Securitisation Swaps A Practitioner's Handbook

Develop the skillset essential to successful securitisation swaps management

Securitisation Swaps is a complete practitioner’s guide to this unique and complex class of derivatives. This detailed examination follows the entire life cycle of securitisation swaps to give quants, structurers, traders, originators, issuers and lawyers a common reference for understanding their shared objective. Broad in scope to provide a common-ground perspective — yet detailed enough to promote full understanding — the discussion takes a distinctly cross-disciplinary approach that encompasses the multi-faceted knowledge base required to successfully execute these complex trades.

Despite the fact that the size of the market is trillions of dollars in notional principal, securitisation swaps have thus far been neglected in both academic and practitioner literature. The numerous stakeholders that work together on these complex deals will all greatly benefit from a thorough understanding of their underlying risks and gain deep insight into the perspectives of each stakeholder. This invaluable guide provides multi-disciplinary insight that allows practitioners to:

• Manage securitisation swaps more effectively, from pre-trade structuring and modelling to post-trade risk management and accounting
• Understand the elements of securitisation and covered bonds, and how swaps mitigate risk in these types of transactions
• Explore how securitisation swaps differ from other derivatives and delve into their three specific risk factors — swap prepayment risk, swap extension risk and downgrade risk
• Learn practical methods and strategies of risk management, accounting, pricing and transaction execution

When securitisation trades go wrong, they become front-page news — but when each participant understands accurate modelling, risk mitigation, optimal structuring, costs, pricing, commercial backgrounds and other integral practices, they are able to work together to achieve a shared objective. Securitisation Swaps provides the essential knowledge that streamlines and safeguards these important trades.

MARK AARONS is Head of Investment Risk at a leading Australian funds manager and an Adjunct Associate Professor in the Centre for Quantitative Finance and Investment Strategies at Monash University. Previously he was Head of FICC Structuring at the National Australia Bank, where he built a leading securitisation swap business in both Australia and the UK.

VLAD ENDER is a director at Kauri Solutions, a financial markets consulting practice. Prior to founding Kauri Solutions, he spent eight years at National Australia Bank's London office. He also served as an Executive Director in the FICC Structuring team.

ANDREW WILKINSON is a senior legal counsel in Australia who specialises in bespoke derivatives and securitisation. Previously, Andrew spent a decade in London working through the financial crisis and beyond for leading law firms Linklaters LLP and Weil, Gotshal & Manges.

About the Author xiii

Foreword xv

Acknowledgements xix

Chapter 1

Introduction 1

Chapter 2

Overview of Structured Funding 5

Funding 5

Funding Instruments 7

Securitisation 8

The Securitisation Process 8

Structured Funding Participants 9

Asset and Cash Flow Transformation 16

Summary of Securitisation 18

Master Trusts 18

Securitisation and the GFC 21

Covered Bonds 22

Documentary Framework 24

Offer Document 24

Subscription Agreement 25

Sale Agreement 25

Trust Documentation 25

Servicing Agreement 27

Swaps 27

Ancillary Service Provider Documentation 28

Structured Funding Markets 31

Risks 32

Credit Risk 32

Market Risk 32

Liquidity Risk 33

Prepayment Risk 33

Extension Risk 34

Downgrade Risk 34

Operational Risk 35

Legal Risk 35

Chapter 3

Asset-Backed Debt Structures 37

Loan Pool Dynamics 37

Derivation of Eq. (3.1) 38

Pool Amortisation 42

Securitisation Structures 42

Standalone Structures with Pass-Through Tranches 42

Standalone Structures with Bullet Tranches 47

Standalone Structures with Controlled Amortisation Tranches 48

Tranche Conservation Laws 49

Master Trust RMBS Structures 50

Credit Card ABS Structures 55

Covered Bond Structures 57

Hard Bullets 57

Extendible Maturity Structures 58

Comparison of Structures 59

Chapter 4

Swaps in Structured Funding 61

An Overview of Vanilla Swaps 61

Interest Rate Swaps 61

Cross-Currency Swaps 64

Vanilla Swap Pricing 66

Asset Swaps 68

Liability Swaps 70

Standby Swaps 72

Swap Priority and Flip Clauses 74

Chapter 5

Swap Prepayment Risk 79

What is Swap Prepayment Risk? 79

The Expected Swap Schedule 80

Balance Guarantee Swaps 83

Re-Hedging 84

What Factors Drive Prepayment Rates? 90

Monte Carlo Modelling of Swap Prepayment Risk 91

Working with a Mixed Measure 92

Modelling Prepayment 93

Modelling the Market Risk Factors 96

Simulation Methodology 97

Greeks, Hedging and VaR 103

Computing Greeks 103

Hedging 104

Value-at-Risk 106

XVA 108

Computing XVA for Swaps with Prepayment Risk 108

Intermediated Asset Swaps 109

Mitigation Strategies 110

Risk Transfer 110

Controlled Amortisation Structures 111

Reducing Prepayment Volatility via Diversification 112

Due Diligence and Surveillance 114

Duty of Continuous Disclosure 115

Step-Ups 116

System Issues and Whole-of-Life Deal Management 116

Trade Capture 116

Trade Maintenance 117

Risk Systems 118

Chapter 6

Swap Extension Risk 119

What is Swap Extension Risk? 119

Examples of Extension Risk 121

Dependence on the Capital Structure: Standalone SPVs 126

Extension Risk in UK RMBS Master Trusts 127

Covered Bond Extension Risk 127

A Simple Pricing Framework for 1-Factor Stochastic FX 128

Full Pricing Framework in a Multi-Factor Setting 132

Mitigation Strategies 133

Pre-Trade Structuring versus Real-Time Hedging 133

Pre-Trade Structuring 135

Real-Time Hedging 138

Stress Testing 139

Chapter 7

Downgrade Risk 141

Rating Agency Criteria 142

Criteria Specifics 144

Examples 146

Legal Aspects 149

Updates of Counterparty Criteria 151

Trade Capture and System Challenges 153

The Competitive Landscape for Third-Party Swap Providers 155

Basel III and the Liquidity Coverage Ratio 157

Liquidity Transfer Pricing 159

Constructing the LTP Curve 161

Updating the LTP Curve 162

Contingent Funding Valuation Adjustment 162

What Is CFVA? 162

Costs and Probabilities 163

The CFVA Calculation 165

Revaluation and Hedging 170

Risk Limits 171

Tenor 172

Currency 172

Purpose 172

Mitigation Strategies 172

Choice of Rating Agencies 173

Contractual Protections 174

Optimum Implementation of Counterparty Criteria 174

Risk Transfer 176

Collateralisation from Day One 176

Replacement Risk 177

Replacement of the Swap Provider 178

Third-Party Guarantors 178

Restructuring 179

Mitigants 179

Chapter 8

Deal Management 181

Pricing 181

The Total Swap Cost 181

Pricing Transparency 183

Execution Charges 184

Deal Checklist for Swap Providers 185

Closing the Deal 186

The Pricing Call 186

Executing the Documents 187

Covered Bond Coupon Rounding 187

Market Risk Management 188

Measurement 189

Monitoring 189

Governance and Risk Limits 189

Inform and Act 190

Future Regulation 193

Accounting 194

Fair Value 194

Revenue Reserves 196

Fair Value Hierarchy of Valuation Inputs 197

Glossary 199

References 201

Index 203

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