*internal credit enhancement:
- subordination: first internal credit enhancement
- hold back: SPV buy assets at discount by originator
- cash colleral account
- excess spread
*external credit enhancement:
- insurance, wraps & guarantees
- LOC
- basket CDS
- put option on assets
*Subprime
- Debt Servie-to-Income > 50%
- FICO less than 660
- 60 day delinquency in last 24 months
- 2+ 30 day delinquencies in last 12 months
- Judgment, foreclosure in prior 24 months
- Bankruptcy in last 5 years
1-1. Mortgage Process
- Friction 1: Mortgagor & Originator; possibility of predatory (unfair) lending -> stretch the bounds of the application resulting in larger than optimal lending- Friction 2: Originator & Arranger (issuer) - the originator creates bankruptcy the remote trust and the arranger perform due diligence, but operate at an information disadvantage to the originator -> adverse selection problem
- Friction 3: Arranger & Third-Parties; adverse selection and information problem; retain higher quality mortgage & securitize lower quality mortgage; Warehouse lender fund less than 100% of estimated collateral value; Asset portfolio manager use a adequate due diligence; Rating agencise determine the amount of credit enhancement but dependent on the information provided by the arranger
- Friction 4: Servicer & Mortgagor; the servicer manage the CF of the MBS pool and follow up on delinquencies and foreclosure; moral hazard problem
- Friction 5: Servicer & Third-Parties; lack of effort can impact the asset manager and credit rating agencies without directly affecting CF distribution -> moral hazard problem
- Friction 6: Asset manager & Investor; moral hazard by managers & principle agency problem
- Friction 7: Investor & Credit Rating Agencies; conflict of interest (compensated by the arranger) -> model error
**video clips: Frictions in subprime securitization http://www.youtube.com/watch?v=F_GwmUUJX3E
2. Characteristics of the Subprime Mortgage Market
2-1. Characteristics
- subprime borrower
- ARM (adjustable rate mortgage) & a teaser rate for a short period
- borrowers bear interest rate risk
- performance of subprime pools indicates defaults and foreclosures way above historical levels
2-2. Structure of securitization process
**protection
- subordination: creating tranches of differing priority levels
- excess spread: excess spread = (weighted average coupon) - (servicing, hedging & other expenses) - (weighted average payout)
- shifting interest: senior receive all principal in the pool while mezzanine interest only
- performance trigger: overcollateralization
- interest rate swaps: fixed rate & LIBOR
3. Credit Rating Process
3-1. Rating process
An unconditional view: through-the-cycle
Two Steps:
- estimation of loss distribution
- simulation of CF
After obtaining the estimates, rating agencies indicate the level of credit enhancement necessary to achieve the desired rating
**video clips: credit enhancements in a securitization: http://www.youtube.com/watch?v=Ip0lZ-TjdHI&feature=related
3-2. Difference between credit ratings for subprime securities & corporate ratings
- corporate bond ratings based on the firm-specific characteristics <-> MBS: systematic risk & degree of correlation between assets are important, claims on a static pool
- MBS: future economic conditions
- if PDs are same, the MBS will exhibit much wider variation in losses
3-3. Credit ratings cycle & housing cycle
- through-the-cycle: no excessive upgrades (downgrades) even though housing market heats up (slow down)
- AAA rating during a boom period -> as the housing market slow down, MBS would migrate to AA
- As economic conditions change, the effect may amplify up and down markets
3-4. CF Analysis of Excess Spread
3-4-1. Interrelated factors for forcasting the degree of excess spread
- credit enhancement: amount of collateral that can be impaired before the tranche suffers an economic loss
- timing of losses: front-loading the losses (conservative approach)
- prepayment rates: CPR (conditional prepayment rate); hybrids will have higher than predicted defaults on or about the reset date due to the sudden change
- interest rates
- trigger events
- weighted average loan rate decrease
- prepayment penalties
- pre-funding accounts
- hedging instruments
3-5. Annual review of mortgage pools
- Important performance measures: Loss Coverage Ratio (LCR)
LCR = (current credit enhance ment for tranche) / (estimated unrealized losses)
- if the LCR is breached, a full review is warranted
4. Predatory Lending & Borrowing
4-1. Predatory lending: borrower becomes worse off
4-2. Predatory borrowing: misrepresentation in the mortgage application from the borrower side or overstating (falsifying) creditworthiness for rapid home application in high price real estate markets
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