Swap spreads counterparty

The default risk component of a swap spread will be smaller than for a comparable bond credit spread. The reasons are straightforward. First, since only net interest payments are exchanged rather than both principal and coupon interest payments, the total cash flow at risk is lower. Second, the probability of default depends jointly on the probability of the counterparty defaulting and whether or not the swap has a positive value. See John C. Hull, Introduction to Futures and Options Markets, Third Edition (Upper Saddle River, NJ Prentice Hall, 1998). 

During the financial crash of2007—2008, in reaction to bond market volatility around the world brought about by the bank liquidity crisis and subsequent global recession, the USD swap spread widened, as did the spread between 2- and 10-year swaps, reflecting market worries about credit and counterparty risk. Spreads narrowed in the first quarter of 2009, as credit concerns sparked by the 2007—2008 market corrections declined. The evolution of the 2- and 10-year USD swap spreads is shown in FIGURES 7.4 and 7.5. 

For both Globaldrive B and PPAFl the first layer of protection is excess spread in the transaction, which is the difference between (1) the income received from the pool of receivables, and (2) the coupon due under the notes/payments due to the swap counterparty plus a certain servicing fee. Excess spread that is not used to cover losses on the loans within a certain period is returned to the originator (i.e., excess spread benefits the transaction on a use it or lose it basis). 

Strictly speaking, the FIAT 1 transaction does not generate excess spread. This explains the high level of credit enhancement from the unrated class M notes (usually, unrated tranches are either privately sold or kept as an equity tranche by the originator). On the closing date, an amount of notes was issued which was equal to the net present value of all future cash payments due from the collateral (as opposed to the principal balance of the collateral). The discount rate used was the fixed rate payable to the swap counterparty (swap rate plus coupon on the class A notes and all fees associated with the transaction). Structured this way, the receivables always yield the discount rate, leaving no excess spread in the transaction. However, losses on the FIAT 1 portfolio can be covered to a certain degree from interest collections because the structure provides for delinquent principal and defaults to be covered before interest is paid on the class M notes. 

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