Frederick Frank Adjunct Professor of Finance School of Management Yale University
The investor in nonagency mortgage-backed securities products is exposed to credit risk. Because there is no explicit or implicit government guarantee, all nonagency securities are credit enhanced in order to obtain a specific credit rating for each tranche in a deal. Credit enhancement mechanisms can take various forms, both from external parties and within the structure of the deal. External credit enhancement mechanisms are third-party guarantees. Internal credit enhancement mechanisms are forms of self-insurance. In addition, derivative instruments, specifically interest-rate swaps and interest-rate caps, can be used as a form of credit enhancement. The credit enhancement mechanism(s) used are those that provide the seller with the best execution. That is, it will maximize proceeds from the sale of the pool of mortgage loans after credit enhancement expenses (implicit and explicit) are taken into account.
This chapter examines and explains the various forms and usages of credit enhancement in mortgage-backed securities (MBS) and mortgage-related asset-backed securities (ABS). It discusses issues related to both internal and external credit enhancement and how differences in collateral quality and expected credit performance influence the form and amount of enhancement needed. It concludes with a discussion of how interest-rate derivatives are used for hedging interest-rate risk.
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