Fabozzi Ch13 BMAS 7thEd

8/19/2019 Fabozzi Ch13 BMAS 7thEd

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Copyright © 201013-1

Chapter 13

onagency

!esidential

"ortgage-#ac$ed

%ecurities


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Learning ObjectivesAfter 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 measuredthe subprime crisis in the summer of 2007


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Credit Enhancement

Securities without a government guarantee ora GSE guarantee must be structured with

additional credit support to receive an

investment-grade rating

!his additional credit support is needed toabsorb e"pected losses from the underlying

loan pool due to defaults

!his credit support is referred to as a creditenhancement


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Credit Enhancement 'continued(

#hen rating agencies assign a rating to the bond classes in a

nonagency $%S& they look at the credit risk associated witha bond class

%asically& that analysis begins by looking at the credit

'uality of the underlying pool of loans

Given the credit 'uality of the borrowers in the pool andother 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

!he process by which the rating agencies determine theamount of credit enhancement needed is referred to as sizing

the transaction


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!here are standard mechanisms for providing credit

enhancement in nonagency $%S #hen prime loans are securiti(ed& the credit enhancement

mechanisms and therefore the structures are not complicated

)n contrast& when subprime loans are securiti(ed& the structures

are more comple" because of the need for greater credit

enhancement

!here are four forms of credit enhancement:i senior-subordinated structure

ii e"cess spread

iii overcollaterali(ationiv monoline insurance


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Credit Enhancement 'continued( Senior-Subordinated Structure )n a senior-subordinated structure& two general categories of

bond classes are created: a senior bond class and subordinatedbond classes

*or e"ample& consider the following hypothetical nonagency

$%S structure consisting of +,00 million of collateral:

Bond Class Principal Amount Credit Rating

. +/0 million 111

2 +20 million 11

/ +.0 million 1

, + million %%%

+ million %%

+ million %

7 + million not rated


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Credit Enhancement 'continued( Senior-Subordinated Structure !he bond class with the highest rating 3%ond 4lass . from

the previous overhead5 is referred to as the senior bond class !he subordinated bond classes are those below the senior

bond class

!he rules for the distribution of the cash flow 3interest and

principal5 among the bond classes as well as how losses are to be distributed are e"plained in the prospectus

!here rules are referred to as the deal6s cash flow waterfall & or

simply waterfall

%asically& the losses are distributed based on the position of the

bond class in the structure osses start from the bottom 3the lowest or unrated bond class5

and progress to the senior bond class


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Credit Enhancement 'continued( Senior-Subordinated Structure #e can compare what is being done to distribute credit risk in a

nonagency $%S with what is done in an agency 4$8 )n an agency 4$8& there is no credit risk for Ginnie $ae issued structures

and the credit risk of the loan pool for *annie $ae and *reddie $ac issued

structure is viewed until recent years as small #hat is being done in creating the different bond classes in an agency 4$8

is the redistribution of prepayment risk )n contrast& in a nonagency $%S& there is both credit risk and prepayment

risk %y creating the senior-subordinated bond classes& credit risk is being

redistributed among the bond classes in the structure 9ence& what is being done is credit tranching

#hen the bond classes are sold in the market& they are sold atdifferent yields

8bviously& the lower the credit rating of a bond class& the higher is

the yield at which it must be offered


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Shifting Interest Mechanism in a Senior-

Subordinated Structure

1lmost all e"isting senior-subordinated structures

backed by residential mortgage loans also incorporate a

shifting interest mechanism

!his mechanism redirects prepayments disproportionately

from the subordinated bond class to the senior bond class

according to a specified schedule

!he rationale for the shifting interest structure is to have

enough subordinated bond classes outstanding to coverfuture credit losses


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!he 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 li'uidation proceeds

!he obective is to distribute these payments of principal

such that the credit protection for the senior bond classdoes not deteriorate over time


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Subordinated Structure !he 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. !he higher the percentage& the greater the level of

protection for the senior bond class

!he subordinate interest changes after the deal is closed

due to prepayments !hat is& the subordinate interest shifts 3hence the term

;shifting interest


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Subordinated Structure !he prospectus will specify how different scheduled

principal payments and prepayments will be allocated

between the senior bond class and the subordinated bond

class !he scheduled principal payments are allocated based on

the senior percentage

!he senior percentage& also called the senior interest& is

defined as the ratio of the balance of the senior bondclass to the balance of the entire deal and is e'ual to

.00= minus the subordinate interest


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1llocation of the prepayments is based on the senior

prepayment percentage 3in some deals called the

accelerated distribution percentage5

!his is defined as follows:

Senior prepayment percentage > Shifting interest percentage ?

Subordinate interest

!he ;shifting interest percentage< in the formula above isspecified in the prospectus


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!ample" !o illustrate the ;shifting interest percentage<

formula& suppose that in some month the senior

int erest 3or senior prepayment percentage5 is @2=& the subordinate interest is .@=& and the shifting interest

percentage is 70= !he senior prepayment percentage

for that month is

Senior prepayment percentage > Shifting interest percentage ?Subordinate interest A @2= > 070 ? .@= A #$"%&


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Credit Enhancement 'continued( Shifting Interest Mechanism in a Senior-


!he prospectus will provide the shifting interest percentage

schedule for calculating the senior prepayment percentage

1 commonly used shifting interest percentage schedule is as

follows:

'ear After Issuance Shifting Interest Percentage

()* (++&

% +&

%+&

$+&

# .+&

After year # +&


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Subordinated Structure !he shifting interest percentage schedule given in the

prospectus is the ;base< schedule !he schedule can change over time depending on the performance of

the collateral

)f the performance is such that the credit protection isdeteriorating or may deteriorate& the base shifting interest

percentages are overridden and a higher allocation of

prepayments is made to the senior bond class Berformance analysis of the collateral is done by the trustee for

determining whether to override the base schedule !he 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


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#hile the shifting interest structure is beneficial to

the senior bond class holder from a credit standpoint&

it does alter the cash flow characteristics of thesenior bond class even in the absence of defaults

!he si(e of the subordination also matters

1 larger subordinated class redirects a higher

proportion of prepayments to the senior bond class&thereby shortening the average life even further


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/eal Step-/own Pro0isions

1n important feature in analy(ing senior-subordinated

bond classes or deals backed by residential mortgages is

the deal6s step-down provisions

!hese provisions allow for the reduction in credit supportover time

1 concern that investors in the senior bond class have is

that if the collateral performance is deteriorating& step-

down provisions should be altered !he provisions that prevent the credit support from

stepping down are called ;triggers<


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/eal Step-/own Pro0isions !here are two triggers based on the level of credit performance

re'uired to be passed before the credit support can be reduced:

a delinquency trigger and a loss trigger

!he triggers are e"pressed in the form of a test that is applied

in each period !he delinquency test & in its most common form& prevents any

step-down from taking place as long as the current over 0-

day delin'uency rate e"ceeds a specified percentage of the

then-current pool balance

!he principal loss test prevents a step-down from occurring if

cumulative losses e"ceed a certain limit 3which changes over

time5 of the original balance


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/eal Step-/own Pro0isions

)n addition to triggers based on the performance of

the collateral& there is a balance test

!his test involves comparing the change in the senior

interest from the closing of the deal to the currentmonth

)f the senior interest has increased& the balance test is

failed& triggering a revision of the base schedule for

the allocation of principal payments from thesubordinated bond classes to the senior bond class


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!cess 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 3ie& the

interest payments to the bond classes in thestructure5 and the fees 3such as mortgage

servicing and administrative fees5

!he e"cess spread can be used to reali(e any

losses

E"cess spread is a form of credit enhancement


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10ercollaterali2ation E"cess collateral is referred to as overcollateralization

and can be used to absorb losses

9ence& it is a form of credit enhancement

8vercollaterali(ation is more commonly used as a formof credit enhancement in sub-prime deals than in prime

deals

!his is one of the aspects that makes subprime deals

more complicated because there are a series of tests builtinto the structure as to when collateral can be released


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Monoline Insurance

!here are insurance companies that& by

charter& provide only financial guarantees

!hese insurance companies are calledmonoline insurance companies

*or C$%S& they provide the same function&

and therefore& this is viewed as a form ofcredit enhancement


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Cash Flow for Nonagency M!

)n agency $%S& the cash flow is not affected by

defaults in the sense that they result in a

reduction in the principal to some bond class

Cather& defaulted principal is made up by theagency as part of its guarantee

*or a nonagency $%S& one or more bond classes

may be affected by defaults& and therefore&

defaults must be taken into account in estimating

the cash flow


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Cash Flow for Nonagency M!'continued(

Measuring /efault Rates !here are two measures used for 'uantifying

default rates for a loan pool: conditional default

r ate and cumulative default rate !he conditional default rate 34DC5 is the

annuali(ed 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 pool3before scheduled principal payment5 at the

beginning of the month


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Cash Flow for Nonagency M! 'continued(

Measuring /efault Rates

!he 4DC calculation begins with computing the default ratefor the month as shown below:

default rate for month t A

!hen& this is annuali(ed as follows to get the 4DC:

CDt A . 3. default rate for month t 5.2

!he cumulative default rate& abbreviated as 4D in order to avoid

confusion with 4DC& 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

d e f a u l t e d l o a n b a l a n c e i n m o n t h

b e g i n n i n g b a l a n c e f o r m o n t h - s c h e d u l e d p r i n c i p a l p a y m e n t i n m o n t h

t

t t


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Standard /efault Rate Assumption

1 standardi(ed benchmark for default rates was formulated

by the Bublic Securities 1ssociation 3BS15

!he BS1 standard default assumption 3SD15 benchmark

gives the annual default rate for a mortgage pool as a

function of the seasoning of the mortgages

E"hibit ./-. 3 see !verhead "#-$%5 illustrates the BS1

SD1 benchmark& or .00 SD1

1s with the BS1 prepayment benchmark& multiples of the benchmark are found by multiplying the default rate by the

assumed multiple


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Cash Flow for Nonagency M! 'continued(E"hibit 13#1 $he %!& !'& enchmar(

Mortgage Age 3Months4

. /. . F. .2. .. .@. 2.. 2,. 27. /0. //.

0,

0

0/

0

0.

02

A n n u a l i 2 e d / e f a

u l t R a t e 3 & 4


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Prepayment Measures Brepayments are measured in terms of the conditional prepayment

rate 34BC5

%orrower characteristics and the seasoning process must be kept in

mind when trying to assess prepayments for a particular deal

)n the prospectus of an offering& a base-case prepaymentassumption is madethe initial speed and the amount of time until

the collateral is e"pected to be seasoned !hus& the prepayment benchmark is issuer specific

!he benchmark speed in the prospectus is called the prospectus

prepayment curve 3BB45 Slower or faster prepayment speeds are a multiple of the BB4


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5onagency Prepayment Models

!he components of nonagency prepayment models are

the same components used in agency prepayment

models

9owever& because the issuer of nonagency $%S provides more detailed loan-level information& a

prepayment model is estimated for each type of loan

*or each type of representative loan& a baseline for the

components is constructed& and then the baseline ismodified for different permutations of loan-level

characteristics


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&ppendi" !)bprime Meltdown in *++, )n the summer of 2007& there was a crisis in the subprime $%S

market and this crisis& it has been argued& led to a credit and

li'uidity crisis that had a rippling impact on other sectors of thecredit market as well as the e'uity market

!his episode is referred to as the ;subprime meltdown<

)n keeping with the history of financial innovation bashing& there

have been overreactions& misinformation& and widely differingviewpoints regarding the crisis

Some market observers saw it as the inevitable bursting of the

;housing bubble< that had characteri(ed the housing market in

prior years

8thers viewed it as the product of unsavory practices by mortgage

lenders who deceived subprime borrowers into purchasing homes

that they could not afford


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&ppendi" !)bprime Meltdown in *++, 'continued( Specific mortgage designs such as hybrid loans made it possible for a

subprime borrower to obtain a loan that could have been e"pected to

cause financial difficulties in the future when loan rates as part of the

loan agreement were adusted upward $ortgage lenders blamed borrowers for misleading them 1nother contingent laid the blame at the feet of #all Street bankers who

packaged subprime loans into bonds and sold them to investors in the

form of $%S

#hatever the precise cause& it6s hard to deny that securiti(ationthe

financial framework that allowed #all Street to package these loans into

C$%Sis of enormous benefit to the economy Securiti(ation has increased the supply of credit to homeowners and

reduced the cost of borrowing

)t also spreads the risk among a larger pool of investors rather thanconcentrating it in a small group of banks and thrifts

Securiti(ation is an important and legitimate way for the financial

markets to function more efficiently today than in the past


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&ppendi" !)bprime Meltdown in *++, 'continued(

Cating agencies were also viewed by some market observers as

being a maor contributor to the crisis

Cecall 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 securiti(ation !he accuracy of ratings& like any other indicator of credit risk& can only be

assessed on a statistical basis over a long period of time

#hat is surprising market observers is why the crisis occurred in

uly 2007 !here was no new information in the market at the time )nvestors knew well before that time all about the potential defaults $oreover& since 200& the rating agencies took action that was transparent to

the market

Specifically& rating agencies adusted their criteria and assumptions regardinghow they were rating subprime $%S transactions& they downgraded some

issues& and they publicly commented on their concerns about the subprime

sector


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&ppendi" !)bprime

Meltdown in *++, 'continued( !he subprime crisis should not be minimi(ed

Some homeowners have suffered from an inability

to pay their mortgage

)nvestors in some C$%S have lost real money

%ut none of this suggests that securiti(ation created

the subprime problem

)nstead& securiti(ation has contributed to long-termeconomic growth by getting credit to the people

who really need and can use it


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Fabozzi Ch13 BMAS 7thEd