The Federal Reserve Bank of New York published a research report in 2008 regarding the securitization process for subprime mortgages…
It is these products and the structured products which they formed that constituted the bulk of toxic assets that the upcoming Geithner plan will attempt to move off the balance sheets of the “too big to fail” banks…
This report details the development and structure of several subprime MBS originated by New Century Financial and underwritten by Goldman Sachs… (New Century went bankrupt in 2008)
It is helpful as background to the upcoming discussion about valuing these products…
It is true that these products embody so much opacity that valuing them is very difficult… and goes to explain why the Treasury and Federal Reserve will be providing 33 times leverage to the firms bidding on them…
I believe that it is important to understand who will be invited to participate in the process… and who is excluded…
And what are lessons can we derive from the substantial problems embodied in this report related to the oversight of the fixed income markets …
A big issue is the flow of information (or lack thereof) from originator and underwriter to the rating agencies to the investor…
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Understanding the Securitization of Subprime Mortgage Credit…
| March 2008 Number 318 |
| JEL classification: G24, G28 |
| Authors: Adam B. Ashcraft and Til Schuermann
In this paper, we provide an overview of the subprime mortgage securitization process and the seven key informational frictions that arise. We discuss the ways that market participants work to minimize these frictions and speculate on how this process broke down. We continue with a complete picture of the subprime borrower and the subprime loan, discussing both predatory borrowing and predatory lending. We present the key structural features of a typical subprime securitization, document how rating agencies assign credit ratings to mortgage-backed securities, and outline how these agencies monitor the performance of mortgage pools over time. Throughout the paper, we draw upon the example of a mortgage pool securitized by New Century Financial during 2006. |
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Page 35-42
…The typical subprime trust has the following structural features designed to protect investors
from losses on the underlying mortgage loans:
• Subordination
• Excess spread
• Shifting interest
• Performance triggers
• Interest rate swap
We discuss each of these forms of credit enhancement in turn.
4.1. Subordination
The distribution of losses on the mortgage pool is typically tranched into different classes. In
particular, losses on the mortgage loan pool are applied first to the most junior class of
investors until the principal balance of that class is completely exhausted. At that point, losses
are allocated to the most junior class remaining, and so on.
The most junior class of a securitization is referred to as the equity tranche. In the case of
subprime mortgage loans, the equity tranche is typically created through over-collateralization
(o/c), which means that the principal balance of the mortgage loans exceeds the principal
balance of all the debt issued by the trust. This is an important form of credit enhancement that
is funded by the arranger in part through the premium it receives on offered securities. O/C is
used to reduce the exposure of debt investors to loss on the pool mortgage loans.
A small part of the capital structure of the trust is made up of the mezzanine class of debt
securities, which are next in line to absorb losses once the o/c is exhausted. This class of
securities typically has several tranches with credit ratings that vary between AA and B. With
greater risk comes greater return, as these securities pay the highest interest rates to investors.
The lion’s share of the capital structure is always funded by the senior class of debt securities,
which are last in line to absorb losses. Senior securities are protected not only by o/c, but also
by the width of the mezzanine class. In general, the sum of o/c and the width of all tranches
junior is referred to as subordination. Senior securities generally have the highest rating, and
since they are last in line (to absorb losses), pay the lowest interest rates to investors.
The capital structure of GSAMP 2006-NC1 is illustrated in Table 17. First, note that the o/c is
the class X, which represents 1.4% of the principal balance of the mortgages. There are two B
classes of securities not offered in the prospectus. The mezzanine class benefits from a total of
3.10% of subordination created by the o/c and the class B securities. However, note that the
mezzanine class is split up into 9 different classes, M-1 to M-10, which class M-2 being junior
to class M-1, etc. For example, the M-8 class tranche, which has an investment grade-rating of
BBB, has subordination of 3.9% and pays a coupon of 100 basis points. Investors receive 1/12
of this amount on the distribution date, which is the 25th of each month. The senior class
benefits from 20.65% of total subordination, including the width of the mezzanine class
(19.25%).
Note that the New Century structure is broken into two groups of Class A securities,
corresponding to two sub-pools of the mortgage loans. In Group I loans, every mortgage has
original principal balance lower than the GSE-conforming loan limits. This feature permits the
GSEs to purchase these Class A-1 securities. However, in the Group II loans, there is a mixture
of mortgage loans with original principal balance above and below the GSE-conforming loan
limit.
The table does not mention either the class P or class C certificates, which have no face value
and are not entitled to distributions of principal or interest. The class P securities are the sole
beneficiary of all future prepayment penalties. Since the arranger will be paid for these rights,
it reduces the premium needed on other offered securities for the deal to work. The class C
securities contain a clean-up option which permits the trust to call the offered securities should
the principal balance of the mortgage pool fall to a sufficiently low level.12 In our example
deal, the offered debt securities are rated by both S&P and Moody’s. Note that Table 17
documents that there is no disagreement between the agencies in their opinion of the
appropriate credit rating for each tranche.
4.2. Excess spread
Subordination is not the only protection that senior and mezzanine tranche investors have
against loss. As an example, the weighted average coupon from the mortgage loan will
typically be larger than fees to the servicers, net payments to the swap counterparty, and the
weighted average coupon on debt securities issued by the trust. This difference is referred to as
excess spread, which is used to absorb credit losses on the mortgage loans, with the remainder
distributed each month to the owners of the Class X securities. Note that this is the first line of
defense for investors for credit losses, as the principal of no tranche is reduced by any amount
until credit losses reduce excess spread to a negative number. The amount of credit
enhancement provided by excess spread depends on both the severity as well as the timing of
losses.
In the New Century deal, the weighted average coupon on the tranches at origination is LIBOR
plus 23 basis points. With LIBOR at 5.32% at the time of issue, this implies an interest cost of
5.55%. In addition to this cost, the trust pays 51 basis points in servicing fees and initially pays
13 basis points to the swap counterparty (see below). As the weighted average interest rate on
collateral at the time of issue is 8.30%, the initial excess spread on this mortgage pool is 2.11%.
More generally, the amount of excess spread varies by deal, but averaged about 2.5 percent
during 2006. Dealers estimate that loss rates must reach 9 percent before the average BBB
minus bond sustains its first dollar of principal loss, about twice its initial subordination of 4.5
percent in Figure 6 above.
4.3. Shifting interest
Senior investors are also protected by the practice of shifting interest, which requires that all
principal payments to be applied to senior notes over a specified period of time (usually the
first 36 months) before being paid to mezzanine bondholders. During this time, known as the
“lockout period,” mezzanine bondholders receive only the coupon on their notes. As the
principal of senior notes is paid down, the ratio of the senior class to the balance of the entire
deal (senior interest) decreases during the first couple years, hence the term “shifting interest”.
The amount of subordination (alternatively, credit enhancement) for the senior class increases
over time because the amount of senior bonds outstanding is smaller relative to the amount
outstanding for mezzanine bonds.
4.4. Performance triggers
After the lockout period, subject to passing performance tests,13 the o/c is released and principal
is applied to mezzanine notes from the bottom of the capital structure up until target levels of
subordination are reached (usually twice the initial subordination, as a percent of current
balance). In addition to protecting senior note holders, the purpose of the shifting interest
mechanism is to adjust subordination across the capital structure after sufficient seasoning.
Also, the release of o/c and pay-down of mezzanine notes reduces the average life of these
bonds and the interest costs of the securitization.
In our example securitization, o/c is specified to be 1.4% of the principal balance of the
mortgage loans as of the cutoff-date, at least until the step-down date. The step-down date is
the earlier of the date on which the principal balance of the senior class has been reduced to
zero and the later to occur of 36 months or subordination of the senior class being greater than
or equal to 41.3% of the aggregate principal balance of remaining mortgage loans. The trigger
event is defined as a distribution date when one of the following two conditions is met:
• The rolling three-month average of 60-days or more delinquent (including those in
foreclosure, REO properties, or mortgage loans in bankruptcy) divided by the remaining
principal balance of the mortgage loans is larger than 38.70% of the subordination of
the senior class from the previous month; or,
• The amount of cumulative realized losses incurred over the life of the deal as a fraction
of the original principal balance of the mortgage loans exceeds the thresholds in Figure
7.
If the trigger event does not occur, the deal is 36 months old, and the subordination of the
senior class is larger than 41.3%, then the deal will step-down. In this case, o/c is specified to
be 2.8 percent of the principal balance of the mortgage loans in the previous month, subject to a
floor equal to 0.5% of the principal balance of the mortgage loans as of the cut-off date. At this
time, any excess o/c is released to holders of the Class X tranche. Note that the trigger event
only affects whether or not o/c is released.
4.5. Interest rate swap
While most of the loans are ARMs, as discussed above, the interest rates will not adjust for two
to three years following origination. It follows that the trust is exposed to the risk that interest
rates increase, so that the cost of funding increases faster than interest payments
received on the mortgages. In order to mitigate this risk, the trust engages in an interest rate
swap with a third-party named the swap counterparty. In particular, the third-party has agreed
to accept a sequence of fixed payments in return for promising to send a sequence of
adjustable-rate payments.
In our example, Goldman Sachs is the Swap counterparty, which has agreed to pay 1-month
LIBOR and accept a fixed interest rate of 5.45% on a notional amount described in Figure 8
over a term of 60 months. Note that the notional amount hedged decreases over time, as the
trust expects pre-payments of principal on the pool of mortgage loans to reduce the amount of
debt securities outstanding.
4.6 Remittance reports
The trustee makes monthly reports to investors known as remittance reports. In this section, we
use data from these reports in order to document the performance of the New Century deal
through August 2007.
Table 18 documents cash receipts of the trust. Scheduled principal and interest are collected
from a borrower’s monthly payment. Unscheduled principal is collected from borrowers who
pay more than their required monthly payment, as well as borrowers who either pre-pay or
default on their loans. The first three columns of the table report the remittance of scheduled
and unscheduled principal as well as interest and pre-payment penalties. The fourth column
reports advances of principal and interest made to the trust by the servicer to cover the nonpayment
of these items by certain borrowers. The fifth column documents the repurchase of
loans by New Century which have been determined to violate the originator’s representations
and warranties. Note that only one loan has been repurchased with a principal balance of
$184,956 as of this writing. Finally, realized losses are reported in the sixth column.
Table 19 documents the cash expenses of the trust. The net swap payments are reported in the
first column. Recall that the trust pays Goldman Sachs a fixed interest rate of 5.45 percent and
receives an amount equal to one-month LIBOR, each on the amount referenced by Table 18
above. The servicer fees are based on the outstanding principal balance of the mortgage loans
at the end of the last month, with 50 basis points paid to the servicer (Owcen) and just under 1
basis point paid to the master servicer (Wells Fargo). All principal paid by the borrower is
advanced to the holders of Class A certificates. Each tranche is paid the stated coupon from
Table 18 above based on the amount outstanding at the end of the previous month. Prepayment
penalties are paid to the owners of the Class P tranche. The residual is denoted excess spread,
and is paid to the owners of the Class X tranche each month.
The face value of the Class X tranche is $12.3 million. To date, this tranche has been paid
excess spread in the amount of $16.1 million. Note that the amount paid to this tranche has
decreased over time as credit losses have reduced excess spread. Interestingly, even if the
owners of this class are not paid another dollar of interest, they will have received an amount
equal to 130.9% of par.
There are two trigger events which prevent the release of over-collateralization at the stepdown
date, as shown in Table 20. The trigger amount in the third column for the 3-month
moving average of 60-day delinquencies is 38.7 percent of the previous month’s senior
enhancement percentage reported in the fourth column. Recall that the trigger amount for the
cumulative losses is constant at 1.3 percent over the first two years of the deal. While losses to
date remain lower than the loss trigger amount, the 3-month moving average of 60-day
delinquencies has been larger than the threshold amount since the April 2007 remittance report.
The remittance report also discloses loan modifications performed by the servicer each month.
Note that through the August remittance report, there have been no modifications of any
mortgage loan in the pool. This is not surprising as the first payment reset date for these 2/28
ARMs will not be until spring 2008.
Finally, the remittance report also discloses information that permits a calculation of loss
severity. At the time of this writing, the trust has incurred a loss of $2.199 million on 44
mortgage loans with principal balance of $5.042 million, for a loss severity of 43.6 percent.
This number is only modestly higher than the assumption used in forecasting the lifetime
performance of the deal using the UBS methodology.
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