Winchester Capital Principal Finance is planning to enter an innovative mortgage-backed security transaction in which it sells protection on single pools of MBS still in the pipeline. The motivation for the structured credit fund is to reduce the funding costs to create an arbitrage between its liabilities and its assets. It can do this via unfunded derivatives because it does not need to borrow money in order to take MBS exposure, according to market officials. Officials at Winchester declined comment. Another advantage is that ABS assets are in hot demand and supply is often short, so entering a synthetic deal removes the need to go through the syndication process and ensures the fund gets its desired allocation.
In addition, the default swap eliminates non-credit risks, such as interest rate risk. Most mortgage-backed securities contain a cap on the level of interest, known as the available funds cap, which stops funds being diverted to the securitization structure if rates go over a pre-determined level. This is unlikely to be counted as a credit event, according to credit pros, and therefore purifies the credit risk of the instrument.
The demand for buying protection is likely to come from investment banks looking to lock in spreads at which they can issue mortgage-backed securities. Most dealers enter agreements with mortgage banks in which they commit to issuing the next several months worth of bonds at a set spread. It also removes the credit risk while the dealer is waiting to issue the security.
Credit derivatives referenced to other types of asset-backed securities, such as credit cards, have already been traded but mortgage-backed trades are harder to structure because the credit risk is further removed from the company. For example, MBIA's credit rating is considered to be more closely related to its credit card deals than a German mortgage bank is to its MBS deals.
Rival traders said that they are working on similar projects, but that such deals were hard to document. "It's great in concept, but you try documenting it!" one cried. Each MBS is issued out of a different special-purpose entity and may have different collateral from the previous trades, so the protection is being written on an entity that doesn't exist.
