Structuring Cash Flows for Default Risk

1. Structuring Cash Flows for Default Risk CMBS Private Label (e.g. Subprime) RMBS John P. Harding University of Connecticut

3. The CMBS Marketplace • CMBS was a core fixed-income product. • The market for commercial real estate debt products is greater than $3 trillion. • Less than 33% of U.S. commercial real estate debt has been securitized to date. • significant growth potential relative to residential mortgage market • There is an estimated $.75 Trillion in outstanding CMBS.

8. Evolution of the CMBS Market • The CMBS market emerged post a significant downturn in commercial real estate in the late-1980s/early 1990s, • Downturn instigated by excess supply and a sharp reduction in demand caused by U.S. recession • 1980s tax incentives drove supply higher creating a glut of commercial properties • The Tax Reform Act of 1986 removed tax advantages of owning real estate, rendering many projects insolvent, but authorized new mortgage security vehicle, the REMIC • REMICs (Real Estate Mortgage Investment Conduits) are a tax vehicle designed to facilitate the tax issues associated with mortgage securitizations. REMICs prevent an entity-level tax from being imposed, and all securities issued by the REMIC will not be treated as debt for Federal income tax purposes. • Recession reduced property income, further exacerbating the problem

10. Evolution of the CMBS Market • Early CMBS supply was driven by Resolution Trust Corporation (RTC) liquidations of savings and loans commercial mortgage loans. • The RTC monetized these real estate loans through securitization, issuing nearly $15 b of multifamily and commercial securities between 1991 and 1993. • With the success of the RTC’s efforts, insurance companies, pension funds, and commercial banks began to use CMBS to restructure their balance sheets.

11. Credit Performance of Commercial Mortgages John P. Harding University of Connecticut

12. Attracting More Investors by Creating a Series of Bonds with Different Credit Exposures • While it would be possible to pool commercial mortgages into a single class pass-through, with pro rata pass through, all investors would have a BB security • Below what is generally viewed as “investment Grade” • Many Investors are restricted to investment grade and others want the comfort of highly rated AAA securities • By creating different classes of securities, we can create a series of bonds with different credit ratings • Attract investors with different tastes for credit risk • Maximize the market value obtained by the securities • Thus instead of selling a single class of securities we create senior and junior claimants on the pool John P. Harding University of Connecticut

13. CMBS Structure: Sequential-Pay; Senior Subordinated CMBS • CMBS are generally collateralized by non-investment-grade commercial mortgage loans, but offer securities rated AAA to B. How is it done? • Sequential-Pay Senior/subordinate structure most common form of credit enhancement • Subordinate classes provide credit support to senior classes • Principal allocated top-down (Sequential-Pay) • Each class has specified priority to receive cash flows • Senior securities receive scheduled principal and interest first • Remaining classes are paid in stated order of priority • Loss allocated bottom-up • Senior-most outstanding securities protected from losses by principal balance of all junior securities • The junior bondholder can act as the Special Servicer for “troubled” loans John P. Harding University of Connecticut

14. 70% Debt 70% Debt 75% Debt 70% Debt 75% Debt 65% Debt 75% Debt 75% Debt 80% Debt 75% Debt 50% Debt 70% Debt 80% Debt 75% Debt 65% Debt 75% Debt 60% Debt 65% Debt 70% Debt 60% Debt 70% Debt 75% Debt 60% Debt 75% Debt 80% Debt 75% Debt 75% Debt 55% Debt 75% Debt 70% Debt Property 1 Property 2 Property 3 Property 4 Property 5 Property 6 Property 7 Property 8 Property 9 Property 10 Property 11 Property 12 Property … Property … Property 150 30$Equity 25$Equity 30$Equity 25$Equity 20$Equity 25$Equity 25$Equity 25$Equity 40$Equity 40$Equity 30$Equity 45$Equity 25$Equity 35$Equity 40$Equity 25$Equity 30$Equity 25$Equity 50$Equity 35$Equity 25$Equity 30$Equity 35$Equity 20$Equity 25$Equity 20$Equity 25$Equity 30$Equity 30$Equity 25$Equity CMBS Structure Individual Mortgages Hypothetical Trust AAA to BBB- Rated Investment Grade Bonds (90% of par) = BB (5.25% of par) B (2.50% of par) UR (0% of par) John P. Harding University of Connecticut

15. CMBS “Waterfall” Structure CMBS Cash Flow / Loss Priority • Senior bonds receive P&I payments first. • Losses are applied in reverse order • Senior classes protected from losses by junior classes Losses Cash Flow

16. TYPICAL CMBS STRUCTURE

17. B-Piece Buyers B-Piece Buyers • The B-Piece buyer in a CMBS transaction will normally buy all bonds from unrated up through to BB+ • B-Piece deal negotiated right at the start of the transaction – the B-Piece buyer will take up to 7-8 weeks to complete due diligence • All other bonds normally sold in a 1-2 week time-frame after the B-Piece buyer has agreed the pool and the agencies have finalized rating levels • The “universe” of potential B-Piece buyers is normally 5 to 7 institutions, of which perhaps only 2 or 3 may bid on any given deal • Most B-Piece bidders are specialist investors/funds that look solely at CMBS B-Pieces, some are public companies • B-Piece buyers often also act as special servicer on deals so that they can control the liquidation of non-performing assets. Even if they are not the special servicer they always exercise control rights in terms of who is special servicer • B-Piece bids will contain bids as to yields on bonds, and will usually also contain “stips” as to minimum levels of subordination for certain classes, irrespective of the subordination levels the rating agencies provide • The B-Piece buyer underwrites all loans (this can be in excess of 130/140 loans in a standard CMBS conduit deal), and will exercise their right at the end of their underwriting to “kick out” loans that they do not like

18. CMBS Yield Curve

20. A Historical Look at CMBS Credit Enhancement

23. CMBS Delinquencies by Vintage

24. Residential Mortgage-Backed Securities (RMBS) Using Excess Spread for Credit Enhancement

25. Non-Agency Residential Mortgage-Backed Securities (RMBS) • As with CMBS, the primary focus in designing RMBS was credit risk • Unlike commercial mortgages, residential loans typically provide the borrower the right to prepay • Some subprime loans did include prepayment penalties • Two Alternative Structures Were Commonly Used: • The “Six-Pac” structure • similar to the CMBS structures discussed above with senior/junior tranches • Used when “spreads” on mortgages were smaller and risk deemed to be relatively less than high risk subprime • The Excess Spread/Overcollaterization Structure • Sort of like “self-insurance” by the pool itself • Excess spread over what was paid to investors is held in reserve for possible future losses • Used for pools with larger spreads and greater risk John P. Harding University of Connecticut

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27. John P. Harding University of Connecticut

28. OMS Multiple can be thought of as a present value factor for the Indicated spread. It takes into account both prepayments and defaults Which reduce the number of loans paying the spread over time. The fourth Column is the multiple of the spread and the pv factor. The main point is that the accumulated value of the spread was projected to exceed the losses. However note also that 10% cumulative losses was roughly equal to 20% default and 50% losses. John P. Harding University of Connecticut

29. John P. Harding University of Connecticut

30. Observations • On average, the extra interest charged on subprime loans was supposed to be sufficient to cover cumulative losses • It was based on historical experience with rising house prices and limited unemployment • However, there is a timing issue because the extra interest is highest early while costs of foreclosures comes later • Requires “storing” of the extra interest to be able to pay subsequent losses • While it is important to set some aside, if the design is too conservative you wont raise enough cash from the security sales • There is no way to “borrow” from future extra interest payments from non-defaulting borrowers to pay current losses • If losses occur earlier than expected before reserve has been built up, there is no other source to cover losses. • Further, if default rates exceed expectations, they act like prepayments in that there are fewer mortgages paying the extra interest and there is no “Plan B” John P. Harding University of Connecticut

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32. John P. Harding University of Connecticut

33. Overcollateralization • In the preceding discussion, the excess interest was collected in a special “reserve” account • Payout to a claimant after the step-down trigger date was possible (and expected) • Another variation for the use of excess spread was to apply (i.e. pay) it to the senior security holders as a principal reduction • Similar in concept to the Z-bond in a CMO • Over time, the outstanding “bonds” would pay down more quickly than the collateral and the “protection” provided by the subordinated bonds grows. • The result is growing overcollaterization that provides more protection against future losses. • This approach generally produced better economics for the issuer and was used extensively. John P. Harding University of Connecticut