Different Types of Securitization Contracts

There are three types of securities backed by underlying loans. The first type is pass-through, which represents direct ownership in the portfolio of loans (mortgages) with similar maturity, interest rate and quality characteristics. This means that all contracts are similar to investors in the pass-through and investors will receive exactly the same principal and interest cash flows which are guaranteed from mortgage loans in each month. The portfolio is sold to a trust and issues claims against the entire loan portfolio, sold directly to investors. In general, the loan originator or servicer collects principal and interest on the mortgage loans and deducts the fee before passing along to the investors. The pass- through does not appear on the originator’s balance sheet since claims are sold to investors. There are two different structures in the pass- though: static pool and dynamic pool.

Static pool refers to the pool of loan portfolios against claims sold to investors being fixed. Repayments from borrowers are paid to a separate interest-bearing account known as a collection account. Payments from this account are used to pay the servicing fee first and then the trustee passes along monthly payments of principal and interest to investors. A credit enhancement is provided through over-collateralization or an insurance bond purchased (insurance fee paid to credit enhancer) by the

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originator and is used to make up shortfalls in the case of mortgage default. However, it only can cover losses on some proportion of the loan portfolio. Gorton and Souleles (2005) note that about 10-15 percent of the value of a securitized loan portfolio can be covered, which means the credit enhancer is only responsible for covering losses up to the percentage of the loan portfolio specified.5 Ginnie Mae is the most common type of static pass-through, which is an MBS collateralized by FHA-VA mortgages. Dynamic pool means that the mortgage loans included in the pool against claims sold to investors are usually short term and the compositions of loan portfolios can be changed. The average maturity of mortgage loans included in a pool is shorter than the maturities of claims against the pool, which is referred to as a “revolving structure’’. During this period, only interest is paid to debt holders. Principle is reinvested and not paid until the end of the revolving period. This approach is most commonly used in credit card receivables. The second type is the asset-backed bond (ABB), which is also collateralized by a portfolio of loans. Unlike the pass-through, underlying assets against ABBs are sold to a financial company which is a subsidiary owned by the originator for the purpose of securitization

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In order to cover loan defaults, the credit enhancer usually purchases default contracts and the payments from a credit enhancer are received to cover the losses up to specified percentage of the value of loan portfolios.

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and, thus, the assets remain on the originator’s balance sheet. Another difference between ABBs and pass-through is that the subsidiary issues its claims to investors usually with the help of the underwriter (an investment bank), rather than selling assets to a trust and then issuing claims. The principle and interest payments are collected by the financial company and are transferred to the trustee, but cash flows from underlying assets are not dedicated to paying principal and interest on ABBs. In general, ABBs are created through over-collateralization; collateral against these securities is regularly evaluated to check whether their value falls below the amount stated.

The third type of securitization contracts is the pay-though bond. The Collateralized Mortgage Obligation (CMO) is a common example of pay-though bond, first issued by Freddie Mac in 1983. It combine features of both the pass-though and the ABB. Like the pass-through, cash flows collected from underlying assets against bonds are used to pay bondholders but the assets remain on the balance sheet of the originator. Each CMO is divided into three tranches and each tranche can receive interest rate semi-annually, but the principal payments are strictly prioritized and scheduled. On the top of this tranche structure, bondholders of tranche A have priority to be paid off. Tranche B starts to receive principal payments until bondholders of tranche A completely are paid off. Then tranche C bondholders can receive payments and

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Mortgage Collateral Payments

prepayments after bondholders of tranche B are entirely paid off. The following figure shows the scheduled payments structure of a CMO.

Figure 2.4: Cash-flow pattern for a CMO structure during the first five years

Source: Greenbaum and Thakor, 2011

Tranche A receives all principal payments and interest collected from underlying mortgage loans until it is paid off entirely within 5 years whereas tranche B and tranche C can only receive interest payments during 5 years. By scheduling cash flows this way, the CMO structure can reduce the variability of repayment rate and be used as a management tool of prepayment risk - which arises from borrowers prepaying their loans before maturity in order to refinance at lower rate when interest rates generally have fallen, especially for long-term mortgage without prepayment penalties. Therefore, financial institutions tend to invest in the lower level tranches in the CMO structure (the

Tranche A Tranche B Tranche C

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tranche C in the figure 2.4) in to reduce exposure to prepayment risk. Moreover, the CMO structure also can be used to manage banks’ assets/liabilities. As an example, a Saving & Loan Association (S&L) has a 30 years fixed-rate mortgage financed with liabilities, so it is suggested that an S&L can swap its mortgage for top CMOs tranches with shorter maturities, avoiding problems with mismatching of maturities (Greenbaum and Thakor, 2011).