Certain hedging shortfalls on residential mortgage-backed security (RMBS) transactions in Europe, the Middle East and Africa (EMEA) may lead to reduced levels of credit enhancements that protect investors, according to a report this week by Moody’s Investors Service. Cases where the hedging agreements fail to mitigate interest rate risk in RMBS transactions include imperfect hedges, basis risks and swap bands, Moody’s said. These shortfalls may lead to greater rating volatility in stressed interest rate environments. With imperfect hedges, Moody’s said, there’s a mismatch between the swap notional amount and the outstanding pool balance. Sometimes the amount to be paid under the swap might exceed the amounts to be received from the pool. With basis risk, floating-rate loans in the pool and coupon on the issued notes are linked to different indices and therefore have different reset dates. In extreme scenarios, an issuer’s payments on the notes may exceed those received from the pool and the difference must be covered from other sources like the excess spread and/or reserve fund. This reduces the credit enhancement available to the note holders, Moody’s said. In the swap band structure, minimum and maximum levels are in place for the notional amount of the swap. The interest rate risk is not covered outside the upper and lower bands of this range. Moody’s report author Stanislav Nastassine, a structured finance analyst, tells HousingWire the goal of the swap band structure is for the swap counterparty to make swaps as simple as possible. The swap band structure reduces the risk from the side of the counterparty against the movement of the notional within the upper and lower level bands, he said. “For swaps in general for securitisation, one of the challenges is determining over which notional you want to hedge,” said Moody’s report contributor Christophe de Noaillat. “It’s not like a normal bullet bond with a fixed amount. You have a pool that amortizes based on some parameters such as prepayments.” de Noaillat added: “By having these bands, the swap counterparty is trying in essence to minimize the amount which he would have to hedge, which has the downside for the transaction that if ever the notional of the pool were to go outside the bands’ confines, it wouldn’t be protected.” Write to Diana Golobay.