Session Plan

Chapter Eleven:– Origins of real estate securitization– Agency Guarantees vs. Private Label– CMOs and REMICs– CMBS & QQD

Origins of Securitization

Securitization: Process of pooling individual assets that are used as collateral, for the issuance of securities– Residential Mortgage Backed Securities (RMBS)– Collateralized Mortgage Obligations (CMO)– Collateralized Debt Obligations (CDO)– Commercial Mortgage Backed Securities (CMBS)

Origins of Securitization

Federal Housing Administration (FHA) in 1934– 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

Federal National Mortgage Assoc (FNMA) in 1938 “Fannie Mae”– Provided liquidity to market, but still no homes

were being built….led to VA Program Veteran’s Administration (VA)

– Grants mortgage funds for veterans at interest rates equal or less than FHA

– Negates mortgage insurance & avoids down payment requirements

Origins of Securitization

FNMA restructured as government sponsored, private corporation in 1968

Government National Mortgage Assoc (GNMA) chartered in 1968– “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

First Mortgage Backed Security (MBS) was in 1970– 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

Secondary Mortgage Market Enhancement Act of 1984– 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

Agency guaranteed MBS allowed for viable secondary mortgage market in US

GNMA secured with “full faith and credit of the US Treasury”– Considered to be free of default risk– They do not underwrite or issue MBS– They guarantee those provided privately

Agency Guarantees

Fannie Mae & Freddie Mac are Government Sponsored Entities– 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

Freddie offers both kinds, Fannie offers “fully” only

Agency Guarantees

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– Guarantees also promoted acceptability of these

investments

Mortgage Conformability

Fannie Mae and Freddie Mac mortgage conformability standards are set by Office of Federal Housing Enterprise Oversight (OFHEO)

– OFHEO sets size limit for conforming loans (i.e. no jumbo mortgages)

Have “super-conforming” loans in areas where prices are higher than the average

GSE’s may only purchase conforming & super-conforming loans

– For borrowers outside of conformability standards, their borrowing expenses are higher

Private Label MBS

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)– By 2006 private label issuances > agency issues

RMBS & Prepayment Risk

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

– 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

And will have to reinvest their money at a lower rate

RMBS & Prepayment Risk

Convexity: Non-linearity in a financial model; the relationship of bond price with respect to interest rates.

– 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!

Could have reinvested cash flows at a higher rate

RMBS & Prepayment Risk

Prepayment risk is the lynchpin to pricing RMBS

As Mortgage Rates fall: pool pays quicker than expected– Investor loses interest income & gets principal

back in a low rate environment As Mortgage Rates rise: pool pays slower

than expected– Investor earns relatively lower rate for a longer

period of time (harms their yield)

CMOs

Collateralized Mortgage Obligation (CMO)– First was by Freddie Mac in 1983– Consists of a multi-class MBS

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

Real Estate Mortgage Investment Conduits– Established in 1986– P&I Payments are divided into various payment

streams to create tranches

REMIC avoids double taxation– REMIC is tax exempt– Investors pay tax on dividends received

Almost all CMOs are issued as REMICs

Types of CMOs

Sequential Pay (Plain Vanilla)– Tranches are paid in strict sequence– Known as “waterfalls” as cash flows down to lower rated

tranches Planned Amortization Class (PAC) CMO

– 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

Planned Amortization Class (PAC) CMO Continued– If prepayment is different than expected, the

support tranche absorbs the variable portion of the payments

– Can have different levels of priority TYPE I PAC, Type II PAC, etc.

– Higher yields are offered for riskier, more variable support tranches

Types of CMOs

Targeted Amortization Class (TAC)– 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

Z Tranches (Z Bonds, Accretion Bonds, Accrual Bonds)

– 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 Have terms of 18-22 years

Types of CMOs

Principal Only (PO) Strips– 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

Interest Only (IO) Strips– 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

Non Agency backing allows for any asset to be included in the pool

Creating a Private Label MBS or Asset-backed Security

Borrowers Originator Special Purpose Vehicle

Investors

Credit Enhancement

Credit Rating Agency

Underwriter

Servicer

Creating a Private Label MBS

Special Purpose Vehicle (SPV)– Controls collateral, collects P&I payments, & passes them

on to investors Underwriter

– Banks, investment banks, brokers that price and market MBS to investors

Credit Agencies– Determine the credit enhancements required– Banks may only hold investment grade MBS

Moody’s Baa3 or higher S&P and Fitch BBB- and higher

Credit Enhancements

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:– Borrower’s credit quality, incentives to default,

size & variability of potential loss, & diversification of loans in the asset pool

Types of Credit Enhancements

External Credit Enhancements– Government Agency Guarantees– Monoline Insurance

Provide “credit wraps’ to bolster ratings

– Letter of Credit Bank assumes default risk by reimbursing SPV in cash Less common given banking issues these days!

– Liquidity Provider Makes short term temporary payments More common in international securitizations

Types of Credit Enhancements

Internal Credit Enhancement– Originator provides protection to cover potential

losses Cash, assets, or profits into transaction while taking a

lower priority bond

– Excess Interest/Spread or Profit 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

– Over-Collateralization Pool of collateral loans has 5-10% higher par value than

the issued securities

– Cash Collateral Account As losses occur, cash is withdrawn At termination remaining funds are returned to originator

– Structural Credit Enhancements Senior/Subordinated Structures: lower credit rated

classes provide protection for senior classes

CMBS

Pools of Commercial Real Estate Loans Prepayments are not a significant issue here

– Due to Lockout period– Defeasance: penalty for early termination

CMBS loans are heterogeneous– 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– A-piece investor vs. B-piece investor

Servicing CMBS Loans

Servicer passes payment to trustee for disbursement

Servicer monitors changes in payment behavior– In default, servicer contacts borrower & may

pursue foreclosure

Servicing CMBS Loans

Master Servicer: servicing all loans not in default– 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

– 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

In default in depressed market?– 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

Tweaking system to generate business– Less tranches now than before– “A-piece” investors now more likely to appoint

special servicer 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

Transparency is needed to revive the market– 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

Much of perceived bloom taken off of securitization rose

– There is good and bad in innovation: autos and electricity examples

Subprime Mortgages– 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?

Originate to Distribute– Hot potato approach vs. originate to hold on

balance sheet

Ratings Agencies– They underestimated default risk

Investors– They asked for it!

Upside of Securitization

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

We will discuss chapter 12 on Real Estate Investment Trusts (REITs)