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Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-1 Chapter 13 Nonagency Residential Mortgage-Backed Securities.

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Presentation on theme: "Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-1 Chapter 13 Nonagency Residential Mortgage-Backed Securities."— Presentation transcript:

1 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-1 Chapter 13 Nonagency Residential Mortgage-Backed Securities

2 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-2 Learning Objectives After reading this chapter, you will understand  the two sectors of the nonagency mortgage-backed securities market: private label and subprime  the structure of a nonagency mortgage-backed securities transaction  how credit risk is redistributed in a nonagency mortgage- backed securities transaction  the different credit enhancement mechanisms  how defaults are measured  how prepayments are measured  the subprime crisis in the summer of 2007

3 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-3 Credit Enhancement  Securities without a government guarantee or a GSE guarantee must be structured with additional credit support to receive an investment-grade rating.  This additional credit support is needed to absorb expected losses from the underlying loan pool due to defaults.  This credit support is referred to as a credit enhancement.

4 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-4 Credit Enhancement (continued)  When rating agencies assign a rating to the bond classes in a nonagency MBS, they look at the credit risk associated with a bond class.  Basically, that analysis begins by looking at the credit quality of the underlying pool of loans.  Given the credit quality of the borrowers in the pool and other factors such as the structure of the transaction, a rating agency will determine the dollar amount of the credit enhancement needed for a particular bond class to receive a specific credit rating.  The process by which the rating agencies determine the amount of credit enhancement needed is referred to as sizing the transaction.

5 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-5 Credit Enhancement (continued)  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.  There are four forms of credit enhancement: i.senior-subordinated structure ii.excess spread iii.overcollateralization iv.monoline insurance

6 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-6 Credit Enhancement (continued)  Senior-Subordinated Structure  In a senior-subordinated structure, two general categories of bond classes are created: a senior bond class and subordinated bond classes.  For example, consider the following hypothetical nonagency MBS structure consisting of $400 million of collateral: Bond ClassPrincipal AmountCredit Rating X1$350 millionAAA X2$20 millionAA X3$10 millionA X4$5 millionBBB X5$5 millionBB X6$5 millionB X7$5 millionnot rated

7 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-7 Credit Enhancement (continued)  Senior-Subordinated Structure  The bond class with the highest rating (Bond Class X1 from the previous overhead) is referred to as the senior bond class.  The subordinated bond classes are those below the senior bond class.  The rules for the distribution of the cash flow (interest and principal) among the bond classes as well as how losses are to be distributed are explained in the prospectus. There rules are referred to as the deal’s cash flow waterfall, or simply waterfall. Basically, the losses are distributed based on the position of the bond class in the structure. Losses start from the bottom (the lowest or unrated bond class) and progress to the senior bond class.

8 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-8 Credit Enhancement (continued)  Senior-Subordinated Structure  We can compare what is being done to distribute credit risk in a nonagency MBS with what is done in an agency CMO. In an agency CMO, there is no credit risk for Ginnie Mae issued structures and the credit risk of the loan pool for Fannie Mae and Freddie Mac issued structure is viewed until recent years as small. What is being done in creating the different bond classes in an agency CMO is the redistribution of prepayment risk. In contrast, in a nonagency MBS, there is both credit risk and prepayment risk. By creating the senior-subordinated bond classes, credit risk is being redistributed among the bond classes in the structure. Hence, what is being done is credit tranching.  When the bond classes are sold in the market, they are sold at different yields. Obviously, the lower the credit rating of a bond class, the higher is the yield at which it must be offered.

9 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-9 Credit Enhancement (continued)  Shifting Interest Mechanism in a Senior- Subordinated Structure  Almost all existing senior-subordinated structures backed by residential mortgage loans also incorporate a shifting interest mechanism. This mechanism redirects prepayments disproportionately from the subordinated bond class to the senior bond class according to a specified schedule. The rationale for the shifting interest structure is to have enough subordinated bond classes outstanding to cover future credit losses.

10 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-10 Credit Enhancement (continued)  Shifting Interest Mechanism in a Senior- Subordinated Structure  The basic credit concern that investors in the senior bond class have is that although the subordinated bond classes provide a certain level of credit protection for the senior bond class at the closing of the deal, the level of protection may deteriorate over time due to prepayments and certain liquidation proceeds.  The objective is to distribute these payments of principal such that the credit protection for the senior bond class does not deteriorate over time.

11 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-11 Credit Enhancement (continued)  Shifting Interest Mechanism in a Senior- Subordinated Structure  The percentage of the mortgage balance of the subordinated bond class to that of the mortgage balance for the entire deal is called the level of subordination or the subordinate interest.  The higher the percentage, the greater the level of protection for the senior bond class.  The subordinate interest changes after the deal is closed due to prepayments.  That is, the subordinate interest shifts (hence the term “shifting interest”).

12 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-12 Credit Enhancement (continued)  Shifting Interest Mechanism in a Senior- Subordinated Structure  The prospectus will specify how different scheduled principal payments and prepayments will be allocated between the senior bond class and the subordinated bond class.  The scheduled principal payments are allocated based on the senior percentage.  The senior percentage, also called the senior interest, is defined as the ratio of the balance of the senior bond class to the balance of the entire deal and is equal to 100% minus the subordinate interest.

13 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-13 Credit Enhancement (continued)  Shifting Interest Mechanism in a Senior- Subordinated Structure  Allocation of the prepayments is based on the senior prepayment percentage (in some deals called the accelerated distribution percentage). This is defined as follows: Senior prepayment percentage + Shifting interest percentage × Subordinate interest The “shifting interest percentage” in the formula above is specified in the prospectus.

14 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-14 Credit Enhancement (continued)  Shifting Interest Mechanism in a Senior- Subordinated Structure Example. To illustrate the “shifting interest percentage” formula, suppose that in some month the senior interest (or senior prepayment percentage) is 82%, the subordinate interest is 18%, and the shifting interest percentage is 70%. The senior prepayment percentage for that month is Senior prepayment percentage + Shifting interest percentage × Subordinate interest = 82% + 0.70 × 18% = 94.6%

15 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-15 Credit Enhancement (continued)  Shifting Interest Mechanism in a Senior- Subordinated Structure  The prospectus will provide the shifting interest percentage schedule for calculating the senior prepayment percentage.  A commonly used shifting interest percentage schedule is as follows: Year After IssuanceShifting Interest Percentage 1–5100% 6 70% 7 60% 8 40% 9 20% After year 9 0%

16 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-16 Credit Enhancement (continued)  Shifting Interest Mechanism in a Senior- Subordinated Structure  The shifting interest percentage schedule given in the prospectus is the “base” schedule. The schedule can change over time depending on the performance of the collateral.  If the performance is such that the credit protection is deteriorating or may deteriorate, the base shifting interest percentages are overridden and a higher allocation of prepayments is made to the senior bond class. Performance analysis of the collateral is done by the trustee for determining whether to override the base schedule. The performance analysis is in terms of tests, and if the collateral or structure fails any of the tests, this will trigger an override of the base schedule.

17 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-17 Credit Enhancement (continued)  Shifting Interest Mechanism in a Senior- Subordinated Structure  While the shifting interest structure is beneficial to the senior bond class holder from a credit standpoint, it does alter the cash flow characteristics of the senior bond class even in the absence of defaults.  The size of the subordination also matters.  A larger subordinated class redirects a higher proportion of prepayments to the senior bond class, thereby shortening the average life even further.

18 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-18 Credit Enhancement (continued)  Deal Step-Down Provisions  An important feature in analyzing senior-subordinated bond classes or deals backed by residential mortgages is the deal’s step-down provisions.  These provisions allow for the reduction in credit support over time.  A concern that investors in the senior bond class have is that if the collateral performance is deteriorating, step- down provisions should be altered.  The provisions that prevent the credit support from stepping down are called “triggers.”

19 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-19 Credit Enhancement (continued)  Deal Step-Down Provisions  There are two triggers based on the level of credit performance required to be passed before the credit support can be reduced: a delinquency trigger and a loss trigger.  The triggers are expressed in the form of a test that is applied in each period. The delinquency test, in its most common form, prevents any step-down from taking place as long as the current over 60- day delinquency rate exceeds a specified percentage of the then-current pool balance. The principal loss test prevents a step-down from occurring if cumulative losses exceed a certain limit (which changes over time) of the original balance.

20 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-20 Credit Enhancement (continued)  Deal Step-Down Provisions  In addition to triggers based on the performance of the collateral, there is a balance test. This test involves comparing the change in the senior interest from the closing of the deal to the current month. If the senior interest has increased, the balance test is failed, triggering a revision of the base schedule for the allocation of principal pay­ments from the subordinated bond classes to the senior bond class.

21 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-21 Credit Enhancement (continued)  Excess Spread  Excess spread, also referred to as excess interest, is basically the interest from the collateral that is not being used to satisfy the liabilities (i.e., the interest payments to the bond classes in the structure) and the fees (such as mortgage servicing and administrative fees). The excess spread can be used to realize any losses. Excess spread is a form of credit enhancement.

22 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-22 Credit Enhancement (continued)  Overcollateralization  Excess collateral is referred to as overcollateralization and can be used to absorb losses. Hence, it is a form of credit enhancement.  Overcollateralization is more commonly used as a form of credit enhancement in sub-prime deals than in prime deals. This is one of the aspects that makes subprime deals more complicated because there are a series of tests built into the structure as to when collateral can be released.

23 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-23 Credit Enhancement (continued)  Monoline Insurance  There are insurance companies that, by charter, provide only financial guarantees.  These insurance companies are called monoline insurance companies.  For RMBS, they provide the same function, and therefore, this is viewed as a form of credit enhancement.

24 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-24 Cash Flow for Nonagency MBS  In agency MBS, the cash flow is not affected by defaults in the sense that they result in a reduction in the principal to some bond class.  Rather, defaulted principal is made up by the agency as part of its guarantee.  For a nonagency MBS, one or more bond classes may be affected by defaults, and therefore, defaults must be taken into account in estimating the cash flow.

25 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-25 Cash Flow for Nonagency MBS (continued)  Measuring Default Rates  There are two measures used for quantifying default rates for a loan pool: conditional default rate and cumulative default rate.  The conditional default rate (CDR) is the annualized value of the unpaid principal balance of newly defaulted loans over the course of a month as a percentage of the unpaid balance of the pool (before scheduled principal payment) at the beginning of the month.

26 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-26 Cash Flow for Nonagency MBS (continued)  Measuring Default Rates  The CDR calculation begins with computing the default rate for the month as shown below: default rate for month t =  Then, this is annualized as follows to get the CDR: CDR t = 1 – (1 – default rate for month t ) 12  The cumulative default rate, abbreviated as CDX in order to avoid confusion with CDR, is the proportion of the total face value of loans in the pool that have gone into default as a percentage of the total face value of the pool.

27 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-27 Cash Flow for Nonagency MBS (continued)  Standard Default Rate Assumption  A standardized benchmark for default rates was formulated by the Public Securities Association (PSA).  The PSA standard default assumption (SDA) benchmark gives the annual default rate for a mortgage pool as a function of the seasoning of the mortgages.  Exhibit 13-1 (see Overhead 13-28) illustrates the PSA SDA benchmark, or 100 SDA.  As with the PSA prepayment benchmark, multiples of the benchmark are found by multiplying the default rate by the assumed multiple.

28 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-28 Cash Flow for Nonagency MBS (continued) Exhibit 13-1 The PSA SDA Benchmark Mortgage Age (Months) 1316191121151181211241271301331 0.4 0.6 0.3 0.5 0.1 0.2 Annualized Default Rate (%)

29 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-29 Cash Flow for Nonagency MBS (continued)  Prepayment Measures  Prepayments are measured in terms of the conditional prepayment rate (CPR).  Borrower characteristics and the seasoning process must be kept in mind when trying to assess prepayments for a particular deal.  In the prospectus of an offering, a base-case prepayment assumption is made–the initial speed and the amount of time until the collateral is expected to be seasoned. Thus, the prepayment benchmark is issuer specific. The bench­mark speed in the prospectus is called the prospectus prepayment curve (PPC). Slower or faster prepayment speeds are a multiple of the PPC.

30 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-30 Cash Flow for Nonagency MBS (continued)  Nonagency Prepayment Models  The components of nonagency prepayment models are the same components used in agency prepayment models.  However, because the issuer of nonagency MBS provides more detailed loan-level information, a prepayment model is estimated for each type of loan.  For each type of representative loan, a baseline for the components is constructed, and then the baseline is modified for different permutations of loan-level characteristics.

31 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-31 Appendix Subprime Meltdown in 2007  In the summer of 2007, there was a crisis in the subprime MBS market and this crisis, it has been argued, led to a credit and liquidity crisis that had a rippling impact on other sectors of the credit market as well as the equity market.  This episode is referred to as the “subprime meltdown.”  In keeping with the history of financial innovation bashing, there have been overreactions, misinformation, and widely differing viewpoints regarding the crisis.  Some market observers saw it as the inevitable bursting of the “housing bubble” that had characterized the housing market in prior years.  Others viewed it as the product of unsavory practices by mortgage lenders who deceived subprime borrowers into purchasing homes that they could not afford.

32 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-32 Appendix Subprime Meltdown in 2007 (continued)  Specific mortgage designs such as hybrid loans made it possible for a subprime borrower to obtain a loan that could have been expected to cause financial difficulties in the future when loan rates as part of the loan agreement were adjusted upward.  Mortgage lenders blamed borrowers for misleading them.  Another contingent laid the blame at the feet of Wall Street bankers who packaged subprime loans into bonds and sold them to investors in the form of MBS.  Whatever the precise cause, it’s hard to deny that securitization–the financial framework that allowed Wall Street to package these loans into RMBS–is of enormous benefit to the economy.  Securitization has increased the supply of credit to homeowners and reduced the cost of borrowing.  It also spreads the risk among a larger pool of investors rather than concentrating it in a small group of banks and thrifts.  Securitization is an important and legitimate way for the financial markets to function more efficiently today than in the past.

33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-33 Appendix Subprime Meltdown in 2007 (continued)  The securitization of subprime loans works by dividing pools of credit into classes, or bond classes, separated by the amount of risk each class represents.  The classes with less risk offer lower potential returns while the classes with more risk offer higher potential returns.  The more junior, riskier classes are purchased by sophisticated institutional investors who understand that they may incur losses but hope for high enough returns over a long period of time to offset possible losses.  The demand for this product must come from investors.  In the case of RMBS backed by subprime loans, it came ultimately from hedge fund managers.  The major purchasers of subprime MBS were portfolio managers of collateralized debt obligations (CDOs).  Managers of CDOs created bond classes that were effectively leveraged positions in a portfolio of RMBS.  Hedge fund managers bought the bond classes that were necessary for a transaction to get done.

34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-34 Appendix Subprime Meltdown in 2007 (continued)  Rating agencies were also viewed by some market observers as being a major contributor to the crisis.  Recall that to aid investors in comparing the relative credit risk of securities, issuers generally ask one or more rating agencies to assign a credit rating to the securitization.  The accuracy of ratings, like any other indicator of credit risk, can only be assessed on a statistical basis over a long period of time.  What is surprising market observers is why the crisis occurred in July 2007.  There was no new information in the market at the time.  Investors knew well before that time all about the potential defaults.  Moreover, since 2005, the rating agencies took action that was transparent to the market.  Specifically, rating agencies adjusted their criteria and assumptions regarding how they were rating subprime MBS transactions, they downgraded some issues, and they publicly commented on their concerns about the subprime sector.

35 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-35 Appendix Subprime Meltdown in 2007 (continued)  The subprime crisis should not be minimized.  Some homeowners have suffered from an inability to pay their mortgage.  Investors in some RMBS have lost real money.  But none of this suggests that securitization created the subprime problem.  Instead, securitization has contributed to long-term economic growth by getting credit to the people who really need and can use it.

36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13-36 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.


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