Today we will examine in more detail the value of CDS contracts.
2.1) CDS at Loan Origination:
If at loan initiation, the borrower requires more than the maximum of 80% LTV, then the lender can buy a CDS to cover the increased risk to protect their balance sheet holdings from any potential default.
The lender can negotiate such in the primary CDS market on behalf of the borrower and pass on the quarterly premium to the borrower through the establishment of an escrow account at origination.
Such CDS contract will continue to exist and is payable by the borrower until such time as the LTV reaches the required 80% value, upon which the CDS will cease to exist.
In order to determine the annual LTV, we refer back to the mark-to-market strategy as previously discussed.
In case of default by the borrower during the existence of the CDS, either due to personal default or through a decline in home prices, both the mortgagor and mortgagee are protected from any potential shortfall.
This can be equated as follows in two scenarios:
The borrower sells the home for less than the total outstanding principal:
L(it2) > P(it2)
Whereby L(it2) represents the outstanding loan value and P(it2) reflects the sale price of the home.
In this case, the borrower will repay the original 80% of the initial loan minus any principal paid prior to the sale.
The lender will call in the CDS contract to make up for the shortfall as covered by the contract.
The borrower defaults on the loan and the bank repossesses the home.
In this case, the lender will sell the property at FMV and apply the proceeds to the outstanding principal.
The lender will call in the CDS contract as in scenario 1 to cover the shortfall.
2.2) CDS during the Life of the Loan:
Assuming that a standard 80% loan was approved and went into effect.
During the life of the loan and according to the mark-to-market strategy, the LTV rises above the mandated 80%.
In this case, the lender will buy a CDS contract to cover the default risk and will mandate from the borrower to pay the quarterly premiums through the establishment of an escrow account (see above) until such time as the LTV reaches a normal level again or until the property is sold and the loan repaid.
Tomorrow we will look at the market conditions and draw our final conclusions.