All investors are encouraged to look at the potential for extension risk on every deal that they buy into, analysts said.
"Investors have bought ABS bonds on the basis that they would be repaid at the expected maturity, either the step-up date or the cleanup call date, and are now facing the risk of extension beyond these expectations," Barclays Capital analysts said.
ABS bonds with step-up coupons have an increased note margin payable in the event that the bonds are not fully repaid , either through amortization or prepayment, at their expected maturity date. A non-call of the ABS bonds at the step-up date does not necessarily lead to default, but the likelihood of prepayment decreases and investors are unable to capitalize on higher interest rates because their investments are locked in at a lower rate for a longer period of time.
According to Barclays, issuers will have to decide whether to call the bonds at the step-up date on a case-by-case basis. U.K. nonconforming RMBS and CMBS transactions have used step-ups minimally, although U.K. RMBS master trusts have used them extensively. Analysts said that only some Dutch Prime RMBS have an incentive to refinance at the current level of secondary spreads, adding that the extension risk is also low for U.K. prime RMBS. The risk of extension is moderate for CMBS and corporate securitization structures, and as there are not many upcoming expected loan maturities in these two sectors in 2008 and 2009, the impact is expected to be minimal overall.
Meanwhile, extension risk in the U.K. nonconforming sector is considered the highest in the near term, Barclays said. However, analysts said that there are no step-up dates until December 2008, which gives the market time for conditions to improve. In the U.K. buy-to-let sector, Barclays analysts see some extension risks for the First Flexible 4 transaction, which is backed by Paragon collateral, as a result of the funding issues currently faced by Paragon Mortgages.
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