What is an Asset-Backed Credit Default Swap?
An asset-backed credit default swap (ABCDS) is a credit default swap (CDS) wherein the reference asset is the asset-backed security rather than a corporate credit instrument.
Understanding Asset-Backed Credit Default Swaps (ABCDS)
Asset-backed credit default swap (ABCDS) agreements are similar to traditional credit default swap agreements. ABCDS are like insurance, where a buyer pays regular premiums to protect against the possibility that a borrower will not fully repay a financial loan. However, in the case of an ABCDS, the buyer receives protection for defaults on asset-backed securities or tranches of securities, rather than protecting against the default of a particular issuer. Asset-backed securities are securities backed by a pool of loans or receivables, such as auto loans, home equity loans or credit cards loans.
Asset-Backed Credit Default Swap (ABCDS) Compared to Credit Default Swap (CDS)
Because ABCDS can be hedged, they are structured differently from other CDS agreements. For example, since many asset-backed securities amortize and pay monthly, the asset-backed swap will more closely match those features.
Also, an ABCDS operates with a broader definition of a credit event than a traditional credit default swap (CDS). On a regular CDS, a credit event typically only occurs if the borrowing organization goes bankrupt. Since a credit event on a corporate credit instrument is usually a one-time occurrence, under a CDS this event will trigger a large, one-time settlement.
But with an ABCDS, since the protection effectively covers cash flows from many different loans, there can be multiple credit events over the term of the agreement. These various events can trigger settlements of varying durations and sizes. Further, the credit event can occur not just in the case of non-payment of an underlying loan, but also in the case of a write-down, i.e., the reduction of an underlying asset’s book value due to it exceeding its market value.
ABCDS agreements often deliver settlements on a pay-as-you-go basis, meaning the seller compensates the buyer for any write-downs or non-repayments as they occur. For instance, if the value of one of the underlying loans in the asset-backed security declines by $10,000, the asset-backed credit default swap (ABCDS) seller will compensate the buyer by $10,000. From the ABCDS buyer’s perspective, their asset-backed security always operates as if every loan in the pool of loans is being repaid according to its original terms and expected rate of interest. But in exchange for that security, the buyer must pay a regular premium to the ABCDS seller.