Securitisation Swaps

CHAPTER 6Swap Extension Risk

Remember that time is money.

– Benjamin Franklin

WHAT IS SWAP EXTENSION RISK?

Acting as a swap provider to a highly‐rated securitisation is a serious long‐term commitment. A large number of securitised bonds have a call date some time in the future, and the market expects originators to honour their implied commitment to call their bonds. However, if the originator doesn't call the bonds as expected, both the bonds and the swap will extend until either (i) the bonds are eventually called or (ii) the final cash flow has occurred. While non‐call events are very rare, they are potentially high impact, necessitating careful consideration of deal structuring, pricing and risk management. For swap providers, accepting this risk is akin to writing a swaption on a complex swap, where the exercise condition is not driven by observable market rates, but rather by the financial position of the originator.

Covered bond swaps can also extend in tenor, but the cause is issuer default rather than the bonds not being called. This is a simpler exercise condition, which is easier to model. For ease of exposition, this chapter will discuss extension risk mainly in the context of swaps over residential mortgage‐backed securities (RMBS) and asset‐backed securities (ABS). However, almost all of the content is equally applicable to covered bonds swaps, with the term ‘non‐call’ replaced by ‘default’. Footnotes will clarify this explicitly where it is helpful.

Since swap ...