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Mortgage-Backed Securities: Products, Structuring, and Analytical Techniques by WILLIAM S. BERLINER, ANAND K. BHATTACHARYA, FRANK J. FABOZZI

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ADDITIONAL STRUCTURING ISSUES AND DEVELOPMENTS

Deals are also commonly structured with embedded derivatives as part of the credit support mechanism. The presence of the swap within a structure acts to augment its credit support by reducing the basis risks embedded in the deal. As discussed in the section on available funds risks, there is often a fundamental mismatch in many deals between the bonds within a deal and the collateral backing it. In a scenario of sharply rising rates, the amount of excess spread is reduced, particularly soon after the deal is issued; the collateral continues to pay a fixed note rate, while the coupons on the bonds within the deal (which reset on a monthly basis) rise. In addition to mitigating potential available funds shortfalls, embedded swaps act to augment the excess spread in scenarios where interest rates spike. This allows the rating agencies to reduce the amount of required credit enhancement at each rating level, and typically reduces both the target OC percentage and the amount of initial OC.
The notional value of the swap is calculated in a number of different ways; the methods used vary across issuers and underwriters depending on economic and accounting considerations. The term of the swap and the swap’s declining balance are based on the composition of collateral backing the deal, along with the speed assumption utilized. The swap is typically structured as declining balance derivative contracts, with the speed determined at the ...

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