The relative size of the front-end senior non-NAS cash flows makes their execution highly important to the execution of the entire deal. One structuring variation used in all MBS sectors (both agency and private-label) is to split cash flows into floater/inverse floater combinations. This acts both to improve the deal execution and meet the strong and persistent demand for floating-rate assets.
Exhibit 1 demonstrates how a simple floater/inverse IO (IIO) combination can be structured from collateral or a parent tranche with a 6.0% coupon. However, there are tradeoffs associated with this technique. If the whole tranche is to be utilized, the cap of the floater equals the coupon of the collateral; this level is typically lower than that desired by investors in floating-rate bonds. If the floater cap is to be raised to a higher level, a premium/discount split must be used to create parent bonds with a high enough cap, limiting the proportion of the parent that can be structured into the floater/IIO combination.
A solution to this conundrum in private-label deals is the inclusion of amortizing cap corridors. In general terms, corridors are offsetting long and short positions in caps with the same expiration but different strike rates. An investor seeking to raise the cap on a floating-rate asset would buy the lower-strike cap and sell the one with the higher strike. Since the premium on a lower-strike cap is greater than on the one with a higher strike, the resulting corridor has a positive cost.
Utilizing cap corridors allows dealers to structure entire tranches into floater/inverse IO combinations. This creates large floater tranches with a cap (referred to as the hard cap) equal to the parent tranche's coupon. The cap corridor is used to raise the cap on the floater to a level acceptable to investors. The revised cap level is referenced as the effective cap, and is the strike level of the higher cap in the corridor. Cap corridors are typically used in deals with floater/inverse IO combination where the parent's coupon rate (and thus the floater's structuring cap) is lower than that desired by investors. The corridor is purchased from derivative dealers and embedded in the structure, with the effect of increasing the effective cap of the floater to the higher cap's strike rate. The cost associated with the corridor is effectively deducted from the floater's margin. As we will discuss, this means that both the strike levels and longevity of the corridor have a direct impact on the return and risk profile of the corridor cap floater.
While this concept is quite simple, the behavior of corridor-cap floaters is not straightforward. Because of the way the corridors are structured, the effective cap is not necessarily constant, and can deteriorate over the life of the floater under certain conditions. The value and riskiness of different corridor-cap floaters are a function of both how the corridors are structured and the level of the hard cap associated with the floater. (Unlike the effective cap, the hard cap cannot change.)
Since mortgage cash flows are impacted by both scheduled and unscheduled principal payments, the corridors must be written with an amortization schedule. This schedule is defined at the time of issuance, and can be quoted as either a percentage of the pricing ramp or at a static CPR. Since the corridor is structured at a constant speed but the floaters receive principal cash flows based on the underlying prepayment rate of the collateral, the potential exists for a mismatch between the balances of the floater and the cap corridor. When the deal's prepayment speeds exceed the ramp, the floater tranche pays down faster than the corridor, leaving more corridors than bonds. In theory, this should raise the effective cap to a level higher than the strike level of the higher cap. However, the effective cap of the floater normally never rises above the higher strike, since the corridor is typically quoted as the lesser of the pre-set amortizing balance or the balance of the floater. (For accounting reasons, some investors will not invest in floaters where the effective cap is greater than the level of the higher cap's strike.)
The effective cap is, however, impacted when realized prepayment speeds are slower than the speed at which the corridor is structured (or "struck"). At slow prepayment speeds, the balance of the floater will exceed that of the corridor, causing the effective cap of the floater to decline. Persistently slow prepayment speeds will eventually cause the effective cap to decline to the level of the floater's hard cap. This is shown in Exhibit 2, which shows the effective cap at prepayment speeds slower than the 11% CPR strike speed of a hypothetical corridor-cap floater. At 11% CPR and faster, the effective cap is unchanged; however, at even slightly slower constant speeds, the effective cap eventually declines to 6.5%, the floater's hard cap.
This suggests that the cap corridor's pricing speed is a critical driver of value for the corridor floaters. Floaters with a corridor struck at a faster prepayment speed have a greater risk that the effective cap will deteriorate. However, the corridor is effectively a shorter derivative (since its average life is reduced at faster speeds). This means that the cost of the cap corridor is reduced, thereby increasing the amount of margin that can be paid to the floater. The opposite is the case if the corridor is struck at a slow speed. The risk that the effective cap will erode over time is reduced, at the cost of a lower floating-rate margin. (Note that the speed at which the corridor is struck has no impact on the cash flows directed to the inverse IO.)
The type of loan collateral backing the deal also has an impact on the corridor floater's attributes. Because of the risks associated with slow prepayment speeds, the ideal collateral consists of loans that have relatively fast base-case prepayment speeds. As a result, most deals containing corridor floaters are backed by alt-A and other impaired loans (such as reperforming loans) that consistently exhibit rapid prepayments, due largely to high levels of credit curing and involuntary prepayments.
Finally, the floater's hard cap also impacts its value. As mentioned above, the level of the hard cap cannot change over the life of the floater. Thus, a higher hard cap provides increased protection to the floater's coupon in the event that the corridor deteriorates. As an example, a floater with a 5.5% hard cap that resets at LIBOR plus 30 basis points would "cap out" when LIBOR reaches 5.20% without the benefit of the corridor. The same bond with a 6.5% hard cap would not cap out until LIBOR reaches 6.20%. The value of the higher hard cap is especially important when more aggressive (i.e., faster) pricing speeds are used to structure the corridor.
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