Saturday, April 14, 2007 MBS for UberNerds I: GSE Pass-Throughs We’ve had some fascinating and fun conversations lately about bonds and bondholders and stuff, and I first want to thank everyone who has contributed so much. I also observe that we do occasionally seem to be talking over or under or around each other, at times, about what mortgage-backed bonds are and how they work. There are places on the net you can get lots of technical information on this subject, but I’m not sure they are all pitched high enough to satisfy UberNerds or low enough to work for beginners, and in any case they lack periodic outbursts of editorializing, which is just boring. Here, then, is installment one on the subject of mortgage-backed securities. I think the ones most people are interested in these days are the complex structured ones, but you really can’t understand what those are until you understand how the simple single-class ones work. Also, there’s a huge difference between a GSE-issued security and a private-issue one. Again, I think you need to understand the GSEs before you can really wrap your mind around the private-label stuff. So that’s where we start. As usual, if you’d rather eat toenail clippings than read something this long, by all means jump down to the next post. There are also lots of places on the web you can get the bullet-point version of this, and become appropriately dangerous; just Google it. The oldest and simplest mortgage-backed security is the single-class “pass-through.” These are the specialty of Ginnie Mae and the GSEs. (The GSEs can and do issue structured securities, but their bread and butter is the pass-through. Private issuers can offer pass-throughs, although they’re much more attracted to the fancy ones.) To create one, the issuer acquires a pool of mortgage loans that meet all of its requirements. The underlying mortgages are serviced by someone other than Ginnie Mae or the GSEs—either the originating lender or a servicer to whom the originator sold the servicing rights, with the consent of the issuer. The pool of loans becomes a security by a kind of “swap” transaction: the ownership interest in the pool of loans is converted into a security—a bond—which can be sold on the secondary market. The security has a “coupon,” which is the interest rate that the investor in the security receives. The “pass-through” concept is just that simple. Interest received on the underlying loans is passed through, on a pro-rata basis, to the investor, net of two or three things: 1. The servicing fee is retained by the servicer 2. The guarantee fee is retained by the issuer 3. Any lender-paid mortgage insurance or pool insurance is remitted to the insurer The net result is the “coupon” of the security. For instance, one might have a pool of mortgages that back a security with a coupon of 5.50%. The underlying loans must, in aggregate, yield more than 5.50%. For example, assume a pool that has all low-LTV or primary MI policy loans, so we don’t have to mess with mortgage insurance at the pool level. They’re fixed rate loans, so the servicing fee is .25%. We’ll assume that they are of such high quality that the guarantee fee is 0.125% (it can be much higher than that). Therefore, the weighted average gross coupon of the underlying loans would have to be at least 5.875%, to make the bond coupon of 5.50%. This doesn’t mean that every loan in the pool has a note rate of 5.875%, although it’s likely that 5.875% is the statistical “mode.” The underlying loans will have note rates in a “band” around 5.875%, so that the weighted average works out. (The average is weighted by loan amount.) Most simple pass-throughs aim for a fairly narrow band, because of the prepayment problem. High-rate loans pay off (refinance) very quickly when prevailing mortgage rates decline, and low-rate loans just sit there looking unprofitable when market rates rise. Because residential home mortgages always give the borrower the right to prepay, and because the GSEs don’t allow prepayment penalties in most cases (and if they do, it is only when the borrower is offered a lower note rate than market), the coupon of the security could fall pretty quickly if the underlying WA was based on half a pool of very high-yield loans and the other half of very low-yield loans. Achieving a band around the gross WAC of, say, no more than 1.00% plus or minus (200 bps total) keeps the prepayment characteristics of the underlying loans more uniform. You can see, I hope, that there is already an “anti-predation” control here on a GSE pass-through (in terms of note rate, at least, if not fees and points). The GSE “bids” for loans to fill its desired current (par) coupon, the originator has to allocate loans to the pools within the required note-rate band, and there is thus a natural limitation on the originator’s incentive to produce loans that yield a great deal more than the market rate. (There can be excess yield here—it’s called “excess servicing” on the assumption that it is retained by the seller/servicer of the loans—but it does have those prepayment issues.) Of course, the GSEs can and do enforce other mechanisms for keeping predatory loans out of their pools, like refusing to allow prepayment penalties unless the borrower gets a rate cut in return. I’m simply making the point that certain forms of predation were less attractive to originators back in the day when they were selling all their loans to the GSEs in pass-throughs, long before the enactment of “high cost loan” laws. This in turn is one reason why the anti-predation laws are only really “catching up.” So what does the guarantee on a pass-through mean? First, it means something different for Ginnie Maes than it does for GSEs. Ginnie Mae is an actual agency of the government, and its guarantee is therefore backed by the full faith and credit of the United States of America. That means that if a Ginnie Mae security suffered net losses (after FHA insurance or VA guaranty on the underlying loans) in excess of its guarantee fee collected, the payment of principal (and accrued but unpaid interest) would have to be covered by the taxpayer. Fannie Mae and Freddie Mac are government-sponsored enterprises, meaning that they are private corporations (owned by shareholders) with a special government charter that gives them some advantages (tax relief, an emergency line of credit with the government in the event of disaster) in exchange for a government mandate and oversight. Their securities are not, therefore, backed by the full faith and credit: they are the sole obligation of the issuer. The bond market has always considered GSE securities to be “implicitly” government-backed, so GSE MBS trade a lot like Ginnie Maes, although there is some actual discount for the lack of the explicit full faith and credit backing. There is also a difference in what, actually, is guaranteed here. First of all, Ginnie Mae does not actually buy the pool of underlying loans backing its securities. It “wraps” them with its guarantee, but does not invest equity in them; the loans are still owned by the originator/issuer. The GSEs can, although they do not have to, actually purchase loans outright for their pools. In any case, all Ginnies and Fannies, and all new Freddies, guarantee timely payment of principal and interest to the investor, even if it has not been collected from the borrower. (There are some old Freddies that guarantee timely payment of interest and eventual payment of principal.) So what does that mean? “Timely” means as scheduled. If the underlying loans are, say, amortizing fixed-rate loans, then each is scheduled to pay interest and principal each month. Therefore, the guarantor makes sure that the investor receives its pass-through payments each month, even if the borrower did not make the payment. Partial or total prepayments of principal are “unscheduled,” and are passed through to the investor if and as they are made. As a general rule, the GSEs require the mortgage servicer to advance payments on delinquent loans, so that the timely remittance to the investor can happen, and then to collect on those loans to pay itself off. Only when the loan gets to 90 days delinquent, usually, does the loan become “non-accrual” and the servicer’s obligation to advance end. The borrower still owes interest each month, but at this point the GSE (or the servicer, if such option is in the servicing contract) buys the loan out of the pool. This “prepays” the principal to the investor, which is now made whole, although it is no longer earning interest on that principal. If the GSE is now the owner of a delinquent whole loan, it directs the servicer to foreclose in the usual fashion, and is made whole out of the proceeds in the usual fashion, as is the servicer who advanced those delinquent payments. If mortgage insurance is involved, the MI pays its claim here, too. So you can see that the GSEs are not, actually, guaranteeing that any investor is going to end up making any actual real money off the deal. The guarantee is that you will get interest payments as long as there is still principal invested to earn interest (that is, while there is still an underlying balance of mortgage loans), you will get it on time, and you will not lose your principal. If most of the pool prepays on you very quickly, via refinances or home sales or foreclosure (which, remember, is a prepayment to the investor), then you’ll need to reinvest that money elsewhere. If you paid a premium (a price above par) to buy the MBS in the first place, your actual yield could be zero or even less, but the GSEs do not guarantee that the MBS will be priced properly by you or anyone else. What the guarantee protects the investor from is credit risk, not prepayment risk, price risk, market risk, duration risk, etc. It is important to understand that the GSEs do not hedge their credit risk—the credit risk they take off the investor—solely with a guarantee fee. In fact, the g-fee, as it is called, is for practical purposes the GSE’s “add on” hedge against its counterparty risk as much as the credit risk it thinks the underlying loans might have. A GSE seller/servicer with excellent performance and high net worth gets a better (lower) g-fee than its lesser-performing competitors. The g-fee is also driven heavily by the extent to which the loans underlying the pool are originated under standard GSE guidelines or any contract variances (typically referred to as “waivers,” more formally as “limited waivers of representations and warranties”) an individual seller/servicer might have negotiated with the GSE. For example, the standard rule for a given loan type and borrower might be that the CLTV cannot exceed 90%. A seller/servicer might get a waiver to originate some total dollar amount of loans with a CLTV of 95% with some other conditions (such as, for instance, a higher FICO than the required minimum in the standard program). This still requires the seller/servicer to rep and warrant that the waiver terms were not exceeded. In any case, the g-fee “prices in” such things. But nobody, least of all the GSEs, pretends or claims that the g-fee is the total price of the credit risk or the timely payment guarantee cost. This is a very important and incredibly widely-misunderstood part of the whole thing, and it gets to the very heart of the issue with “nontraditional mortgages.” As I have indicated before, the GSEs control credit risk by making the pools diversified (in terms of geography, borrower type, etc.) and homogeneous in terms of the product type, the credit quality, the underwriting rules, the loan documentation, the legal documentation (the wording in the notes and mortgages), and a host of other factors including servicing rules. The combined “Selling” and “Servicing” guides published by Fannie and Freddie run to hundreds and hundreds of pages. There are rules for every damned little thing, as well as all the usual big things. The idea is that what you end up with is a big honkin’ pool of loans with some variation in credit quality, but which results in acceptable average credit quality. After all, the whole point of owning an interest in a pool of loans, rather than owning a bunch of whole loans, is that they are “granular” rather than “lumpy,” and the investor is buying a pro-rata share of a lot of loans, not the total share of a few loans, which is what whole-loan investing is. I have used the old mortgage-bond-market metaphor of “sausage-making” before; this is what I’m talking about. The credit quality of a pool of loans is not equivalent to the weakest loan in the pool. It is a matter of the average of the loans in the pool, as long as the distribution or variation in credit quality is under control. We talk a lot about representations and warranties, so let’s be clear on this. GSE MBS deals do not work by having originators of loans make up their own rules. What you represent and warrant is that you followed all the GSE rules on the loans (or any waivers you might have gotten). The GSE rules rule. Therefore, if subsequent to purchase, the GSE finds out you didn’t follow the rules—you made an untrue representation—you can be forced to buy the loan back (that is the warranty). The reason the whole thing works on a rep and warrant basis is just because it’s too big, there are too many loans, and it’s too expensive for the GSE to do several hours worth of due diligence review on each and every individual loan before securitizing it. It’s a kind of “trust, but verify” with some practical limitations. That doesn’t mean the GSEs don’t do due diligence. They audit their seller/servicers, they sample loans for Quality Control review post-purchase, and they have a lot of up-front filters in place (largely in the loan underwriting and delivery software) to catch “out-of-scope” stuff. Again, a portion of the g-fee is based on the results of the GSE’s audit of the seller/servicer. Audit acceptability is a question not just of whether you tend to make true representations, but also how good you are for those warranties, should you have to cough up the cash. Propaganda from certain other market participants aside, you cannot just put any old loan in a GSE MBS. You can’t do that even if you correctly represent up front that you just put any old loan in the pool: you must represent that any loan in the pool meets the GSE’s guidelines, and there is a very, very long list of loans they won’t allow. Some people seem to think the GSEs are the “buyer of last resort” for mortgage loans. That’s simple propaganda, folks. We can and ought to have a good conversation about the credit quality of what they do buy, but if you think they’re feeding at the bottom of the pond, you are mistaken. They take some risk—significantly on their “affordable housing” products, which risks they are mandated by the government to take. But there is no mortgage lender who does not take risk. There are just degrees of risk, and degrees of risk management. This gets us to two related issues: “transparency” and “perfection” of the market price for credit risk. First of all, if the GSEs don’t have the time and energy to wade through every loan in the pool, you the investor certainly don’t have it, and you also lack the expertise. You can, if you want, go read 500 pages of GSE seller/servicer guidelines if you want to be all serious UberNerdy about it, but that isn’t how the bond market works last I checked. Most investors just accept the guarantee. Those investors who have a concern about whether the guarantee is reasonable, or who are concerned about their prepayment risk (that being an issue of the underlying loan quality and servicer competence as much as a question of market rates, as not all loans have the same opportunity to refinance or likelihood of prepaying via default), might put some effort into understanding what the underlying loans are all about. But what is “transparent” to the investor are the GSE guidelines, and the reputation of the seller/servicer. Sophisticated institutional investors can do their own due diligence on that, as well. But bear in mind that the whole point of securitization is to “de-link” the originator of the loans from the issuer of the security. From the investor’s perspective, the net worth or vigiliance or competence of the seller/servicer is the GSE/issuer’s problem, since the GSE makes the guarantee. Can the GSEs make some bad bets there? Did we just read in the paper that Fannie Mae had to cancel a servicing contract with New Century? Why yes, we did just read that. From a public-policy or taxpayer-interest point of view, there may be plenty of reasons for you and me to get concerned about the counterparty or servicer risks the GSEs take, but from the simple perspective of our famous bondholders, it’s the GSE’s problem. That’s what the guarantee means. The other issue is that, in short and simple terms, the investor in a pass-through MBS gets paid less interest than another privately-issued security might pay, because the MBS is credit-risk free. The price of the credit risk, you need to remember, is not equal to the g-fee; it is also a matter of the type of loans in the pool. In a sense, you can think of the price of credit risk as an issue of opportunity cost or resource allocation. By investing in a GSE MBS, you bought the kind of loans that the GSE can reasonably guarantee. That means you didn’t buy the kind of loans that the GSEs do not think they can cost-effectively guarantee. Back when the GSEs and Ginne Mae were the only games in town, that meant certain loans just didn't get made very often. I have heard a lot of people calling lately for the re-imposition of the old requirement that every mortgage loan be a 30-year fixed with a 20% down payment. At some level, this is an “old requirement” in the sense that walking to school barefoot in the snow—uphill both ways—was an old requirement for educational transportation: less a fact about the old days than an artifact of a certain nostalgia for them. Were this to happen, in any case, investors in bonds would be buying MBS backed only by such loans, since those would be the only loans out there. There would be little issue with average credit quality if the weakest loan had to be better than average (the “Lake Wobegon” MBS). It would certainly be cost-effective for the guarantor, which could improve yields to investors somewhat, if you assume that increased demand for fewer bonds doesn’t drive the yields back down to where they were or lower, and the increased hedge costs to the investor—who is no longer asking the borrower to pay it via an ARM—won’t end up in the (fixed) rate to the borrower somewhere. It would limit the returns available to bond buyers who might want to take a little more risk in return for a little more reward, since there wouldn’t be another other (mortgage) risk to invest in. Insofar as people who would be required to cough up 20% down payments were trying to save those up in bond funds, it could produce a certain conundrum. The other side of the problem, as far as I’m concerned, are these voices demanding increased “flexibility” and “market share” and “modernization” of FHA, in particular. Remember that the issue isn’t just the reasonableness of the guidelines, it’s the homogeneity of the loans in the pool. “Flexible” is so often code for allowing a lot of variation on the bottom end that it’s impossible, for me at least, to imagine these proposals making any sense without significant increases in the insurance premiums paid by the borrowers to FHA and the g-fee paid by the lenders to Ginnie Mae. Unless we want to see the taxpayers actually buying out Ginnie Mae MBS holders for the first time in history. I notice no one cheering on these “modernization” proposals talking about the lunch tab, but perhaps I am simply inattentive. Until such a day arrives that all loans must be more or less conservative than average, then, there will be opportunities for riskier mortgage investments. That gets us to the whole question of private-label and structured, as opposed to simple pass-through, securities, which will be the next installment. Posted by Tanta http://calculatedrisk.blogspot.com/2007/04/mbs-for-ubernerds-i-gse-pass-throughs.html ============================================================= MBS For UberNerds II: REMICs, Dogs, Tails, and Class Warfare Our last installment went into some fair detail on the old-fashioned single-class pass-through MBS as practiced by Ginnie Mae and the GSEs. These securities always had a huge advantage: they’re cheap to produce and easy to understand. Back in the days when there wasn’t much about the underlying loans that was hard to understand—you had your basic fixed rate, your basic amortizing one-year ARM—you could master the cash-flow issues over lunch. The big drawback of the pass-through was always its prepayment and duration problems. The actual dollar yield on a bond—or a mortgage—is a matter of how long you earn interest at a given rate. If the loan prepays much earlier than you expect, you get your principal back, but you must now reinvest it somewhere else, and loans generally prepay fast when prevailing market rates are lower, putting the refinance “in the money” for the borrower and forcing the prepaid investor to buy a new lower yield. When market rates rise, prepayments slow considerably, but this extension means an investor has funds sunk in a low-yielding bond when new ones yield much more. Some investors, of course, would want to be prepaid more quickly or more slowly than average, if they were using MBS to hedge some other investment risk or just needed very high liquidity. The trouble with the single-class pass-through is that it’s just too unpredictable. The big innovation in the MBS world was the CMO (Collateralized Mortgage Obligation, not to be confused with the CDO, or Collateralized Debt Obligation, which we’ll get to later). A CMO is also often called a REMIC (Real Estate Mortgage Investment Conduit) since that is the legal structure on which most of them are built. REMICs were developed in the 1980s, and the advantage (or disadvantage) to an issuer or investor of owning part of a REMIC has a lot to do with tax treatment of certain kinds of investment income. That is a level of detail into which I will not get. Suffice it to say that most CMOs work like REMICs even if they aren't true REMICs, and that I prefer to use the term REMIC here to keep from getting lost in the CMO-CDO confusion weeds. REMICs are very complex, and so we’re just going to skim here. The basic idea is that the cash-flow from an underlying pool of whole loans—even one or more underlying pass-through MBS—can be sliced up or “tranched” into separate securities with differing cash-flow characteristics and time-to-maturity horizons. The simplest approach is “sequential pay”: a structure of classes is set up, with each tier getting its scheduled pro-rata share of the pool interest, but the top tier getting all the scheduled (and all or most of the unscheduled) payments of principal, until that tranche or class is paid off. Then the next tier gets principal payments, and so on. This lets you take an underlying pass-through with an expected maturity of 25 years and turn it into one 2-5 year bond, one 5-7 year bond, one 7-10 year bond, and so on. It also creates a “yield curve” within the REMIC, as the shorter-maturity classes earn a lower rate of interest than the longer ones. This is true even if the underlying loans are all 30-year fixed rates. Remember that individual loans are not assigned to tranches or classes; what is being “allocated” in a REMIC is the total cash flow of principal and interest from the aggregated underlying loans. The underlying loans can be “grouped” in certain ways—they can be already securitized into pass-throughs, and you can have a group of loans or MBS assigned to a set of classes or tranches, but legally the REMIC trust owns all the underlying loans, and all underlying loans are available to pay whatever any given tranche-holder is owed. But even a sequential-pay structure allows some unpredictability in the repayment characteristics of each tier. So most REMICs improve on the simple sequence by further refining the cash flow characteristics of each tranche. There is the “stripped” tranche: an IO strip pays interest only (on a nominal balance) while the PO strip pays principal only (the investor buys that bond at a deep discount). There are PACs and TACs (Planned or Targeted Amortization Classes) which pay principal according to a schedule that may have nothing to do with the actual amortization of the underlying loans. There are floaters and inverse floaters—tranches that pay interest that increases with a rise in an underlying index or the inverse (the yield decreases when the index rises, making these hedge vehicles). There are “accrual bonds,” which pay no cash flow for the initial years of the REMIC (the “lockout period”), although they accrue interest during that period. There are also several kinds of “support bonds,” which is a generic term for a tranche needed to do or get the opposite of what one of the above tranches does or gets. An amortization class, for instance, generally needs a corresponding support bond that will get excess or shortfall prepayments of principal “left over” from the principal allocation to the PAC or TAC. There is always, finally, a “residual” bond, at the bottom of the whole elaborate structure, that gets whatever is left. Residuals are nearly impossible to accurately value. With a true REMIC, the residual is generally held by the security trust. (Other kinds of structured MBS can generate a residual that can trade in the junk bond market.) The expected yield on any given class or tranche can vary widely, based on how close to expectations the actual payment and prepayment characteristics of the underlying loans end up being. Having fun yet? For our purposes, here’s the point of caring about this: first, the original idea of the REMIC is to make mortgages a more attractive investment by controlling their repayment characteristics (just as single-class pass-through MBS made mortgages more attractive by controlling their credit risk). Over time, however, tails can start wagging dogs, and some of us are firmly convinced that mortgages started to become originated in products that would make a great REMIC. Imagine trying to do a simple pass-through MBS with interest-only hybrid ARMs combined with amortizing true ARMs. Or a pass-through with Option ARMs. Or HELOCs with an initial interest-only draw period followed by an amortizing repayment period. You need, basically, an exotic security in order to successfully originate exotic loans. Or, perhaps, you need increasingly exotic loans in order to feed the increasingly exotic securitization machine. Second, the notion of a multi-class security is generally premised on the happy assumption of a bunch of different investors with different investment needs—fixed income, hedges, what have you—all of whom can come together, take the piece they want, and play “support bond” for each other, while the REMIC issuing trust happily takes the leftovers in the residual out of the kindness and generosity of its heart. What lurks beneath this premise—and will get crucial when we start talking about credit risk again—is that multi-class can introduce “class warfare.” One thing you can say about the various part-owners of a big single-class pass-through is that they’re all in the same boat, since they’re all getting a pro-rata share of whatever is going on—fast prepayments, slow prepayments, high-coupon, low-coupon—in the underlying pool. In a multi-class REMIC, fast prepayments could be great for me and tough luck for you. Changes in the underlying interest rates on the loans could be tough for me and great for you. Theory says this is fine, because you are a rational informed agent, as am I, and we are buying whatever tranche we picked in order to hedge some risk we perceive, accurately, that we have. Besides the obvious retort to that—rational? bond investors?—there is the question of further, possibly quite unpleasant, effects on what the underlying mortgages have to look like to support all these harmoniously opposing classes. In the big picture, we have a security structure that biases the mortgage market to refinances rather than modifications, and to loans that really have to refinance in practical terms (ARMs, IOs, balloons) over those that don’t (fixed rates). The structure readily accommodates exotic underlying mortgage loan structures, and hence removes “complexity risk” from the investor side (if not the mortgagor side). Very importantly, it removes investor aversion to early payoff risk—there’s always a “support bond” to profit from prepayments—eliminating a great deal of a mortgage originator’s disincentive to keep refinancing the same loan. Prepayment penalties get put on loans that are destined to prepay, given their toxic adjustments, which appears to be the only way the servicing for these securities can stay profitable. Some people like to focus obsessively on mortgage broker and mortgage originator culpability for the mess we’re in, and certainly it never pays to underestimate that. But no broker or correspondent lender can originate an Option ARM with a shockingly high margin (the rate that kicks in when the “teaser” is gone) with no points unless some aggregator or REMIC conduit or other investor is paying 105 cents on the dollar for it. You can ask why anyone would pay so much premium for such a loan, especially given the likelihood that it will, you know, refi and pay off early. The claim that premium pricing prevents rate predation—that the investor doesn’t “gain” by having a borrower pay an above-market rate because it pays too much premium for the loan—is a mite disingenuous in the context of structured securities. If you are buying whole loans for an investment portfolio, or for inclusion in a simple pass-through, that might make some sense. But if you are buying loans for a security in which someone will benefit from the fast prepayment of that loan—and someone else will benefit if it stays on the books—you may well be paying up for that loan precisely because it has the payment and prepayment characteristics you want, not in spite of them. There is always someone on the other side of a hedge trade. If there were no incentive for conduits to pay 105 for a loan, I can assure you that they wouldn’t pay it, or not for long. (Note to self: why did Grant Thornton just walk out on a couple of its auditees when the subject of secondary market pricing strategies came up? Are all these Wall Street-inspired conduits really paying a perfect price for this stuff? Hmmm.) Remember the average 200 bps note rate spread in an old-fashioned GSE MBS? I just looked at a Fannie Mae 2007 issue REMIC, backed by Fannie Mae pass-throughs, with a note spread of 275 bps. A private-issue REMIC backed by non-GSE loans can easily have a total spread on the underlying loans of ten points or more, with an age-adjusted spread of 500 bps. (Remember that you must look at the age of the loans in a REMIC pool. The pass-through MBS loans are originated into a current (par) coupon, but a REMIC with flow or seasoned loans will have loans that were originated into different current coupons. A mortgage note rate is “above” or “below” market only in reference to what the par coupon was that day.) How much of the note spread in a private-issue REMIC is a question of credit quality we will deal with in the next installment. For now, just note that a GSE REMIC will have those famous fairly uniform and geographically diverse loans in its pools, so that duration—sensitivity to market rate changes—is affected by loan quality, not just note rate. By and large, GSE loans are refinanceable, whether or not they’re in the money for a refi. A private-issue REMIC backed by jumbos, Alt-A, subprime, reperforming, scratch & dent, or a mixture thereof can require exceptionally complex prepayment calculations, as these loans may be less sensitive to market rate changes alone. In the “old days,” the cruddier the credit, the longer the loan stayed on the books, since there were fewer refi options. Then we went through this period where there was a REMIC for every loan, cruddy or not, and so sensitivity calculations all of a sudden got “counter-intuitive.” One definition of a “credit crunch” is a giant blow-up in durations. When the music stops, everybody has to take a chair and then sit there. If you didn’t get a chair, you default, the lender forecloses, and losses are dealt with somewhere. But if you did get a chair—and I continue to think that most prime borrowers will get one—you will, if it makes you feel any better, possibly be sticking it to some bondholders just by paying your loan back as agreed. Whether all of these REMICs were structured carefully enough that they can fully survive a “crunch” is a good question. But it also depends on how REMICs deal with credit risk once we get away from the GSE ones and into the private-issues, where there is no GSE to guarantee the investor against principal loss. That part of the “musical chairs” game awaits the next installment. Tanta http://www.haloscan.com/tb/calculatedrisk/505536853949582786/ ============================================================= Last episode, we looked at the classic multi-class mortgage-backed security, the REMIC, from the perspective of its distinctive cash-flow issues. REMICs can and do take an existing GSE-guaranteed single-class pass-through MBS, or several of them, and “tranche them up” into multiple classes with differing payment, prepayment, maturity, and yield to investor characteristics. That’s relatively easy to do, because the underlying collateral is guaranteed from the perspective of credit risk and timely payment of principal and interest. But REMICs (and REMIC-style CMOs) can most assuredly be backed by whole loans, or by single-class MBS that are not agency-guaranteed, such as Alt-A, subprime, HELOCs and HELs, scratch and dent, reperforming, seasoned (old loans), even nuclear waste (nonperforming). How do you deal with not just the cash flow but the credit risk of that? From a loan quality perspective, the pool backing a simple GSE MBS is a bag of Raisinettes—whatever serving size you take, you get the same candy in it, with the natural variation God gave a raisin. A REMIC pool, on the other hand, is more like a bag of Bridge Mix. There can be jellies in there. There can be a lot of them, and some of those “raisins” are possibly, um, insufficiently raisin-like. As a matter of fact, some of these private-issue pools can go out of their way to add a substantial chunk of poor-quality loans to a pool, because the pool “needs” the higher interest rate those loans pay in order for its cash-flow calculations to work out (we’ll get into that below). What is required is “credit enhancement” (CE): something that makes up for the greater likelihood of default in the underlying mortgages. No private-issue REMIC is guaranteed, the way GSE MBS are. They all have at least potential risk to the investor of loss of principal, as well as uncertain timing of payment of principal or interest. But because they are structured, they end up with tranches of varying degrees of credit risk. This allows each tranche to receive its own rating, and the rating of the tranche can be much higher than the rating of the underlying mortgages. As this fact has caused more confusion than nearly anything else I’ve seen lately, we will go into some detail. First, do remember that individual loans can be “credit enhanced”; that’s what mortgage insurance is. Some individual loans are credit enhanced by, basically, being tranched themselves: that’s what an 80/20 deal is. (Which is why CE on a HELOC pool is a whole different bowl of chocolates from a first-lien mortgage pool.) Whole pools can also be enhanced with MI: that’s a pool-level policy. There can also be other kinds of insurance on the security, such as a letter of credit or surety bond, although these forms of “external” CE are less and less common. Part of the reason for that is the rating issue: with an externally-enhanced security, the rating of the security can be no better than the rating of the guarantor. (Remember that GSE MBS get their AAA rating not because each individual loan is AAA—mortgages to just plain folks like us don’t get better than “A” ratings—but because the guarantor, the GSE, has an implicit AAA rating.) You don’t find enough AAA-rated banks writing letters of credit against subprime pools for that kind of credit enhancement to work out. And the best of the MIs are AA or A; that’s not enough, by itself, to get you an AAA rating on any part of your security. What you get, then, is generally “internal” credit enhancement. Remember the “sequential pay” idea? We went through that from a perspective of cash-flow and time-to-maturity, but it has, actually, an imbedded or implicit credit enhancement function. Think of a sequential-pay security as a line at the teller window: the top tranche is first in line for payments, then the second, and so on. All tranches might get scheduled payments of principal and interest, but prepayments (voluntary ones, like refis and property sales, as well as involuntary ones like recoveries from foreclosure or even put-back of a loan to the originator) are directed first to the topmost tranche until it is retired. That means that, all other things being equal, the first-to-be-retired tranche is least likely to ever lose principal. Of course, it means that the last-paid tranche becomes the bag-holder: by the time it gets eligible for principal payments there may be none left. If you just left the credit risk issue as luck of the draw like that, you wouldn’t get far with the rating of the various tranches, nor would you get anybody sufficiently fired up about owning the bottom tranche. So this kind of CE is actually formalized in the security structure in a feature called “subordination,” or “senior/sub” structure. In essence, the tranches become liens on the underlying loans, and just like mortgages, each lien has a legal priority. Furthermore, the issue of loss timing cannot be just left to chance. Remember that, historically, most mortgage losses do not occur in the first two years of the loan. (Yeah, I know it’s different right now. That’s why what is happening right now is so scary.) Mortgages have a loss curve, and predicting that curve is hugely important and hugely difficult. Besides the loss curve, you also have a prepayment curve—or vector—or explosion—or collapse—take your pick. Prepayments are as difficult to model as losses. Prepayments return principal to investors, so in that sense they reduce credit risk, but they don’t necessarily randomly represent the underlying pool. It is possible, indeed, it is likely, that the fastest prepayments in a given pool are the best-quality loans (those with refi opportunities). Insofar as there is significant variation of credit quality in the underlying pool, once we’re out of the GSE cookie-cutter business, you can end up with a pool that is paid down, but the remaining loans are the dregs. If you relied simply on prepayments to control credit quality, you’d end up with constant downgrades of the remaining tranches over time. That would not make these tranches attractive to investors, particularly to institutional investors who have to have, by law or bylaw, high-rated securities in their portfolios. Therefore, what you generally get in a REMIC backed by first lien Alt-A or subprime is a combination of subordination, sequential pay, “overcollateralization” (OC), and excess interest. OC is simply a case of having an underlying pool that is larger than the face value of the security. If you issued a $100MM security backed by a $105MM pool of loans, you would have OC. The OC portion is sometimes called “equity,” and that’s what it is: just like in a mortgage loan, that’s the part that takes the first loss. Keep in mind that it’s not a separate pool. It’s not that there’s a special $5MM piece that does or does not experience loss. OC means that the issuer of the security did not get funded at “100% LTV,” as it were; it got funded (sold bonds to investors) for only 95% of the pool it created. And like homeowner’s equity, OC is not constant: there is an initial OC amount, and also a “target” OC amount on these pools. OC can grow (and shrink). With REMICs, it doesn’t grow by having more loans added after the cut-off date (that can happen with some ABS home equity deals). It grows because that OC portion earns interest, and if that excess interest is not needed to cover losses, it can be used to increase OC. Here’s a simple chart (I’m not an artist, you know) of an actual new Option ARM-backed REMIC issue I was looking at the other day. (I’m not here to encourage or discourage investing in anyone’s new issue, so whose issue this is isn’t the issue.) The credit enhancement percent on each tranche is the amount of lower-ranked principal that would have to be lost before the tranche in question took a loss; it’s the total of the lower-ranked tranches plus the OC divided by the pool balance. http://bp0.blogger.com/_kQmcDGJ6WuI/Rjya2wOjjnI/AAAAAAAAABs/hD1DXR2eihA/s1600-h/MBSIII+Chart+I.bmp The way this particular deal is set up, the monthly gross remittance (pool interest less servicing fee, master servicer fee, and lender-paid MI plus scheduled and unscheduled payments of principal) is applied first to the senior notes, on a pro-rata basis; then to the subordinate notes on a sequential basis (the highest-ranked subordinate note gets principal and interest payments until it is retired, then the next one down gets payments, and so on); and third to “excess cash.” Each month, the “excess cash” is applied first to the OC, as principal, if the OC amount is under target; then to any realized losses of the senior notes; then to any realized losses of the subordinate notes, in order; then to the holder of the residual interest (the unrated interest of the security issuer). If in any period realized losses on the pool exceed the excess cash, then they are applied as a principal write-down first to the OC, then to the lowest subordinate tranche, then to the next-highest tranche, and so on. In this deal, the “excess cash” is coming both from the interest on the OC portion and from excess spread on the collateralized portion—the rate paid on the underlying loans is greater than the coupon rate to the bondholders plus the fees. The actual payment structure on this deal is more complex than my summary would lead you to believe, and that is largely due to the fact that it’s backed by neg am loans. There are all kinds of “interest deferrals” and “carryovers” and a “final maturity reserve” and further weirdness that is necessary to deal with the underlying problem that the loans generate accrual but not cash-flow sometimes. I tend to wonder how many investors looking at this prospectus have any idea whatsoever about what it all means, but I have been called cynical. I do, however, have some experience with misunderstanding of the underlying loans, so there. This deal also has a “step-down date,” which they all do. That is a date on which, if certain “trigger events” have not happened, the “excess cash” stops being applied to OC and can be released as distributions to the bondholders. In this deal, the triggers are 1) a serious delinquency rate in the pool of 40% or more of the total balance of subordinate bonds plus OC, or 2) realized losses of a certain percent or more as of a set of future dates. The step-down date calculation on my example pool is really complicated—they’re neg am loans—but generally it will be when the senior notes are completely paid down to zero principal. Remember that the senior notes get principal prepayments first, before the subordinate notes do, so they will mature faster. How fast will that be? Good question. Anybody issuing a new Option ARM Alt-A pool (this one is more than 75% stated income and most loans have a balance cap of 115%) in 2007 had better have a “Plan B” for dealing with very slow prepays. Don’t ask me what Plan B is. So you can see how a tranche of this deal can get a credit rating that is much better or much worse than the rating of the underlying loans. You can also see how a downgrade of a tranche can happen. The credit rating of each tranche is not just a matter of the percent of credit enhancement under it, but it is strongly dependent on that, and if, say, sudden early losses on this pool wiped out the OC and ate into one or two of those subordinate tranches in a big way, you would see the senior notes and the top tier of subs downgraded, even though they may not have realized losses. They get the downgrade because they have less “support” than they were intended to have. This one being a neg-am-backed deal, it wouldn’t surprise me any to see some subsequent downgrade if the loans negatively amortized a lot faster than initially predicted. That could create some evil cash-flow problems at the same time that any thinking person would conclude that the underlying loans were at greater risk of default, even if they hadn’t managed to default in abnormal numbers yet. That’s important to keep in mind, because it implies that forcing a troubled loan to refinance (making it a prepayment, possibly with a prepayment penalty to goose the interest payment) will improve the cash-flow of this security (deferred interest will be replaced with cash interest), pay down the senior note balances (which will bring that step-down date, when the others finally get paid, closer), or supply some “excess cash” that can be used to cover current period losses. If you lowered the accrual rate on too many of these loans, you wouldn’t have that nice juicy “excess spread” to cover losses with. On the other hand, if too many performing or even just under-performing but not yet loss-generating loans pay off too soon, you’re more likely to hit that “trigger,” because the percentage of seriously delinquent loans you’re left with gets up there. And, of course, if you refuse to modify but the borrower can’t get a refi from some other lender, you’re going to realize some losses. “You” are probably not a senior note holder in that case, but you could see your nice AAA drop down to AA if your CE gets whittled away too far. At the same time all this is going on, you have a servicer whose monthly servicing fee goes away when loans prepay, but who also has to keep advancing interest on delinquent loans until they are declared “uncollectable.” Your security can get a rating downgrade because your servicer’s got a cash-flow or capitalization problem, too. The point here is that it is dangerous in the extreme to think that the interests involved here are either simple or uni-directional. We’ve seen Lewis Ranieri sounding the alarm over a security servicer’s inability to modify loans if it wanted to. It is not at all clear to me that all bondholders would want to, or that all classes would want to in the same degree or at a period in time that is mutually convenient. Conundrums are nasty things, as a certain Fed Chairman might have said once. For those of you keeping score at home, notice that we haven’t yet gotten to the question of how a tranche of a REMIC becomes part of an asset pool backing a CDO. We’ll get there eventually. At the moment, just imagine the lowest-rated tranches of REMICs backed by some pretty scary loans becoming collateral for subsequent debt-funded securitization instruments that have even weirder and more complex structures than any known REMIC does. But don’t be frightened at the thought that we are getting to dangerous levels of derivation and dispersion and complexity, or some braver soul will call you a simple-minded cave bear and you’ll have to pretend that your feelings were hurt by that. I’ve got Kleenex if the tear-jerking gets out of hand, but I doubt the Calculated Riskers will need it. Tanta http://www.haloscan.com/tb/calculatedrisk/8185077756557219572/ ===============================================================