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Payments waterfall: Difference between revisions
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It became ''a la mode'' in the dog days of the [[CDO]] market for rating agencies to require the priority as between [[Counterparty|swap counterparty]] and [[noteholder]]s to be inverted upon a swap counterparty insolvency — this is the so-called rating agency “flip” clause. | It became ''a la mode'' in the dog days of the [[CDO]] market for rating agencies to require the priority as between [[Counterparty|swap counterparty]] and [[noteholder]]s to be inverted upon a swap counterparty insolvency — this is the so-called rating agency “flip” clause. | ||
The theory was simple | The theory was simple: if a [[Counterparty type|swap counterparty]] has been ''gauche'' enough to default on its contractual obligation, even if forced to by the vicissitudes of [[insolvency]] (and realistically, that is the only time a regulated swap counterparty to a [[repackaging]] vehicle ''will'' default on its obligations) then it should forgo its privileged place in the security waterfall instead slum it with or, heaven forfend, ''below'' the Noteholders. | ||
At first | At first glance this made sense, and must have seemed ''righteous'' and ''just'', in a “ratings analyst living my own truth” kind of a way, but on a second one, the analysis rather falls apart. | ||
For one thing, contracts are not meant to be punitive, judgmental or even evaluative. Contracts are are what they are; you get what you bargained for regardless of the good or bad grace of your counterparty in providing it, as long as it is around and able to perform it for you. | |||
In the case of a repackaging, a Noteholder bargains for “the value of the underlying asset, plus or minus the value of the [[swap]]”. This is the basic articulation of the economic value of the Note. Where the swap counterparty features in the waterfall does not come into it. Thus, the value of the swap is necessarily cleared to zero ''in order to determine what the Noteholder is owed''. See the set of diagrams to the panel at right. | |||
If the swap counterparty is bust, there are two ways things can go: either it is ''[[out-of-the-money]]'', in which case it net ''owes'' something to the Issuer and has no claim on the security package, so does not really care whether the priority is flipped or not, or it is ''[[in-the-money]]'' | |||
Given that the ratings goal — the repayment of principal at maturity — would usually be predicated on the credit rating of the swap counterparty, this made little sense. And nor did it have any real effect on the payout of the notes: if your counterparty is bust, and it is owed money, then [[Q.E.D.]], the Noteholder’s total claim is limited the the liquidated value of thee bonds minus that payment; if the counterparty owes the SPV money, then no amount of reorganising its place in the security waterfall is going to make any difference since it has no claim against the SPV in the first place. | Given that the ratings goal — the repayment of principal at maturity — would usually be predicated on the credit rating of the swap counterparty, this made little sense. And nor did it have any real effect on the payout of the notes: if your counterparty is bust, and it is owed money, then [[Q.E.D.]], the Noteholder’s total claim is limited the the liquidated value of thee bonds minus that payment; if the counterparty owes the SPV money, then no amount of reorganising its place in the security waterfall is going to make any difference since it has no claim against the SPV in the first place. | ||