Mortgage Security
A loan to finance the purchase of real estate, usually with specified payment periods and interests rates. The borrower (mortgagor) gives the lender (mortgagee) a lien (security) on the property as collateral for the loan
Mortgage limitations from the viewpoint of the originators
The issue of a mortgage earns the originator fees, however, mortgages are largely illiquid (terms of up to 25 years)
-This limits the volume of new mortgages which can be created, as funds availability is finite. In turn, this limits fee income
Solutions to the mortgage problem
- Banks can use a mortgage as collateral for investing by a party seeking a higher rate of return than bank interest, BUT investor still has prepayment risk
- Prepayment risk: the risk that the borrower will repay a loan before its maturity, depriving the lender of future interest payments.
Securitisation
The pooling and repackaging of relatively homogeneous assets into securities
-Forms of credit enhancement are available to upgrade the credit rating of the security instrument to a level higher than the underlying asset
Why is mortgage funding a relatively conservative form of investment from the viewpoint of investors?
Mortgage origination process: underwriting standards; the requirements specified by the originator to grant the loan: Primarily two factors which determine the applicant’s creditworthiness:
- Payment-to-income ratio, 2. Loan-to-value ratio
- Hence, the security is granted over property, and in necessary cases there exists a level of insurance (so very secure form of asset to lend against)
Securitisation process
- Originator transfers assets to a trust or company called a special purpose vehicle
- The SPV acts as an intermediary between the originator and investors: acquires the assets, issues securities backed by the assets, proceeds received by mortgage servicer are then paid across to the originator
- The SPV continues to hold the assets for the beneficial interest of the security holders
Credit enhancement
- Higher credit ratings given to the securities issued by the SPV than the bank itself - can be enhanced with a bank letter of credit
- Credit ratings provide investors with an indication of credit risk, with a consequential effect on the risk premium payable
Benefits of securitisation
- originator can tap into new sources of funding at a lower cost of capital;
- the originator removes assets from the balance sheet, representing a reduction in debt/liab ratio, risk weighted assets (cap adequacy requirements) and reduction in exposure to interest rate risk
- conversion of illiquid assets, which provides a fresh injection of funds
Disadvantages of securitisation
- Effort required for first time securitisation
- Greater asset disclosure to rating agencies
Forms of securitisation: Mortgage Pass Through
- Monthly mortgage payments, net of servicing and insurance fees, pass along to investors
- The payments may include prepayments, hence amounts received may be lumpy and unpredictable
- This presents a problem with cash flow forecasting, and also presents a prepayment risk
Forms of securitisation: Pay through security
- Due to prepayment risk undesirability, MBS growth slackened
- Collaterised Mortgage Obligation (CMO) devised
- The CMO does not eliminate prepayment concerns, but instead transfers this risk among different classes called tranches
- Each tranche has a different maturity date, cash flow features and risk exposure
- This broadens the appeal of the security to different classes of investors
How does a CMO alter the cash flow (shifting prepayment risk)?
Example: Tranche A, B and C: class A repaid with all principle repayments from the entire portfolio, Class B repaid only after A, Class C repaid only after B.
- This gives repayment protection for B and particularly C
- As A will be repaid sooner, it could have a lower coupon rate
- More advanced structures were developed through financial engineering: e.g. senior, mezzanine, sub-ordinated tranches, z-bond tranches etc
Securitisation and the balance sheet
In both Pass Through and Pay Through securities, an originator removes the assets from the balance sheet for ratio calculation purposes
Why did MBSs become so popular?
- Offered attractive rates of interest by comparison with similarly rated securities
- Demand for MBSs eventually outstripped supply
What is the structure of subprime mortgage bonds?
- With so much demand for MBSs, the solution was to introduce financial engineering, whereby tranches with different credit rated securities were introduced (as opposed to different prepayment rights)
- AAA securities in the top tranche, and BBB (and eventually) subprime in the bottom
- Massive demand for mortgages due to low (1%) rates, mortgages extended to NINJAs, computerised loan approvals etc
How did the CDO develop?
- More borrowing and continued demand from investors prompted banks to keep lending, however even with subprime mortgages the market was finite
- The CDO was developed
- CDO is a promise to pay investors in prescribed sequence, based on the CFs the CDO collects from the pool of bonds (MBS) it owns. CDO is sliced into tranches based on seniority
Why were CDOs so risky?
- A normal CDO would have tranches comprising AAA down to residual grade, however overall CDOs were constructed from the riskiest tranches of MBSs
- Big institutional investors invested in CDOs (including banks)
- These investors thought that pooling a group of risky assets together diversified the overall risk
What are CDO-squared and synthetic CDOs?
- Some sponsors repackaged tranches again, into CDOs of CDOs (or CDO squared)
- A synthetic CDO invests in credit default swaps (CDSs) or other non-cash assets to gain exposure to a portfolio of fixed income assets. They are typically divided into credit tranches based on the level of credit risk
Credit Default Swap (CDS)
- An insurance contract between the buyer of a CDO (which has credit risk) and the seller (which, for a fee, is prepared to insure that credit risk)
- Problem: no legislation of who could be a CDS writer/seller
- -No capital requirements (no financial strength)
- -No record of outstanding contracts
- -No control on credit risk
Factors that then lead to GFC (given the types of securities being issued)
- Greed took over (in issuance of CDSs/CDOs)
- Easy money
- Belief that housing prices would continue to rise (and non-recourse nature of US loans)
