Moody's Investors Service said that certain swap-related issues frequently encountered in recent ABS and RMBS transactions across the Europe, Middle East and Africa (EMEA) area could have negative ratings impact.
The rating agency outlined the issues related to the economic structure of swap agreements, highlighting that risks vary according to the type of transaction, and that some swap structures have region-specific characteristics.
Among the things the rating agency observed amongst others three imperfections in EMEA interest rate swaps: imperfect hedges, with a mismatch between the swap notional amount and the outstanding pool balance (for example, in some scenarios, the amounts to be paid under the swap might exceed the amounts to be received from the pool); the existence of swap bands, which are agreed between the issuer and the swap counterparty at closing of the transaction, with minimum and maximum levels for the notional amount of the swap, outside which the interest rate risk is not covered; and basis risk, whereby floating-rate loans in the pool (specifically RMBS) and coupon on the issued notes are linked to different indexes and have different reset dates.
Under a stressed scenario, an imperfect interest rate hedge (or hedging shortfall) can have an adverse effect on the credit quality of a structured transaction, ultimately with negative rating implications.
Moody’s said that it’s recently observed a trend where the hedging agreements in some transactions did not fully mitigate the interest rate risk. These interest rate mismatches can lead to increased costs for structured deals, thus reducing the excess spread and ultimately the credit enhancement available to protect investors.
These shortfalls could, in some cases, lead to a greater rating volatility in a stressed interest rate environment; indeed, in some extreme cases, where the portion of the portfolio that is either unhedged or not sufficiently hedged is judged too significant by Moody's, such shortfalls could prevent the transaction from reaching Moody's highest ratings.