Residential mortgage securitizations amortize at different rates, which makes hedging the interest rate risk a complicated task. This article examines what happens if the swap is terminated early.
Most U.K. residential mortgages have a 25-year legal maturity, but the average maturity is much less because homeowners remortgage when they move and frequently refinance their mortgages after introductory offer periods.
When residential home loans in the U.K. are securitized, the loans and the security are transferred/sold as a pool of assets to a specially created company (the "Issuer") which will typically finance its purchase by issuing notes to investors in the capital markets. These securities will have legal maturities exceeding the final legal repayment date of the mortgage loans. So, starting today, the notes might have a legal maturity of 2035. When a homeowner whose mortgage loan forms part of the securitized pool redeems his mortgage (i.e. pays back the borrowing secured by the mortgage), the proceeds will be paid by the Issuer to the investors as a partial repayment of principal on the notes. The notes are therefore expected to amortize. Although there is substantial historic data to give rise to a clear expectation, within fairly narrow margins, of the rate of amortization of the notes, the documentation provides only for the notes to amortize as the mortgages are in fact redeemed and this amortization is therefore at an uncertain rate.
Floating-Rate Obligations
Long-term securitized notes with uncertain amortizations are nearly always floating-rate obligations. In the absence of deteriorating or improving credit, these tend toward a value equal to their face amount on each coupon payment date and so neither the Issuer nor the investors should have a problem with early repayment. Mortgage loans in the U.K. have many different interest rate styles, at least in the initial stages. The interest income for the Issuer is therefore varied: the one thing it will not do, as a whole, is vary with the market floating rate.
The Issuer has an obvious mismatch, a floating rate liability and a fixed-rate asset, and will be required to enter a swap with an appropriately rated counterparty. The swap will broadly be written as floating rate (payable by the counterparty) against a fixed rate (payable by the Issuer) based on the principal amount of mortgage loans (or perhaps of notes outstanding) and lasting until 2035. This description is simplified and ignores the variations which may be included in the swap to address floating rate mortgages or changes in the asset interest, for example, where the originator fixes, for a further period, the rate of interest on the mortgage or holds surplus cash temporarily on deposit.
How To Write The Swap
Such a swap can be written in several ways. Two reasonably standard forms are: to write it as a single period swap (e.g. for a period of six months) with an obligation to write (or abide by) the same interest-rate terms for each successive period. As time passes, the notional amount of the swap, tied to assets or liabilities, will automatically come down as mortgages redeem and notes are repaid (type 1). Another type is to write the swap initially as a fixed rate against floating rate on a notional amount equal to the initial mortgage loans or notes through to legal maturity, but with the notional amount of the swap being reduced irrevocably at the beginning of each future period as assets/liabilities of the Issuer amortize (type 2). But it is a rare event when a swap in this sort of situation is written with an actual amortization profile, that is, with a schedule of pre-agreed notional amounts for all of the future periods under the swap. The reason is that, with uncertain amortization, the parties do not know what amortization profile is right. And to use a profile that is wrong exposes the Issuer to an obvious and unnecessary mismatch in the future, a position that investors and rating agencies seek to avoid.
It is clearly the case, with either suggested form of the swap, that the counterparty is taking the risk of the actual amortization's not matching the expectation and the counterparty will build into its pricing some charge for taking that risk. After all, the counterparty will hedge its own exposure under that swap by going into the swap market itself, but most probably on the basis of what it expects to be the actual amortization.
If the securitization runs its course and a sufficient number of the mortgages are redeemed, so that the notes are repaid in full, then all will be well. But what is the position if the swap is terminated part way through? This can, naturally, happen in circumstances which are unconnected to the performance of the mortgage loans. For example, the counterparty may be downgraded below the ratings required by the rating agencies and a replacement counterparty may take over as the swap provider. Or a change in tax may result in the refinancing of the entire securitization, with an early repayment of all the notes.
The 1992 Master
On an early termination, under the 1992 International and Swaps and Derivatives Association Master Agreement, the terminated transaction will be valued, usually by the counterparty, on the basis of "Market Quotation" or "Loss". Under a type 1 swap, there has to be some doubt as to whether to take account of the obligation to continue to write swap transactions for future periods. A type 2 swap, by contrast, might have, at any time, a notional amount which is the same for all future periods (subject to reduction in the future by reference to actual mortgage redemptions). Market Quotation might give considerable uncertainty as to the value of a type 1 swap, while for a type 2 swap, the numbers which are subject to the Market Quotation do not reflect anyone's expectation of the real future. Where Loss is used, there is an opportunity for the counterparty to develop a valuation based on the costs of breaking the hedge and so the difficulty is reduced, but the hedge was not a perfect hedge in the first place and so there would be an additional task in linking a particular hedge to the securitization swap. Under ISDA's 2002 Master Agreement the situation would be similar to the "Loss" method.
In particular, significant difficulties can arise in the valuation of these swaps where the Issuer (or the originator) has made it quite plain that the structure is to be collapsed or refinanced. If all the parties know that the assets/notes are to be refinanced/redeemed on the next interest payment date, the notional amount for either swap described above would reduce to zero for all future periods, which is the equivalent of an early termination, but here with a zero value. It is unlikely that either party would intend such a change to take place without some form of compensation. They probably intend changes which result from faster or slower asset amortization to be made without cost, but not more dramatic changes resulting from other matters.
Neither type of swap described above is adequate to deal with these issues. One solution is to provide that there is an official amortization profile delivered at the beginning of the swap which sets out the real, genuine expectation of the Issuer/originator as to the amortization of the assets/notes over the life of the deal. This profile can then be updated on each interest payment date, to reflect changes in that expectation for the future. The swap can then provide that, for the purposes of valuation on an early termination, the swap transaction is to be deemed to have an amortization profile which is the same as the profile most recently delivered. This is clearly more complicated than the usual approach, as it requires a person to make calculations toward the end of each period as to the expectations for the future and there will be a debate in any transaction as to which of the many parties is best placed to carry out that task.
A regularly updated amortization profile will deal with the situation of the unexpected early termination, but it does not, without more, address the valuation consequences of a sudden reduction of the amortization profile to zero. Again, there may be several answers, for example, allowing, without cost, changes up to a certain value or within certain parameters or resulting from certain types of events. One of the simplest, conceptually, is to provide that all changes to the amortization profile carry a cost, but that cost is payable, if by the counterparty, on a deferred basis and, if by the Issuer, on a subordinated basis. The Issuer would then need to be restricted as to when it could redeem all the notes early (i.e. only when it could pay out all amounts due in its waterfall down to and including these amounts to the counterparty) and provisions would need to be made to ensure that, if the counterparty owed these amounts to the Issuer, there was some mechanism for the Issuer to pay them out to a third party, otherwise they would be held for the benefit of the Issuer's shareholders.
This week's Learning Curve was written by Patrick Clancy, derivatives counsel at Shearman & Sterling in London.
