Securitisation Swaps

CHAPTER 7Downgrade Risk

No matter what some agency may say, we've always been and always will be a AAA country.

– Barack Obama (after S&P downgraded the USA)

It is possible to structure securitisation notes so that they have a higher credit rating than the banks providing swaps to those transactions. For this to occur, swap providers must assume strict obligations imposed by the rating agencies. Swap providers certainly don't have the luxury that some governments may think they have to ignore the agencies' ratings and criteria!

These obligations typically involve one‐way collateralisation and mandatory novation of the swap when the swap provider's credit ratings fall below specific trigger levels. We will refer to these obligations collectively as downgrade risk assumed by the swap provider.

Downgrade risk and its consequences differentiate securitisation¹ swaps from most other types of derivatives, even before considering prepayment and extension risk. With the exception of sovereigns, supranationals and agencies (SSAs),² derivatives with non‐securitisation counterparties rarely involve the imposition of such conditions on the swap provider. The rating downgrade of a financial institution that also acts as a swap counterparty can have a profound impact across the entire market, which is unique to structured finance and securitisation transactions.³

We devote this chapter to understanding downgrade risk, pricing it and how to optimise it, and to the considerable risk management ...