The underlying went adjustable six months after the wrap closed, and the spread the seller modeled at origination is now 40 basis points thinner.
Say the underlying was a 200k balance at 4.5 percent, seller wrote a wrap at 7 percent on 240k, and the spread on the 200k overlap was 2.5 points, about 415 a month before the seller's own carry costs. The ARM adjusts to 6 percent. That overlap spread just fell to 1 point, roughly 165 a month, and the wrap note rate is fixed, so the seller cannot pass the adjustment through. The buyer is still paying 7 percent, the underlying is now at 6, and the seller's margin on that portion of the balance collapsed by about 60 percent. If the underlying adjusts again, the seller could be in a position where the spread disappears entirely on the wrapped portion while still being contractually bound to the fixed rate they promised. The wrap note should have either indexed the buyer's rate to the underlying plus a fixed margin, or capped how much of the risk the seller absorbs, but most wrap notes written between private parties do not address this at all because the underlying looked fixed at signing. A variable underlying is a materially different deal than a fixed one, and the seller's return model changes faster than most people expect once the first adjustment hits. How did your original note handle rate changes on the underlying, if it addressed them at all?
