Session Plan
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Chapter Eleven:
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Origins of real estate securitization
Agency Guarantees vs. Private Label
CMOs and REMICs
CMBS & QQD
Origins of Securitization
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Securitization: Process of pooling individual
assets that are used as collateral, for the
issuance of securities
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Residential Mortgage Backed Securities (RMBS)
Collateralized Mortgage Obligations (CMO)
Collateralized Debt Obligations (CDO)
Commercial Mortgage Backed Securities (CMBS)
Origins of Securitization
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Federal Housing Administration (FHA) in
1934
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US foreclosures were peaking, RE values
dropped to 50% of 1927-1928 levels
Collapse of mortgage banking industry
FHA was to insure mortgages against default & to
require standard contracts
Allowed for mortgages to become practicable
investments for thrifts and insurance companies
Origins of Securitization
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Federal National Mortgage Assoc (FNMA) in
1938 “Fannie Mae”
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Provided liquidity to market, but still no homes
were being built….led to VA Program
Veteran’s Administration (VA)
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Grants mortgage funds for veterans at interest
rates equal or less than FHA
Negates mortgage insurance & avoids down
payment requirements
Origins of Securitization
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FNMA restructured as government
sponsored, private corporation in 1968
Government National Mortgage Assoc
(GNMA) chartered in 1968
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“Ginnie Mae” had explicit government guarantee
and was to carry out FNMA’s prior support of
FHA, VA, and Farmer Home Admin. (FmHA)
loans
Gov’t guarantee was the spark that ignited the
secondary mortgage market in the United States
Origins of Securitization
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First Mortgage Backed Security (MBS) was
in 1970
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Backed by GNMA with VA and FHA loans as
collateral
Investors could purchase securities backed by
conventional home loans
1970 Federal Home Loan Mortgage
Company (“Freddie Mac”) was created to
compete with FNMA & to boost liquidity
Origins of Securitization
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Secondary Mortgage Market Enhancement
Act of 1984
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Vastly expanded number of financial institutions
that could hold mortgage related securities
Origins of Securitization was the creation of
Ginnie Mae, Fannie Mae, and Freddie Mac
which provided implicit and explicit
guarantees necessary to ease investor
unease with mortgage debt
Agency Guarantees
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Agency guaranteed MBS allowed for viable
secondary mortgage market in US
GNMA secured with “full faith and credit of
the US Treasury”
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Considered to be free of default risk
They do not underwrite or issue MBS
They guarantee those provided privately
Agency Guarantees
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Fannie Mae & Freddie Mac are Government
Sponsored Entities
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Provide mortgages, issue securities using pooling
Modified pass-through: guarantees only the
timely repayment of interest and offers default
protection
Fully Modified pass-through: guarantees timely
payment of principal, interest & offers default
protection
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Freddie offers both kinds, Fannie offers “fully” only
Agency Guarantees
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GSE’s have slightly higher credit risk as they
are backed by an agency guarantee and not
explicitly by the US Treasury
Agency backed securities lowered the cost of
home financing by lowering transaction
costs, increasing liquidity,& improving the
standardization of contracts
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Guarantees also promoted acceptability of these
investments
Mortgage Conformability
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Fannie Mae and Freddie Mac mortgage
conformability standards are set by Office of Federal
Housing Enterprise Oversight (OFHEO)
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OFHEO sets size limit for conforming loans (i.e. no jumbo
mortgages)
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Have “super-conforming” loans in areas where prices are
higher than the average
GSE’s may only purchase conforming & superconforming loans
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For borrowers outside of conformability standards, their
borrowing expenses are higher
Private Label MBS
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Issued by banks, insurance companies,
savings institutions (known as underwriters)
Government encouraged private label
development given size of agency
guarantees
Private conduit buys loans from originators &
creates pools for sale (without guarantees)
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By 2006 private label issuances > agency issues
RMBS & Prepayment Risk
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As residential mortgages have the option to prepay,
the uncertainty of timing and the magnitude of the
cash flows received by the investor are uncertain
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As rates drop below the contract rate, prepayment is more
likely
As the interest rates on LT bonds falls, homeowner is more
likely to prepay the mortgage
Prepayment can occur for other reasons such as selling the
property
Just as the reinvestment rate drops, the RMBS investor is
more likely to get paid early
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And will have to reinvest their money at a lower rate
RMBS & Prepayment Risk
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Convexity: Non-linearity in a financial model; the
relationship of bond price with respect to interest
rates.
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Decreases as interest rates fall (& prepayments rise) and as
interest rates rise ( & prepayments fall)
Probability of prepayment is inversely related to the
prevailing mortgage rates
Since prepayment rates fall as mortgage rates rise,
prepayments slow down for RMBS investors just as they
desire them to pick up!
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Could have reinvested cash flows at a higher rate
RMBS & Prepayment Risk
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Prepayment risk is the lynchpin to pricing
RMBS
As Mortgage Rates fall: pool pays quicker
than expected
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Investor loses interest income & gets principal
back in a low rate environment
As Mortgage Rates rise: pool pays slower
than expected
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Investor earns relatively lower rate for a longer
period of time (harms their yield)
CMOs
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Collateralized Mortgage Obligation (CMO)
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First was by Freddie Mac in 1983
Consists of a multi-class MBS
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Different classes (tranches) have different maturities,
interest rates, & prepayment risk
Tranches from 2 to 50
Each tranche has an estimated first and last payment
date
To earn a higher coupon rate, investor must bear
more prepayment risk
REMICs
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Real Estate Mortgage Investment Conduits
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REMIC avoids double taxation
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Established in 1986
P&I Payments are divided into various payment
streams to create tranches
REMIC is tax exempt
Investors pay tax on dividends received
Almost all CMOs are issued as REMICs
Types of CMOs
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Sequential Pay (Plain Vanilla)
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Tranches are paid in strict sequence
Known as “waterfalls” as cash flows down to lower rated
tranches
Planned Amortization Class (PAC) CMO
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Uses support or companion tranche to provide protection for
PAC or “main” tranche
Allows investors in main tranche to receive more certain
cash flows sooner
PAC yield, average life, & lockout periods are more closely
tied to original estimates
Types of CMOs
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Planned Amortization Class (PAC) CMO
Continued
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If prepayment is different than expected, the
support tranche absorbs the variable portion of
the payments
Can have different levels of priority
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TYPE I PAC, Type II PAC, etc.
Higher yields are offered for riskier, more variable
support tranches
Types of CMOs
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Targeted Amortization Class (TAC)
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Structured like PACs, but investor is protected
from rise in prepayment rate (as interest rates fall)
If PAC & TAC are in same CMO, PAC receives
priority
TAC is inferior to PAC as investor is only
protected from unexpected increase in
prepayments
Types of CMOs
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Z Tranches (Z Bonds, Accretion Bonds, Accrual
Bonds)
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Receives no interest until lockout period ends and begins to
receive principal
Lockout period ends when all other tranches have been
paid off
During lockout period, tranche is credited with accrued
interest that is taxable (although not received)
These are best for tax deferred retirement accounts
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Have terms of 18-22 years
Types of CMOs
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Principal Only (PO) Strips
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Investor receives principal only, buys at a steep
discount from face value
As rates fall, prepayments rise which lowers the
effective term of the security
As rates rise, PO investor yield suffers (gets paid
slower)
Types of CMOs
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Interest Only (IO) Strips
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Any CMO offering PO will also offer IO
IO is sold at steep discount to notional principal
(no par or face value)
As principal in pool is paid down, notional value of
tranche declines, as do the interest payments
IO Strips lose value rapidly as interest rates fall
and as prepayments rise
Creating a Private Label MBS
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Non Agency backing allows for any asset to be
included in the pool
Creating a Private Label MBS or Asset-backed Security
Credit
Enhancement
Borrow ers
Originator
Special
Purpose
Vehicle
Servicer
Credit Rating
Agency
Underw riter
Investors
Creating a Private Label MBS
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Special Purpose Vehicle (SPV)
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Underwriter
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Controls collateral, collects P&I payments, & passes them
on to investors
Banks, investment banks, brokers that price and market
MBS to investors
Credit Agencies
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Determine the credit enhancements required
Banks may only hold investment grade MBS
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Moody’s Baa3 or higher
S&P and Fitch BBB- and higher
Credit Enhancements
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Credit Enhancement is a process to lower
risk of entire security within a securitized
asset
Without credit enhancement marketing of
private label MBS is difficult
Size of enhancement is determined by:
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Borrower’s credit quality, incentives to default,
size & variability of potential loss, & diversification
of loans in the asset pool
Types of Credit Enhancements
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External Credit Enhancements
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Government Agency Guarantees
Monoline Insurance
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Letter of Credit
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Provide “credit wraps’ to bolster ratings
Bank assumes default risk by reimbursing SPV in cash
Less common given banking issues these days!
Liquidity Provider
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Makes short term temporary payments
More common in international securitizations
Types of Credit Enhancements
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Internal Credit Enhancement
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Originator provides protection to cover potential
losses
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Cash, assets, or profits into transaction while taking a
lower priority bond
Excess Interest/Spread or Profit
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Interest rate paid by borrowers on loans used as
collateral is not coupon rate
Must also deduct for trustee & servicer expenses
Deduct more from borrower interest payment to
enhance deal
Types of Credit Enhancements
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Over-Collateralization
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Cash Collateral Account
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Pool of collateral loans has 5-10% higher par value than
the issued securities
As losses occur, cash is withdrawn
At termination remaining funds are returned to originator
Structural Credit Enhancements
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Senior/Subordinated Structures: lower credit rated
classes provide protection for senior classes
CMBS
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Pools of Commercial Real Estate Loans
Prepayments are not a significant issue here
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CMBS loans are heterogeneous
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Due to Lockout period
Defeasance: penalty for early termination
Different mortgage styles, maturities, property types,
covenants, tenant and location quality
CMBS lack agency guarantees
Typically set up as REMIC with tranches like for
RMBS
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A-piece investor vs. B-piece investor
Servicing CMBS Loans
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Servicer passes payment to trustee for
disbursement
Servicer monitors changes in payment
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In default, servicer contacts borrower & may
pursue foreclosure
Servicing CMBS Loans
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Master Servicer: servicing all loans not in default
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Collects payment, compiles information
Often is same as original underwriter
Little ability to modify loan or obtain alternative collateral
Accepting alternative collateral could impact REMIC tax
exempt status
Special Servicer
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Servicing loans in default
Named at issuance, usually affiliated with B-piece investors
B-Piece: face higher risk so should be most familiar with
pool risk
CMBS Servicing Conflicts
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In default in depressed market?
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It may be in “A-piece” investors’ interest to
foreclose
“B-piece” may not get anything so special servicer
may wait longer than is prudent for borrower to
become current on payments
Issuance of CMBS (in Billions)
CMBS 2.0
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Tweaking system to generate business
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Less tranches now than before
“A-piece” investors now more likely to appoint
special servicer
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To eliminate perception that investment grade tranches
give up economic value at default
Grant more authority to “A-piece” in defining
commitments made by issuer
Eliminates “B-piece” buyers from selling their part
to a CDO (per Dodd-Frank)
CMBS & QQD
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Transparency is needed to revive the market
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Disclosure of Debt Coverage Ratio for each loan
in pool so investor can better assess risk
More and Better information should reduce
price volatility
Problems of Securitization
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Much of perceived bloom taken off of securitization
rose
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Subprime Mortgages
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There is good and bad in innovation: autos and electricity
examples
As high as 22% of total mortgages, but 80% of these were
securitized
Meltdown after “Yes Era” given higher leverage, poor
underwriting, government intervention in markets,
and extremely low interest rates
Who’s to Blame?
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Originate to Distribute
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Ratings Agencies
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Hot potato approach vs. originate to hold on
balance sheet
They underestimated default risk
Investors
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They asked for it!
Upside of Securitization
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Lowered cost of capital for investors and cost of
funds for borrowers
Often better terms than for on-balance sheet loan
(non-recourse, 30 year amort.)
More consistent funds availability
Added liquidity & higher origination fees for lenders
and investment banks
When done correctly: diversification of investment
options & good return on investment
For Next Session
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We will discuss chapter 12 on Real Estate
Investment Trusts (REITs)