Hedging considerations in CDO transactions.

• Author: O'Keefe, Brian
• Position: Collateralized debt obligations

CDO will use some combination of interest rate swap and cap agreements to hedge its risks against interest rate mismatches between fixed rate assets and floating rate liabilities, or visa-versa. Similarly, it may be necessary to employ a basis-risk swap where the collateral consists of floating-rate assets linked to one index, while the liabilities pay interest based on another. In addition to these interest-rate and basis-risk swaps, a transaction may employ currency hedges where assets and liabilities are paid in different currencies to protect against foreign-exchange risk.

1. INTRODUCTION

   Many CDO structures use swap agreements to transform the cash flow characteristics of the issuer's assets into payment terms sought by investors. Most commonly, the CDO will use some combination of interest rate swap and cap agreements to hedge its risks against interest rate mismatches between fixed rate assets and floating rate liabilities, or visa-versa. Similarly, it may be necessary to employ a basis-risk swap where the collateral consists of floating-rate assets linked to one index, while the liabilities pay interest based on another.

   In addition to these interest-rate and basis-risk swaps, a transaction may employ currency hedges where assets and liabilities are paid in different currencies to protect against foreign-exchange risk. The overwhelming majority of these hedges are documented using the master agreement prepared by the International Swap Dealers Association, Inc. (ISDA). Set forth below is a discussion of the criteria that Standard and Poor's applies in transactions with "AAA" rated tranches for determining which parties are eligible to be swap counterparties and the provisions that are acceptable under the ISDA documentation.

2. INTEREST RATE AND BASIS RISK SWAPS

   1. HEDGE COUNTERPARTIES RATINGS REQUIREMENTS

      Entities rated with a short-term rating of 'A-1' or better may serve as swap counterparties in interest-rate and basis-risk hedges. To the extent that a potential counterparty does not have a short-term rating (or prefers to use a long-term rating to satisfy the ratings requirement), the entity must have a long-term rating of 'A+' or higher to be an acceptable interest-rate and basis-risk hedge counterparty. (These rating requirements may be satisfied by the rating of a guarantor of the swap counterparty's obligations under the hedge agreement, provided that such guarantor is identified under the ISDA documentation as a Credit Support Provider.)

   2. REQUIREMENTS UPON DOWNGRADE

      Should the rating of the counterparty (or the rating of its guarantor, if satisfaction of the ratings requirement is dependent upon the rating of such guarantor) fall below the 'A-1' or the 'A+' thresholds discussed above, the swap counterparty will then have an obligation to find a substitute counterparty that satisfies these rating requirements, All costs associated with finding such a replacement and assigning the agreement shall be borne by the "downgraded" swap counterparty. In the event that the agreement has not been assigned to a new counterparty within 30 days, the swap counterparty will be required to post collateral in amount equal to the greater of the market-to-market value of the swap, the amount of the next payment due, or 1% of the outstanding notional amount of the hedge agreement. These amounts should be posted in accordance with the collateral posting requirement set forth below.

      Regardless of the fact that the counterparty may have posted such collateral in accordance with Standard & Poor's criteria after 30 days, the obligation of the swap counterparty is to find a replacement swap counterparty to which it may assign its rights and obligations under the agreement, which will remain in effect. In the event the swap is not replaced within this 30-day period, then a rating action may be taken. Standard & Poor's will weigh the following: the swap maturity; the market value of the swap; the market for similar swaps; the current rating of the transaction; and the rating outlook of the swap provider.

   3. COLLATERAL POSTING REQUIREMENTS

      All collateral should be pledged to the trustee or other independent third party acting as agent for investors. The collateral should be segregated and pledged under normal ISDA requirements and in the possession of the trustee or some other fiduciary third party.

      Collateral is to be invested in eligible investments (other than debt of the counterparty) in the currency of the rated securities and should be deposited in an account in the name of the trustee or issuer. The funds should be invested with an eligible institution other than the swap provider. If the funds do not mature before the next interest payment due on the rated securities, additional collateral may be...