Introduction to Securitization

COUNTERPARTY RISK

The use of derivative instruments introduces counterparty risk for the trust, and therefore the way counterparty risk is managed in securitizations should be understood.

The risk of counterparty default can be partially mitigated by entering into swaps with highly rated counterparties and using commonly developed methods in the derivatives market for doing so (e.g., margin, netting, and overcollateralization). The majority of the swaps in securitizations involving investment-grade-rated notes contain rating triggers specifying certain steps that must be taken by the counterparty if its debt rating migrates below a certain level. Typically, the counterparty must, at its own cost and within a specified time period, usually 30 days, either (1) find a replacement counterparty with a rating higher than the rating specified in the trigger; (2) post a specified amount of collateral; or (3) obtain a guarantee from an entity with a rating higher than the rating specified in the trigger. The counterparty may also need to receive confirmation from the specified rating agencies that the rating of the notes will not move downward as a result of these actions. If the counterparty does not satisfy these requirements, then depending on the swap documents, either the swap is terminated automatically or the trust may have the option of terminating the swap. Upon a termination of the swap, it is probable that there would be a swap termination payment due by the trust to the ...