a credit event.
Another difference is that due to the prepayments, and the paydown of principal on underlying loans, the outstanding balance of the reference entity will decline. Accordingly, the notional of the CDS will also decline.