Securitisation Swaps: A practitioner handbook Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation and financial instrument analysis, as well as much more For a list of available titles, visit our website at www.wileyfinance.com Securitisation Swaps: A practitioner handbook MARK AARONS VLAD ENDER ANDREW WILKINSON This edition first published 2019 © 2019 Mark Aarons, Vlad Ender, Andrew Wilkinson Registered office John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, United Kingdom For details of our global editorial offices, for customer services and for information about how to apply for permission to reuse the copyright material in this book please see our website at www.wiley.com All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, except as permitted by the UK Copyright, Designs and Patents Act 1988, without the prior permission of the publisher Wiley publishes in a variety of print and electronic formats and by print-on-demand Some material included with standard print versions of this book may not be included in e-books or in print-on-demand If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com For more information about 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should be sought Library of Congress Cataloging-in-Publication Data Names: Aarons, Mark, 1975- author | Ender, Vlad, 1974- author | Wilkinson, Andrew, 1979- author Title: Securitisation swaps : a practitioner’s handbook / Mark Aarons, Vlad Ender, Andrew Wilkinson Description: Chichester, West Sussex, United Kingdom : Wiley, 2019 | Series: Wiley finance series | Includes bibliographical references and index | Identifiers: LCCN 2018041666 (print) | LCCN 2018048782 (ebook) | ISBN 9781119532347 (ePub) | ISBN 9781119532309 (Adobe PDF) | ISBN 9781119532279 (hardcover) | ISBN 9781119532309 (ePDF) | ISBN 9781119532330 (ebook) Subjects: LCSH: Derivative securities—Handbooks, manuals, etc Classification: LCC HG6024.A3 (ebook) | LCC HG6024.A3 A2325 2019 (print) | DDC 332.64/57—dc23 LC record available at https://lccn.loc.gov/2018041666 A catalogue record for this book is available from the British Library ISBN 978-1-119-53227-9 (hardback) ISBN 978-1-119-53234-7 (ePub) ISBN 978-1-119-53230-9 (ePDF) ISBN 978-1-119-53233-0 (Obook) 10 Cover Design: Wiley Cover Image: © chain45154 / Moment / Getty Images Set in 10/12 pt, TimesLTStd-Roman by SPi Global, Chennai, India Printed in [Printer country] by [Printer Name and location] To Suzanne, Alex, Will and Jacqui with love and gratitude – M.A To Irena and Anna – you gave me support and love when I needed it – V.E To Amy, who never fails to shine a guiding light for me – A.W Contents About the Author xiii Foreword xv Acknowledgements xix CHAPTER Introduction CHAPTER Overview of Structured Funding Funding Funding Instruments Securitisation The Securitisation Process Structured Funding Participants Asset and Cash Flow Transformation Summary of Securitisation Master Trusts Securitisation and the GFC Covered Bonds Documentary Framework Offer Document Subscription Agreement Sale Agreement Trust Documentation Servicing Agreement Swaps Ancillary Service Provider Documentation Structured Funding Markets Risks Credit Risk Market Risk 8 16 18 18 21 22 24 24 25 25 25 27 27 28 31 32 32 32 vii viii CONTENTS Liquidity Risk Prepayment Risk Extension Risk Downgrade Risk Operational Risk Legal Risk CHAPTER Asset-Backed Debt Structures Loan Pool Dynamics Derivation of Eq (3.1) Pool Amortisation Securitisation Structures Standalone Structures with Pass-Through Tranches Standalone Structures with Bullet Tranches Standalone Structures with Controlled Amortisation Tranches Tranche Conservation Laws Master Trust RMBS Structures Credit Card ABS Structures Covered Bond Structures Hard Bullets Extendible Maturity Structures Comparison of Structures CHAPTER Swaps in Structured Funding An Overview of Vanilla Swaps Interest Rate Swaps Cross-Currency Swaps Vanilla Swap Pricing Asset Swaps Liability Swaps Standby Swaps Swap Priority and Flip Clauses CHAPTER Swap Prepayment Risk What is Swap Prepayment Risk? The Expected Swap Schedule Balance Guarantee Swaps 33 33 34 34 35 35 37 37 38 42 42 42 47 48 49 50 55 57 57 58 59 61 61 61 64 66 68 70 72 74 79 79 80 83 Contents Re-Hedging What Factors Drive Prepayment Rates? Monte Carlo Modelling of Swap Prepayment Risk Working with a Mixed Measure Modelling Prepayment Modelling the Market Risk Factors Simulation Methodology Greeks, Hedging and VaR Computing Greeks Hedging Value-at-Risk XVA Computing XVA for Swaps with Prepayment Risk Intermediated Asset Swaps Mitigation Strategies Risk Transfer Controlled Amortisation Structures Reducing Prepayment Volatility via Diversification Due Diligence and Surveillance Duty of Continuous Disclosure Step-Ups System Issues and Whole-of-Life Deal Management Trade Capture Trade Maintenance Risk Systems CHAPTER Swap Extension Risk What is Swap Extension Risk? Examples of Extension Risk Dependence on the Capital Structure: Standalone SPVs Extension Risk in UK RMBS Master Trusts Covered Bond Extension Risk A Simple Pricing Framework for 1-Factor Stochastic FX Full Pricing Framework in a Multi-Factor Setting Mitigation Strategies Pre-Trade Structuring versus Real-Time Hedging Pre-Trade Structuring Real-Time Hedging Stress Testing ix 84 90 91 92 93 96 97 103 103 104 106 108 108 109 110 110 111 112 114 115 116 116 116 117 118 119 119 121 126 127 127 128 132 133 133 135 138 139 x CONTENTS CHAPTER Downgrade Risk Rating Agency Criteria Criteria Specifics Examples Legal Aspects Updates of Counterparty Criteria Trade Capture and System Challenges The Competitive Landscape for Third-Party Swap Providers Basel III and the Liquidity Coverage Ratio Liquidity Transfer Pricing Constructing the LTP Curve Updating the LTP Curve Contingent Funding Valuation Adjustment What Is CFVA? Costs and Probabilities The CFVA Calculation Revaluation and Hedging Risk Limits Tenor Currency Purpose Mitigation Strategies Choice of Rating Agencies Contractual Protections Optimum Implementation of Counterparty Criteria Risk Transfer Collateralisation from Day One Replacement Risk Replacement of the Swap Provider Third-Party Guarantors Restructuring Mitigants CHAPTER Deal Management Pricing The Total Swap Cost Pricing Transparency Execution Charges Deal Checklist for Swap Providers 141 142 144 146 149 151 153 155 157 159 161 162 162 162 163 165 170 171 172 172 172 172 173 174 174 176 176 177 178 178 179 179 181 181 181 183 184 185 Contents Closing the Deal The Pricing Call Executing the Documents Covered Bond Coupon Rounding Market Risk Management Measurement Monitoring Governance and Risk Limits Inform and Act Future Regulation Accounting Fair Value Revenue Reserves Fair Value Hierarchy of Valuation Inputs xi 186 186 187 187 188 189 189 189 190 193 194 194 196 197 Glossary 199 References 201 Index 203 Deal Management 195 as ‘other comprehensive income’ (OCI) known as fair value through other comprehensive income (FVOCI) OCI is presented separately to PnL as a special item in financial reports IFRS 13 defines fair value by reference to an exit price This is the price at which the swap could be sold in an orderly transaction Specifically, IFRS 13 states: When measuring fair value, an entity uses the assumptions that market participants would use when pricing the asset or the liability under current market conditions, including assumptions about risk The phrase ‘assumptions about risk’ has been widely interpreted, amongst other things, as including counterparty credit risk so that CVA is to be included in the exit price of a derivative (though curiously not KVA at this point in time) In the same vein, one can safely assume that charges for swap prepayment risk, extension risk and downgrade risk are also to be included Including these more esoteric risk charges, while eminently reasonable, is not without its challenges Specifically: ■ ■ ■ Opaqueness These charges are highly opaque They are only ever communicated bilaterally Assumption dependence Computing these charges involves many assumptions, which can vary considerably – and perfectly legitimately – between different swap providers depending upon many factors including their business models, risk appetites, internal rates and revaluation policies, modelling choices, calibration methodologies, funding costs, credit rating outlook and the composition of their back-books (which can impact incremental risk pricing) Uniqueness Since there is a very wide range of securitisation and covered bond structures, each deal can be very different This may be reflected in a high dispersion of esoteric risk charges depending on the specific structure Finding comparable deals to benchmark pricing is not always possible Despite these material challenges, a defensible position for third-party swap providers is revaluation based on the parameters and model pricing that won the trade at inception This is especially defensible if the swap was won in competition with other swap providers – the inception price is then a ‘market price’ Nevertheless, it is fair to say that a significant degree of judgement is required when revaluing securitisation swaps, especially if the market has moved a long way since inception and/or if there have been any material changes in the estimation of unobservable valuation inputs, such as expected average prepayment In such circumstances, it is essential that the bank’s Product Control function has sufficient understanding of the modelling 196 SECURITISATION SWAPS: A PRACTITIONER HANDBOOK Revenue Reserves The three esoteric risk charges – swap prepayment risk, extension risk and downgrade risk – are often calculated with a degree of conservatism due to their unhedgeability This means that it is likely that these risk charges will not be fully drawn down over the life of the deal Common examples include: ■ ■ ■ ■ For a BGS over a controlled amortisation tranche, where the schedule is never broken by unexpectedly low prepayment rates, no re-hedging is ever required hence the entirely of the prepayment risk charge remains For a BGS over a pass-through tranche, where realised prepayment volatility is low and realised average prepayment follows the expected trajectory, some of the prepayment risk charge remains For any securitisation swap that doesn’t extend, the entirety of the extension risk charge remains For any securitisation swap where the swap provider isn’t downgraded to the first trigger level or below, some of the downgrade risk charge remains (noting that the LTP component would have still been paid away to cover HQLA holding costs) From an accounting perspective, these charges are often held as revenue reserves This means they are not taken to PnL on day one, but can be potentially taken to PnL through the life of the transaction, if they are not drawn down Note that reserves form part of shareholder’s equity and are to be distinguished from provisions, which are liabilities Operationally, the simplest and more prudent way to manage revenue reserves is to only take what remains of them to PnL when the deal has terminated This reduces PnL volatility and management of cash transfers However, fair value accounting under IFRS stipulates that the reserves should be revalued periodically to ensure that the positions are correctly marked, at least if the position is deemed ‘material’ This means that revenue reserves may not eliminate PnL volatility as they may need to be topped-up during the life of the deal For third-party swap providers, an additional challenge when reserving revenue, but expecting to get some of that revenue back in PnL at some point, is how to compute the expected RoE of a deal at inception This is a point of considerable importance as all banks will have minimum RoE hurdles to pass before they will enter into a transaction Given the uncertain amount and timing of PnL drip-back from reserves, one needs to be careful to communicate what assumptions have been used when computing RoE One possible way forward is to compute RoE based on two scenarios: Day one RoE Assume zero drip-back of reserves to PnL Expected whole-of-life RoE Assume some (‘expected’) drip-back of reserves to PnL based on clear and consistent criteria, for example: ■ no extension events (as these are very rare); ■ no downgrade to the first trigger level (if appropriate, e.g if not on negative watch and deal isn’t very long-dated); Deal Management ■ ■ 197 prepayment rates follow the expected trajectory; and unstressed prepayment volatility and correlation parameters While this makes trade decisioning more complex (and it can be fraught already), it arguably provides a more complete picture of the distribution of RoEs that may eventuate Fair Value Hierarchy of Valuation Inputs IFRS implements a three-level valuation hierarchy as follows: ■ ■ ■ Level inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that are accessible at the measurement date Level inputs are inputs other than quoted prices included within Level that are observable for the asset or liability, either directly or indirectly (this can include interpolated rates, implied volatilities and credit spreads) Level inputs are unobservable inputs for the asset or liability Levels 1, and have facetiously been parodied as mark-to-market, mark-to-model and mark-to-make-believe Entities are required to use the highest available level of input Valuation of securitisation swaps can involve extensive use of level inputs including: ■ ■ ■ ■ ■ historically estimated realised prepayment parameters; expected average prepayment; historically estimated cross-currency basis volatility parameters; historically estimated correlations; and credit rating transition probabilities IFRS requires level valuation inputs to be disclosed in financial accounts if their use is ‘significant’ and ‘recurring’ Glossary ABS ADI BCBS BGM BGS CAF CBG CDO CDS CE CFR CFVA CPT CSA CVA DPC EM ENE EPE FBA FCA FVA FX GAAP GBM GFC GIC HQLA IASB IFRS ISDA LCR LTP Asset-backed securities Authorised deposit-taking institution (Australian regulatory term) Basel Committee on Banking Supervision Brace-Gatarek-Musiela model Balance guarantee swap Controlled amortisation facility Covered bond guarantor Collateralised debt obligation Credit default swap Credit enhancement Contingent funding risk Contingent funding valuation adjustment Conditional pass-through Credit support annex Credit valuation adjustment Derivative product company Expected maturity Expected negative exposure Expected positive exposure Funding benefit adjustment Funding cost adjustment Funding valuation adjustment = FCA + FBA Foreign exchange Generally Accepted Accounting Standards (USA) Geometric Brownian motion Global financial crisis Guaranteed investment certificate High quality liquid asset International Accounting Standards Board International Financial Reporting Standards International Swaps and Derivatives Association Liquidity coverage ratio Liquidity transfer price 199 Securitisation Swaps: A practitioner handbook, First Edition Mark Aarons, Vlad Ender and Andrew Wilkinson © 2019 Mark Aarons, Vlad Ender, Andrew Wilkinson Published 2019 by John Wiley & Sons, Ltd 200 GLOSSARY Capital valuation adjustment Legal final maturity London interbank offer rate Loan-to-value ratio Maximum likelihood estimation Mark-to-market Medium term note Margin valuation adjustment Non-centrally cleared derivative Net stable funding ratio Over-collateralisation Overnight index swap Ordinary least square Over-the-counter (a bilateral method of trading derivatives rather than via an intermediary such as an exchange) OU Ornstein-Uhlenbeck Par swap A swap with a mark-to-market of zero PCE Potential credit exposure PDL Principal deficiency ledger (a record of tranche losses in UK RMBS master trusts) PnL Profit and loss PV01 Interest rate delta, defined as the change in value of a derivative due to a basis point shift in interest rates RMBS Residential mortgage-backed securities RoE Return on equity RVA Replacement valuation adjustment SDE Stochastic differential equation SMM Single monthly mortality rate SONIA Sterling overnight index average SPM Single period mortality rate SPV Special purpose vehicle SVR Standard variable rate VaR Value-at-Risk WAL Weighted average life XVA General derivative valuation adjustments i.e encompassing CVA, FVA, KVA, etc These are added to the mark-to-market to complete the valuation of a derivative or portfolio of derivatives KVA LFM LIBOR LTV MLE MTM MTN MVA NCCD NSFR OC OIS OLS OTC References [AB] Brace, A Mixing real and arbitrage free measures, private correspondence 2015 [BDNT] Brigo, D., Dalessandro, S., Neugebauer, M and Triki, F, A Stochastic Processes Toolkit for Risk Management 15 Nov 2007 Available at: https://ssrn.com/abstract=1109160 [BG] Broadie, M and Glasserman, P (1996) Estimating security price derivatives using simulating Management Science 42 (2): 269–285 [CJ] Chan, J.H and Joshi, M (2013) Fast Monte Carlo Greeks for financial products with discontinuous payoffs Mathematical Finance 23 (3): 459–495 [DJ] Daniel, J (2008) A variable-rate loan-prepayment model for Australian mortgages Australian Journal of Management 33 (2): 277–305 [DL] Davidson, A and Levin, A (2005) Prepayment risk- and option-adjusted valuation of MBS Journal of Portfolio Management 31 (4): 73–85 [FC] Fabozzi, F and Choudhry, M (2004) The Handbook of European Structured Financial Products Wiley [JG] Grant, J Liquidity transfer pricing: a guide to better practice BCBS Occasional Paper No 10 December 2011 [AH] Holmes, A Operational Constraints on the Stabilization of Monetary Supply Growth Federal Reserve Bank of Boston Conference Proceedings 1969 Available at: https://www.bostonfed.org/news-and-events/events/economic-research-conferenceseries/controlling-monetary-aggregates.aspx [HJ] Hull, J (2018) Options, Futures and Other Derivatives, 10e Pearson [JP] Jäckel, P (2002) Monte Carlo Methods in Finance Wiley Finance [JM] Joshi, M (2003) The Concepts and Practice of Mathematical Finance Cambridge University Press [AP] Pelsser, A (2000) Efficient Methods for Valuing Interest Rate Derivatives Springer [RR] Rudolf, F and Rühlmann, K (2017) Extendible Maturity Structures: The New Normal? ECBC European Covered Bond Fact Book [JS] Staum, J (2008) Incomplete markets In: Handbooks in OR & MS, vol 15, Chapter 12 Elsevier B.V 511–563 [HT] Takehashi, H (2005) On embedded complete markets Hitotsubashi Journal of Economics 46: 99 201 Securitisation Swaps: A practitioner handbook, First Edition Mark Aarons, Vlad Ender and Andrew Wilkinson © 2019 Mark Aarons, Vlad Ender, Andrew Wilkinson Published 2019 by John Wiley & Sons, Ltd Index ABS see asset-backed securities account banks 13, 28–29 accounting 194–197 accumulation period 55–56 agency agreements 28 algebraic scripting 117 alternative investment yields 91 amortisation controlled 48–49, 55, 111–112 credit card securities 55–57 expected 81 master trusts 19–20 pools 42 scheduled 17, 38 swap extension risk 129 ancillary service providers 28–31 arrangers 13 asset-backed securities (ABS) 31, 37–59 balance guarantee swaps 83 bullet tranches 47–48 controlled amortization 48–49 covered bonds 22–24, 31, 57–59 credit cards 55–56 liability swaps 70–72 master trusts 18–22, 50–55 pass-through tranches 42–47 pool dynamics 37–42 rating 146–147 residential mortgage-backed securities 48–49, 50–55 structures 42–59 tranche conservation laws 49–50 asset swaps 27–28, 68–70 asset transformation 16–17 asset triggers 52–53 assumption dependence 195 auditors, comfort letters 30–31 automated monitoring 189 back-office notifications 186 back swaps 69–70, 137–138 balance guarantee swaps (BGS) concepts 80, 83–84 controlled amortisation 111–112 credit risk 111 cross-currency 83–84, 85–89, 105 derivative value adjustments 108–110, 118 diversification 112–114 due diligence 115 intermediated 107–108 market risk factors 96–97 regulation 111 re-hedging 84–90, 100 reserves 195–196 risk transfers 110–111 simulation 97–102 single-currency 83–84, 89–90, 104–105 step-ups 116 value-at-risk 106–108, 118 bank bill swap rate (BBSW) 61 bankruptcy remoteness 9, 14, 21, 36 swap priorities 74–78 banks 5, 13, 21, 28–29 Basel III 143, 156, 157–160 contingent funding valuation adjustment 163–171 credit rating 155 liquidity transfer pricing 160–163 risk limits 171–172 Basel Committee on Banking Supervision (BCBS) 158, 191–194 Basel III 143, 156, 157–160 BBSW see bank bill swap rate BCBS see Basel Committee on Banking Supervision BGS see balance guarantee swaps bonds ratings 144 see also covered bonds breakeven margins 69 203 Securitisation Swaps: A practitioner handbook, First Edition Mark Aarons, Vlad Ender and Andrew Wilkinson © 2019 Mark Aarons, Vlad Ender, Andrew Wilkinson Published 2019 by John Wiley & Sons, Ltd 204 bullet tranches 47–48, 57–58, 128 burnout 90 CAF see controlled amortization facilities calculation see computation calibration 96 capitalist structures 21 capped margin reset 125–126, 136 cash flows fixed/floating interest rate swaps 63 transformation 16–17 cash flow waterfalls 17–18 algebraic scripting 117 residential mortgage-backed securities 51, 53 swap priorities 74–78 tranche conservation laws 49–50 cash management agreements 29 cash managers 13, 29 CBG see covered bond guarantor CDOs see collateralised debt obligations CE see credit enhancement CFVA see contingent funding valuation adjustment Chinese walls 185 choice of rating agencies 173–174 closing deals 186–188 collateral, liquidity transfer pricing 160–163 collateral addition 54 collateralised back swaps 137–138, 178–179 collateralised debt obligations (CDOs) 21 comfort letters 30–31 communication of risks 190–192 complexity 7–8 computation contingent funding valuation adjustment 165–171 expected swap schedules 81–82 historical prepayment 82–83 liquidity transfer pricing curves 162–163 re-hedging 84–90 value-at-risk 106–108, 118 see also modelling; Monte Carlo Modelling conditional pass-through (CPT) 47, 58–59, 128 conservation laws, tranches 49–50 constant prepayment rate (CPR) 38–41, 83 contingent funding valuation adjustment (CFVA) 163–171 computation 165–171 costs 164–165 hedging 170–171 Monte Carlo modelling 167–168 INDEX potential funding benefits 169 ratings transition matrix 165 continuous disclosure 115–116 contractual protections 151–152, 174 controlled amortization facilities (CAF) 48–49, 111–112 controlled amortization periods 55 convergence in models 100 corporate services providers 14, 29 correlation, market risk factors 96 counterparties 13–14 replacement 178 counterparty criteria 143–149, 152–153, 174–176 coupon rounding 187–188 covenant to pay 26 covered bond guarantor (CBG) 23 covered bonds 22–24, 31, 71 comparisons 59 coupon rounding 187–188 extension risk 127–128 rating 147–148 structures 57–59 cover pools 22–24 CPR see constant prepayment rate credibility of rating agencies 150 credit card securitisation 55–56 credit enhancement (CE) 13, 17 credit indexes 6, 34–35 credit rating 142, 155 credit risk 32, 111, 118 credit support annex (CSA) 27–28, 110, 142 cross-currency modelling 96 cross-currency swaps 20, 64–66, 71, 83–84, 85–89, 105 cross-gamma 168 CSA see credit support annex currency volatility balance guarantee swaps 83–84, 85–90 risk limits 172 deal management 181–197 accounting 194–197 checklist 185–186 closing 186–188 pricing 181–184, 186–187 deals, closing 186–188 default, probability of 131 de-linkage 21, 142 derivative product companies (DPCs) 154–157 205 Index derivative value adjustments (XVA) balanced guarantee swaps 108–110, 118 contingent funding valuation adjustment 163–171 discounting, simulation 98 diversification, swap prepayment risk 112–114 documentation account banks 28–29 agency agreements 28 ancillary service providers 28–31 cash management agreements 29 comfort letters 30–31 corporate services agreement 29 due diligence 30–31 execution 187 framework 24–31 legal opinions 30–31 liquidity facilities 29–30 offers 24–25 rating protections 151–152 sale agreements 25 servicing agreements 27 subscription agreements 25 swaps 27–28 trusts 25–26 downgrade language 142 downgrade risk 3, 28, 34–35, 141–179, 193 collateralisation 176–177 contingent funding valuation adjustment 163–171 contractual protections 151–152, 174 costs 164–165 counterparty criteria 143–149, 152–153, 174–176 definition 141 liquidity coverage ratio 143, 157–160 liquidity transfer pricing 160–163 mitigation 172–177 Monte Carlo modelling 167–168 potential funding benefits 169 rating agencies 142–157, 169 ratings transition matrix 165 replacement risk 177–179 reporting 193 risk limits 171–172 transfers 160–163, 176 triggers 142–144 variances 145 DPCs see derivative product companies dry runs 185 due diligence 30–31 balance guarantee swaps 115 duty of continuous disclosure 115–116 dynamics, loan pools 37–42, 49–50 EM see expected maturity embedding events of default 27 execution charges 183–184 exit price 194–196 expected amortisation 81 expected average prepayment 94–96, 106–108 expected maturity (EM), swap extension risk 129–132 expected swap schedule 80–82 extension risk 3, 34, 119–139, 192 capped margin reset 125–126, 136 collateralised back swaps 137–138 covered bonds 127–128 examples 121–128 full pricing framework 132–133 hedging 133–134, 138–139 mitigation strategies 133–139 non-par swaps 123–124 par swaps 122–123 pre-trade structuring 133–138 reporting 192 residential mortgage-backed securities 127 simple pricing framework 128–132 standalone vehicles 126–127 step-ups 124–125, 134–136 stress testing 130 triggers 128–129 see also swap extension risk 1-factor stochastic FX pricing framework 128–132 fair value accounting 194–195, 197 re-hedging 84 first downgrade trigger 142, 143 contingent funding valuation adjustment 163–171 counterparty criteria 143–149, 152–153, 174–176 liquidity coverage ratio 143, 157–160 liquidity transfer pricing 143, 160–163 mitigation strategies 172–177 risk limits 171–172 swap providers 154–157 206 fixed/floating swaps 62, 71, 89–90 flip clauses 75–78 floating-rate legs 61–62 foreign exchange (FX) balance guarantee swaps 83–84, 85–89, 105 cross-currency swaps 64–66 risk 2–3, 27–28 spot price modelling 97 swap extension risk 128–133 front swaps 69–70 full pricing frameworks for extension risk 132–133 fully principal amortising loans 38 funding instruments 7–8 overview 5–8 funding share 19–20 funding valuation adjustment (FVA) 138, 168 FVA see funding valuation adjustment FX see foreign exchange GBM see geometric Brownian motion geometric Brownian motion (GBM) 94 GFC see global financial crisis GIC see Guaranteed Investment Certificates global financial crisis (GFC) 6–7, 21–22, 152, 157–160 governance 189 Granite master trust 21 greeks 103–104 Guaranteed Investment Certificates (GIC) 48, 112 guarantors covered bonds 23 third-party 178 hard bullets 47, 57–58, 128 hedging balance guarantee swaps 83–84 contingent funding valuation adjustment 170–171 prepayment risk 80 simulation 98–99 swap extension risk 134, 138–139 swap prepayment risk 104–106 hierarchy of valuation inputs 197 high-quality liquid assets (HQLAs) 143, 158–163 historical data calibration 96 pool cut 80–82 historical prepayment 82–83 INDEX HQLAs see high-quality liquid assets Hull–White models 97 IFRS see International Financial Reporting Standards IMA see Internal Model Approach incentives, extension risk 134, 135–136 informing of risks 190–192 inputs, fair value hierarchy 197 insight, pool cut 81 insolvency 36 interbank loans 6–7 interest accrual periods 62 interest-only (IO) loans 38, 81 interest rate risk 27–28 interest rates modelling 96–97 prepayment risk 91 interest rate swaps 61–64 intermediated asset swaps 69–70, 107–108 Internal Model Approach (IMA) 193–194 internal pricing approvals 185 International Financial Reporting Standards (IFRS) 194–197 International Swaps and Derivatives Association (ISDA) Master Agreement 142 investors 15 investor step-ups 135–136 IO see interest-only ISDA see International Swaps and Derivatives Association issuance 54 issuers 9–11 iteration in modelling 98–99 landed costs LCR see Liquidity Coverage Ratio legal final maturity (LFM) 93–94, 120–121, 128 legal opinions 30–31 legal position of rating agencies 150 legal risk 35–36, 77–78 legs cross-currency swaps 64–66 interest rate swaps 61–63 Lehman Brothers 75–78 LFM see legal final maturity liability swaps 27–28, 70–72 LIBOR see London interbank offer rate limited recourse 28 207 Index Liquidity Coverage Ratio (LCR) 7, 143, 156, 157–160 liquidity providers 14, 29–30 liquidity risks 29–30, 33 liquidity transfer pricing (LTP) 143, 160–163 loans pool dynamics 37–42 seasoning 90 tranche conservation laws 49–50 see also covered bonds; residential mortgage-backed securities London interbank offer rate (LIBOR) 17, 61, 97 loops in modelling 98–99 LTP see liquidity transfer pricing managers 13 market cost of funds 5–6 market objects 98 market price of risk market risk 32–33, 188–194 downgrades 171–172 management framework 188–194 modelling 96–97 markets 31 mark-to-market (MTM) 32, 57, 66–68 balance guarantee swaps 84–90 downgrade triggers 143 liquidity transfer pricing 162–163 swap extension risk 129–133 master trusts 18–22 comparisons 59 new notes 54 residential mortgage-backed securities 50–55 triggers 52–54 maximum likelihood estimation (MLE) 96 mean reversion 94 measurement 189 medium term notes (MTN) 19 minimum seller share 51 mis-hedging 134 mitigation downgrade risk 172–177 swap prepayment risk 110–116 mixed measures 92–93 MLE see maximum likelihood estimation modelling calibration 96 contingent funding valuation adjustment 165–171 convergence 100 greeks 103–104 liquidity transfer pricing 160–163 market risk factors 96–97 pathwise approach 103 prepayment 93–96 simulation 97–102 swap prepayment risk 91–102 validation 101 visualisation 100–102 model parsimony 55, 169 monitoring 189 Monte Carlo modelling calibration 96 contingent funding valuation adjustment 167–168 convergence 100 extension risk pricing 132–133 greeks 103–104 market risk factors 96–97 mixed measures 92–93 objects needed 98 optimisation 100 pathwise approach 103 prepayment 93–96 simulation methods 97–102 swap prepayment risk 91–102 validation 101 visualisation 100–102 monthly payment rate (MPR) 55–56 MPR see monthly payment rate MTM see mark-to-market MTN see medium term notes multifactor frameworks, extension risk pricing 132–133 NCCD see non-centrally cleared derivatives net interest margin (NIM) 5, 69 Net Stable Funding Ratio (NSFR) 7, 157–160 new note issuance 54 NIM see net interest margin non-asset triggers, master trusts 52–53 non-centrally cleared derivatives (NCCD) 138 non-par swaps, extension risk 123–124 non-petition clauses 26, 28 Northern Rock 21, 157 note ratings 144 note trustees 11–12, 26 NSFR see Net Stable Funding Ratio OC see over-collateralisation offer documents 24–25 208 INDEX OIS see overnight index swap rates operational risk 35 optimisation counterparty criteria 174–176 modelling 100 originators 9–10 Ornstein–Uhlenbeck (OU) process 94 OTC see over-the-counter over-collateralisation (OC) 128 overnight index swap (OIS) rates 66 over-the-counter (OTC) swaps 27–28, 64 liquidity transfer 143, 160–163 spot FX movements 96 swap prepayment risk 91–102 total swap cost 181–182 transparency 182–183 vanilla swaps 66–68 principal schedule 28 priority of swaps 74–78 probability of default 131 product approvals 185 parsimony 55 par swaps, extension risk 122–123 partial principal amortising loans 38 pass-through notes 19–20 pathwise differentiation 103 paying agents 14–15 pay legs 61–63 payment dates 62 payment obligations, covered bonds 23 PCE see potential credit exposure perfect hedges Perpetual Trustee Company Limited v BNY Corporate Trustee Services and Lehman Brothers Special Financing Inc 75–78 pi see constant prepayment rate pool amortisation 42 pool cut 80–82 post-processing 100 potential credit exposure (PCE) engines 118 potential funding benefits and downgrade risk 169 pre-hedging 183–184 prepayment definition 79 modelling 93–96 seasoning 90 prepayment rate drivers 90–91 prepayment risk 3, 20, 33–34, 79–118, 191 charge 84, 88 concepts 79–80 definition 79–80 Monte Carlo modelling 91–102 reporting 191 see also swap prepayment risk pre-trade structuring, swap extension risk 133–138 pricing calls 186–187 execution charges 183–184 extension risk frameworks 128–133 rating AAA rating 142 agencies 15, 142–157, 169 bond rating 144 CFVA 169 choice of 173–174 contractual protections 151–152, 174 counterparty criteria 143–149, 152–153, 174–176 credibility 150 downgrade triggers 28, 142–143 global financial crisis 150, 152–153 legal aspects 150–152 note rating 144 ratings transition matrix 165 swap parameters 144 system issues/trade capture 153–154 trustees 151 variances 145 realised prepayment rates 93–94 real-time hedging extension risk 138–139 see also hedging receive legs 61–63 regulation Basel III 143, 157–160 future 191–194 local implementations 159 swap prepayment risk 111 re-hedging 84–90, 100 repayment risk, master trusts 20 replacement risk 177–179 reporting downgrade risk 193 extension risk 192 prepayment risk 191 ‘repos’ see short-term repurchase agreements reserve funds 55, 195–196 Index residential mortgage-backed securities (RMBS) 31 balance guarantee swaps 83, 88–90 collateral addition 54 controlled amortization 48–49 liability swaps 70–72 master trusts 50–55 new note issuance 54 pass-through tranches 43–47 rating 148–149 sale agreements 25 seasoning 90 seller share 50–52 swap extension risk 127 triggers 52–54 residual risk add-on 193 restructuring 179 results objects 98 revaluation 170–171 revenue reserves 55 revolving pools 19 simulation 100 see also master trusts risks 32–36 credit 32 downgrade 3, 28, 34–35, 141–179, 193 extension 3, 34, 119–139, 192 foreign exchange 2–3, 27–28 informing of 190–192 legal 35–36, 77–78 limits 171–172, 185, 189–190 liquidity 29–30, 33 liquidity transfer pricing 143, 160–163 market 32–33, 96–97, 171–172, 188–194 market price of master trusts 20 operational 35 prepayment 3, 20, 33–34, 79–118, 191 replacement 177–179 residual add-on 193 swaps 27–28 unwind 133, 184 risk transfers downgrade risks 160–163, 176 liquidity transfer pricing 160–163 swap extension risk 134–135, 137–138 swap prepayment risk 110–111 RMBS see residential mortgage-backed securities SA see Standardised Approach sale agreements 25 209 scheduled amortisation 17, 38 SDE see stochastic differential equation seasonality, prepayment risk 91 seasoning 90 second downgrade trigger 142, 143, 177–179 securitisation 8–22 arrangers 13 asset swaps 68–70 asset transformation 16–17 bullet tranches 47–48 cash flow waterfall 17–18 covered bonds 22–24 credit cards 55–56 documentary framework 24–31 global financial crisis 21–22 issuers 9–11 liability swaps 70–72 managers 13 markets 31 master trusts 18–22, 50–55 originators 9–10 overview 16 pass-through tranches 42–47 process 8–9 residential mortgage-backed securities 48–49, 50–55 risks 32–36 special purpose vehicles 6, 8–18 structures 42–59 third parties 13–16 transformations 16–17, 71 trustees 11–12 security 7–8 security trustees 12, 26 sellers 9–10 seller share 19–20, 50–52 seniority 7–8 sequential-to-pro rata triggers 44 series 19–21 servicers 11 servicing agreements 27 short-term repurchase agreements (‘repos’) side letters 110–111 simple pricing frameworks for extension risk 128–132 simulation 97–102 convergence 100 objects needed 98 optimisation 100 pathwise approach 103 210 simulation (Continued) validation 101 visualisation 100–102 see also Monte Carlo modelling single currency basis swaps 62, 71, 83–84, 89–90, 104–105 single monthly mortality rate (SMM) 82–83 single period mortality rate (SPM) 82–83 slippage 133 socialist structures 21 soft bullets 47, 58–59, 128 sovereigns, supranationals and agencies (SSAs) 141 special purpose vehicles (SPVs) 6, 8–18 arrangers 13 asset swaps 68–70 bullet tranches 47–48 cash flow waterfalls 17–18 covered bonds 22–24 downgrade triggers 142–143 establishment 9–10 expected swap schedules 81–82 liability swaps 70–72 managers 13 overview 16 pass-through tranches 42–47 replacement risk 177–179 restructuring 179 servicers 11 standy swaps 72–74 structures 42–59 swap extension risk 126–127 swap provider replacement 178 third parties 13–16 third-party guarantors 178 transformations 16–17 trustees 11–12, 26, 151 SPM see single period mortality rate spot FX price modelling 96 SPVs see special purpose vehicles SSAs see sovereigns, supranationals and agencies standalone securitization 8–18 bullet tranches 47–48 comparisons 59 with pass-through tranches 42–47 swap extension risk 126–127 see also special purpose vehicles Standardised Approach (SA) 193–194 standard variable rate (SVR) 68–69 standby swaps 72–74 INDEX step-ups extension risk 124–125, 134–136 prepayment risk 116 stochastic differential equation (SDE) 94 stochastic FX models, swap extension risk 128–133 stress testing, swap extension risk 139 structured funding markets 31 subscription agreements 25 surveillance, swap prepayment risk 115 swap counterparties 13–14, 143–149, 152–153, 174–176 swap extension risk 34, 119–139, 192 capped margin reset 125–126, 136 collateralised back swaps 137–138 concepts 119–121 covered bonds 127–128 examples 121–128 full pricing framework 132–133 hedging 133–134, 138–139 mitigation strategies 133–139 non-par swaps 123–124 par swaps 122–123 pre-trade structuring 133–138 reporting 192 residential mortgage-backed securities 127 risk transfer 134–135, 137–138 simple pricing framework 128–132 standalone vehicles 126–127 step-ups 124–125, 134–136 stress testing 130 triggers 128–129 swap prepayment risk 20, 33–34, 79–118, 191 concept 79–80 controlled amortisation 111–112 definition 79–80 derivative value adjustments 108–110, 118 disclosure 115–116 diversification 112–114 due diligence 115 expected swap schedule 80–82 greeks 103–104 hedging 104–106 historical prepayment 82–83 intermediated swaps 107–108 mitigation strategies 110–116 Monte Carlo modelling 91–102 re-hedging 84–85, 100 reporting 191 step-ups 116 211 Index system issues 116–118 value-at-risk 106–108, 118 whole-of-life management 116–118 swap providers replacement 178 third-party 109–110, 154–157 swaps 61–78 assets 68–70 balance guarantee swaps 84 contractual protections 151–152, 174 cross-currency 20, 64–66 downgrade risk 169 expected schedule 80–82 interest rate 61–64 liabilities 70–72 pricing 66–68 rating criteria 144–145 standby 72–74 third party providers 109–110, 154–157 types 27–28 vanilla 61–68 system issues rating agencies 153–154 swap prepayment risk 116–118 tax considerations 185 tax gross up 28 tenor 7, 31, 39–41, 172 termination events 27 third parties 13–16 third-party guarantors 178 third-party swap providers 109–110, 154–157 replacement 178 time grids 98 total swap cost 181–182 trade booking 185 trade capture rating agencies 153–154 swap prepayment risk 116–117 trade maintenance, swap prepayment risk 117–118 tranche conservation laws 49–50 tranching 17–18, 19–20 bullets 47–48 controlled amortization 48–49 pass-through 42–47 transaction costs transformations 16–17 transparency 182–183 triggers 27–28 downgrade 142–144 master trusts 52–54 sequential-to-pro rata 44–45 swap extension risk 128–129 true sales 25, 36 trust documentation 25 trustees 11–12, 26, 151 underwriters 13 unwind risk 133, 184 updates to counterparty criteria 152–153 validation of models 101 valuation hierarchy of inputs 197 see also pricing value-at-risk (VaR) 106–108, 118, 139, 189 vanilla swaps 61–68 VaR see value-at-risk visualisation tools 100–102 volatility, cash flow 29–30 WAL see weighted average life weakest link method 142 weighted average life (WAL) 3, 16–17, 39–41 expected swap schedules 81–82 pass-through tranches 43–47 re-hedging 84–90 tranche conservation laws 49–50 whole-of-life management contingent funding valuation adjustment 163–171 swap prepayment risk 116–118 XVA see derivative value adjustments year fraction 62 zero amortisation loans 38 ... originator via its capacity as swap provider These include: Australia, Canada, Hong Kong, New Zealand, Singapore, UK and USA 10 SECURITISATION SWAPS: A PRACTITIONER HANDBOOK Borrowers Cash flows... Interest Rate Swaps Cross-Currency Swaps Vanilla Swap Pricing Asset Swaps Liability Swaps Standby Swaps Swap Priority and Flip Clauses CHAPTER Swap Prepayment Risk What is Swap Prepayment Risk?... Risk at a leading Australian funds manager and is also an Adjunct Associate Professor in the Centre for Quantitative Finance and Investment Strategies at Monash University He has degrees in Law and