Why might an interest rate derivative such as an interest rate swap or interest rate cap be used in a securitization transaction for residential mortgage loans?

Question

What will be an ideal response?

Answer 1

Securitization is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming them into a security. There are standard mechanisms for providing credit enhancement in nonagency MBS. When prime loans are securitized, the credit enhancement mechanisms and therefore the structures are not complicated. In contrast, when subprime loans are securitized, the structures are more complex because of the need for greater credit enhancement. Since these more complex structures are found in certain types of asset-backed securities (ABS), this is the reason why market participants classify securitization involving subprime loans as part of the ABS market (recall that they are referred to as mortgage-related ABS).

There are often interest rate derivatives such as interest rate swaps and interest rate caps employed in nonagency MBS structures that are not allowed in agency MBS structures. We can point out that they are used when there is a mismatch between the character of the cash flows for the loan pool and the character of the cash payments that must be made to the bond classes. For example, some or all of the bonds classes may have a floating interest rate, whereas all the loans have a fixed interest rate.