Nonagency Residential MBSs, Commercial MBSs, and Other Asset-Backed Securities

1. Nonagency Residential MBSs, Commercial MBSs, and Other Asset-Backed Securities

2. Other Securitized Assets • Agency MBSs represent the largest and most extensively developed asset-backed security. • Since 1985, a number of other asset-backed securities have been developed. • The most common types are nonagency residential MBS, commercial MBSs, and asset-backed securities backed by automobile loans, credit card receivables, and home equity loans. • These asset-backed securities are structured as pass-through and many have prepayment tranches. • Different from agency MBSs, though, the collateral backing these asset-backed securities are subject to credit and default risk.

3. Nonagency Residential MBS

4. Nonagency Residential MBS • MBS created by one of the agencies are collectively referred to as agency MBSs, and those created by private conduits are called nonagency MBSs or private labels.

5. Nonagency Residential MBS • Agency residential MBSs are created from conforming loans. • All other mortgages that are securitized are nonagency MBSs. • Nonagency residential MBSs can, in turn, be classified as either prime MBSs, in where the underlying mortgages are all prime, or subprime MBSs, where the underlying mortgage pool consists of subprime mortgages. • In grouping the different types of securitized assets (residential mortgages, commercial mortgages, and other assets) nonagency subprime MBSs are typically grouped with asset-backed securities and not mortgage-backed securities.

6. Default Loss and Credit Tranches • Nonagency MBSs or nonagency CMOs are subject to default losses. • A portfolio of 30-year, 8% mortgages with a 100 standard default assumption (SDA) has a cumulative default rate after 120 months of 3.59% and one with a 300 SDA has a cumulative default rate of 10.46%. • Different from agency MBSs, investors of nonagnecy MBS need to taken into account the expected default losses in determining the credit spread for pricing such securities.

7. Projected Cash Flows with Default Loss Mortgage Portfolio = $100,000,000, WAC = 8%, WAM = 360 Months, 100 SDA Model

8. Cumulative Default Rates 100, 200, and 300 SDA Models Mortgage Portfolio = $100,000,000, WAC = 8%, WAM = 360 Months

9. Default Loss and Credit Tranches • MBS conduits address credit risk on nonagency MBSs by providing credit enhancements designed to absorb the expected losses from the underlying mortgage pool resulting from defaults. • For nonagency MBSs or CMOs, credit enhancement include: • Senior-Subordinate Structures • Excess Spreads • Overcollateralization • Monoline Insurance

10. Senior-Subordinate Structures • A MBS issue with a senior-subordinate structure is formed with two general bond classes: a senior bond class and a subordinated bond class, with each class consisting of one or more tranches. • The next slide shows a $500 million senior-subordinate structured MBS with one senior bond class with a principal of $400 million and six subordinate or junior classes with a total principal of $100 million.

11. Senior-Subordinate Structures

12. Senior-Subordinate Structures • For this MBS issue, the default losses are absorbed first by Tranche 7 (starting at the bottom) and ascend up. • If losses on the collateral are less than $10 million, then only Tranche 7 will experience a loss • If losses are $30 million, then Tranches 7, 6, and 5 will realize losses • The senior-subordinated structured MBS spreads the credit risk amongst the bond classes. This is referred to as credit traunching.

13. Senior-Subordinate Structures Waterfalls • The rules for the distribution of the cash flows that include the distribution of losses are referred to as the cash flow waterfalls or simply waterfalls. • Because of the different levels of default risk, each of the subordinate tranches created in a senior-subordinate structured MBS are separately rated by Moody’s or Standard and Poor’s, with the lower tranches receiving lower ratings.

14. Senior-Subordinate Structures Senior Interest • The proportion of the mortgage balance of the senior bond class to the total mortgage deal is referred to as senior interest (initial senior interest = $400m/$500m = .80). Subordinate Interest • The proportion of the mortgage balance of the subordinated bond classes to the total mortgage deal is referred to as subordinate interest (initial subordinate interest = $100m/$500m = .20). • The greater the subordinate interest, the greater the level of credit protection for the senior bond.

15. Senior-Subordinate Structures Shifting Interest Schedule • Over the life of the MBS deal, the level of credit protection will change as principal is prepaid. • In general, with prepayment, senior interest will increase and the subordinate interest will decrease over time. • Because of this, most senior-subordinate structured MBS deals have a shifting interest schedule designed to maintain the credit protection for the senior bond class.

16. Senior-Subordinate Structures Shifting Interest Schedule • Shifting interest schedule is used to determine the allocation of prepayment that goes to the senior and subordinate tranches. • Example: Shifting Interest Schedule

17. Senior-Subordinate Structures Shifting Interest Schedule • In determining the allocation to the senior holders, their percentage of prepayment is equal to their initial senior interest (for example, 80% = $400m/$500m) plus the shifting interest (based on the schedule) times the subordinate interest (20% = ($100m/$500m): Shifting Interest Proportion Initial Senior Interest Percent Initial Subordinate Interest Senior prepayment Percentage = + x

18. Senior-Subordinate Structures Initial Senior Interest Percent Initial Subordinate Interest Shifting Interest Proportion Senior prepayment Percentage + x Shifting Interest Schedule = • Initial senior interest = $400m/$500m = .80 • Initial subordinate interest = $100m/$500m = .20 • Based on the above schedule: • 100% of the prepayment would go to the senior class for the first five years (= 80% + (1)(20%) = 100%) • 96% in year 6 (= 80% + (20%)(.70) • 92% in year 7, and so on. • After year 10, the allocation of principal between senior and subordinate classes would match their initial senior and subordinate interest proportions of 80% and 20%.

19. Senior-Subordinate Structures Step-Down Provision • The shifting-interest schedule from 100% to 70% in year 6, to 60% in year 7, to finally 0% after year 10 is known as a step-down provision; such a provision allows for reductions in the credit support over time.

20. Senior-Subordinate Structures • In many senior-subordinated structured MBS deals, provisions are included that allow for changes in the shifting interest schedule if credit conditions related to the underlying collateral deteriorate. • Typically, the provisions prohibit the step-down provision in the shifting interest schedule from occurring if certain performance measures are not met. • For example, if the cumulative default losses exceed a certain limit of the original balance or if the 60-day delinquency rate exceeds a specified proportion of the current balance, then step downs would not be allowed.

21. Excess Interest • Excess interest (or excess spread) is the interest from the collateral that is not being used to pay MBS investors and fees (mortgage servicing and administrative services). • The excess spread can be used to offset any losses. • If the excess interest is retained, it can be accumulated in an account and used to offset futures default losses. • When this is done, the excess interest can be set up similar to a notional interest-only (IO) class, with the proceeds going to a reserve account and paid out to IO holders at some future date if there is an excess.

22. Overcollateralization • Overcollateralization is having the par value of the collateral exceeds the value of the MBS issued. • For example, if the MBS issue of $500 million had $550 million in collateral. • The $50 million excess would then be used to absorb default losses.

23. Monoline Insurance Companies • Some Nonagency MBSs also have external credit enhancements in the form of insurance provided by Monoline insurance companies. • Monoline insurance companies: Finance Guarantee Insurance Corporation, the Capital Markets Insurance Corporation, or the Financial Security Assurance Company. • The guarantees provided by monoline insurers, in turn, shifts the default risk to the insurer.

24. Commercial MBS

25. Commercial Mortgages Commercial Mortgage Loans • Real estate property can be either residential or nonresidential. • Residential includes houses, condominiums, and apartments; it is classified as either single-family or multiple-family. • Nonresidential includes commercial and agricultural property. • Commercial real estate loans are for income-producing properties. They are used to finance the purchase of the property or to refinance an existing one.

26. Commercial Mortgages • Commercial property can include: • Shopping centers • Shopping strips • Multifamily apartment buildings • Industrial properties • Warehouses • Hotels • Health care facilities

27. Commercial Mortgages Non-Recourse • In contrast to residential mortgages where the interest and principal payments come from borrowers’ income-generating ability or wealth, commercial mortgage loans come from income produced from the property. • As such, commercial mortgage loans are referred to as non-recourse loans.

28. Commercial Mortgages Assessing Credit Quality • Lenders in assessing the credit quality of commercial loans look at • The debt-to-service ratio (= Rental Income – operating expenses)/ Interest Payments) • The loan-to-value ratios, where value is equal to the present value of expected cash flows or the appraised value.

29. Commercial Mortgages Prepayment Protection • Commercial mortgage loans also differ from residential mortgage loans in that they typically have prepayment protection. • Prepayment protection can take the form of prepayment penalties, provisions prohibiting prepayment for a specified period, and defeasance. • Note: Defeasance is an agreement whereby the borrower agrees to invest funds in risk-free securities in an amount that would match the cash flows of a prepayment schedule.

30. Commercial Mortgages Balloon Risk • Unlike residential mortgage loans in which the principal is amortized over the life of the loan, commercial mortgage loans are typically balloon loans. • At the balloon date, the borrower is therefore obligated to pay the remaining balance. This is typically done by refinancing. • As a result, the lender is subject to balloon risk: The risk that the borrower will not be able to make the balloon payment because they either cannot refinance or sell the property at a price that will cover the loan.

31. Commercial Mortgages Special Servicer • With many commercial property loans, there is a special servicer who takes over the loan when default is imminent. • These servicers have the responsibility to try modify the loan terms to avert default.

32. Commercial Mortgage-Backed Security • Commercial Mortgage-Backed Security (CMBS) is a security backed by one or more commercial mortgage loans. • Some CMBSs are backed by Fannie Mae, Freddie Mac, and Ginnie Mae. These agency CMBSs are limited to multifamily mortgages and healthcare facilities. • Most CMBSs are private labels formed by either a single borrower with many properties or by a conduit with multiple borrowers.

33. Commercial Mortgage-Backed Security Features • Similar to nonagency residential MBSs, many CMBSs have • Credit tranches (senior-subordinated structures) • Credit enhancements (overcollaterialization, excess interests, and monocline insurance) • Prepayment tranches (sequential-pay, PACs, notional interest-only (NIO), floaters, etc.)

34. Commercial Mortgage-Backed Security Features • One feature common to residential and commercial mortgage-backed securities is cross-collateralization:property used to secure one loan is also used to secure the other loans in the pool. • Cross-collateralization prevents the MBS investors/lenders from calling the loan if there is a default, provided there is sufficient cash flows from the other loans to cover the loan’s default loss. Such protection is called cross-defaultprotection.

35. Commercial Mortgage-Backed Security Features • Commercial MBS can be formed with a fewer number of loans than residential MBS and with some loans being more important to the pool than others. • As a result, commercial MBSs often have less cross-default protection. • To redress this, some commercial MBSs include a property release provision that requires the borrower of a commercial loan to pay a premium (e.g. 105% of par) if the property is removed from the pool. • The provision is aimed at averting potential deterioration in the overall credit quality of the collateral when the best property in the pool is prepaid.

36. Commercial Mortgage-Backed Security Single Borrower with Multiple Properties • CMBSs can be formed from a single borrower with multiple properties. • These deals are often set up by large real estate developers who use commercial MBSs as a way to finance or refinance their numerous projects: shopping malls, office buildings, hotels, apartment complexes, and the like.

37. Commercial Mortgage-Backed Security Conduit Deals • The other type of commercial MBS deal is one in which there are multiple borrowers or originators with the MBS set up through a conduit—a conduit deal. • When the deal has one large borrower or property combined with a number of smaller borrowers, the deal is referred to as a fusion conduit deal.

38. Commercial Mortgage-Backed Security Conduit Deals • Conduit deals are often structured by large banks such as Bank of America, Well Fargo, or J.P, Morgan. • Note: It is not uncommon for the conduit deal to be used to finance properties totaling as much as $1 billion, with as many as 200 property loans, varying in type (office, multi, warehouses, etc.,), geographical distributions, and credit enhancements.

39. Commercial Mortgage-Backed Security Conduit Deals • With such large deals, there are different servicing levels. • For example, there may be subservicing by the local originators who are required to collect payments and maintain records, a master servicer responsible for overseeing the commercial MBS deal, and a special servicer responsible for taking action if a loan becomes past due.

40. Commercial Mortgage-Backed Security CMBS Investors • Commercial MBS investors include institutional investors. • These investors, in turn, evaluate a commercial MBS issue not only in terms of issue’s general sensitivity to economic conditions and interest rates, but also assess each income-producing property on an ongoing basis.

41. Asset-Backed Securities

42. Asset-Backed Securities • Asset-Backed Securities (ABSs) are securities created from securitizing pools of loans other than residential prime mortgage loans and commercial loans; as noted, residential subprime MBS are included in the ABS category.

43. Asset-Backed Securities • Loans used to create ABSs include • Home Equity Loans • Credit Card Receivables • Home Improvement Loans • Trade Receivables • Franchise Loans • Small Business Loans • Equipment Leases • Operating Assets • Subprime Mortgages

44. Asset-Backed Securities • Like most securitized assets, ABS can be structured with different prepayment and credit tranches and can include different credit enhancements. • The three most common types of ABSs are those backed by: • Automobile Loans • Credit Card Receivables • Home Equity Loans

45. Automobile Loan-Backed Securities • Automobile loan-backed securities are often referred to as CARS (certificates for automobile receivables). • They are issued by the financial subsidiaries of auto manufacturing companies, commercial banks, and finance companies specializing in auto loans.

46. Automobile Loan-Backed Securities • The automobile loans underlying these securities are similar to mortgages in that borrowers make regular monthly payments that include interest and a scheduled principal. • Also like mortgages, automobile loans are characterized by prepayment. For such loans, prepayment can occur as a result of • Car sales • Trade-ins • Repossessions • Wrecks • Refinancing when rates are low

47. Automobile Loan-Backed Securities • CARS differ from MBSs in that they have • Shorter maturities • Their prepayment rates are less influenced by interest rates than mortgage prepayment rates • They are subject to greater default risk

48. Prepayment • The prepayment for auto loans is typically measured in terms of the absolute prepayment speed (APS). • APS measures prepayment as a percentage of the original collateral amount, instead of the prior period’s balance. • The relation between APS and the monthly prepayment rate (single monthly mortality rate maturity, SMM) is where M = month.

49. Prepayment • If the absolute prepayment speed is 2%, then the monthly prepayment rate in month 25 is 3.8462%:

50. Installment Sales Contracts • A large part of auto manufacturers’ sales are sold from installment sales contracts, with the company’s credit department (often a financial subsidiary) making: • Administrative decisions on extending credit • Setting underwriting standards • Originating loans • Later servicing the loans