SECURITISATION ASSET CLASSES

Theoretically, any asset that has a revenue stream can be transformed through securitisation into a marketable debt security. In practice, the majority of asset-backed securities are collateralised by loans and other financial assets.

7.1 Residential Mortgage-Backed Securities

Residential mortgage loans were the first application of securitisation, and the volume of residential mortgage-backed securities (RMBS) far exceed the total value of any other securitisation application (Kothari, 2003:269). Residential mortgage loans are globally considered to be one of the safest financial claims, as the funding of such claims is backed by a claim over the house in which the borrower resides15_{. Investors in residential mortgage-backed securities are investing in a widely} diversified pool of loans backed by residential property, hence making it a safe investment.

The basic mortgage-backed security structure is the pass-through, which means that the monthly principal and interest payments (less a servicing fee) from a pool of mortgage loans are passed- through to the holders of the security. Thus investors in a pass-through security structure are, in effect, buying shares of the cash flows from the underlying loans. On the other hand, structured mortgage-backed securities, such as collateralised mortgage obligations and stripped mortgage securities, carve up mortgage cash flows in a variety of ways to create securities with given prepayment and maturity profiles (Hayre, 1999:9).

7.1.1 Pass-Through Securities

A mortgage pass-through security is created when one or more mortgage loan originators or holders form a pool of mortgage loans and sell shares or participation certificates in the pool (Fabozzi, 1996:232). The cash flows from a pass-through depend on the cash flows from the underlying mortgages and consist of interest, scheduled repayment of principal, and prepayments of principal. Generally, cash is passed through to security holders each month as it is received. The amounts

passed through, however, are not identical to the amounts received. The pass-through coupon rate is less than the mortgage rate on the underlying pool of mortgage loans by an amount equal to the servicing and guaranteeing fees (Fabozzi, 1996:233). Not all the underlying mortgage loans have the same mortgage rate and the same maturity, and when describing a pass-through, a weighted-average coupon rate (WAC) and a weighted-average maturity (WAM) have to be determined. The WAC is determined by weighting the mortgage rate of each mortgage loan by the amount of the mortgage loan outstanding, while the WAM is calculated by weighting the remaining number of months to maturity for each mortgage loan by the amount of the mortgage loan outstanding (ibid.).

A pass-through is essentially an American product. Fabozzi (1996:233 to 253) describes the three types of pass-throughs, called agency pass-throughs, which are guaranteed by three different agencies, namely the Government National Mortgage Association (Ginnie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and the Federal National Mortgage Association (Fannie Mae). An agency can provide one of two types of guarantees. One is to guarantee the timely payment of both interest and principal, even if some mortgagors fail to make their monthly mortgage payments. Pass-throughs with this type of guarantee are referred to as fully modified pass-throughs. The second type, called modified pass-throughs, also guarantees both interest and principal payments, but only the timely payment of interest is guaranteed. The scheduled principal is passed through as it is collected, with a guarantee that the scheduled payment will be made no later than a specified date.

Ginnie Mae pass-throughs are guaranteed by the full faith and credit of the US government and for this reason, are viewed as risk-free just like Treasury securities. Only mortgage loans insured or guaranteed by the Federal Housing Administration, the Veterans Administration, or the Farmers Home Administration can be included in a mortgage pool guaranteed by Ginnie Mae. Ginnie Mae pass-throughs are all fully modified pass-throughs and are called mortgage-backed securities (MBS).

The second largest type of agency pass-through is the participation certificate (PC) issued by Freddie Mac. Freddie Mac purchases mortgage loans from mortgage originators, and issues PCs backed by these mortgage loans. Although a guarantee by Freddie Mac is not a guarantee by the US government, most market participants view Freddie Mac PCs as similar, though not identical, to Ginnie Mae pass-throughs. Freddie Mac offers both modified pass-throughs and fully modified pass- throughs.

Fannie Mae pass-throughs are similar to Ginnie Mae pass-throughs called MBS, but like a Freddie Mac PC a Ginnie Mae MBS is not an obligation of the US federal government. All Fannie Mae MBSs are fully modified pass-throughs.

Private-label pass-through securities are issued by commercial banks, thrifts16 _{and private conduits.} Private conduits purchase non-conforming mortgage loans, pool them and use them as backing for pass-throughs sold by the conduits. These private-label pass-throughs are similar to agency pass- throughs, but without any guarantees, explicit or implicit, from the US government. The pass- throughs are rated by credit rating agencies. Since these pass-throughs carry no government guarantees, credit enhancement techniques have been key to the success of these securities. External credit enhancement are in the form of third-party guarantees, usually from insurance companies, that provide for first-loss protection against losses up to a specified level, e.g. 10%. A security with external credit enhancement is subject to the credit risk of the third-party guarantor. Should the third-party guarantor be downgraded, the pass-through securities could be subject to downgrade even if the structure is performing as expected. Internal credit enhancements come in the form of excess spread accounts, senior and subordinated structures, and reserve funds.

To value an agency pass-through security it is necessary to project its future cash flow, which may be difficult to predict because of prepayments of principal. Two widely used conventions for projecting prepayments are the Conditional Prepayment Rate (CPR), and the Public Securities Association (PSA) benchmark.

The CPR, which is the annual prepayment rate assumed for a pool of mortgage loans, assumes that some fraction of the remaining principal in the pool is prepaid each month for the remaining term of the mortgage loans. It is based on historical prepayment experience and is conditional on the remaining loan balance. To estimate monthly prepayments, it must be converted to a single-monthly mortality rate (SMM), which is determined by a specific formula17 _{for a given CPR.}

The PSA prepayment benchmark is a market convention of prepayment behaviour, and is expressed as a monthly series of annual prepayment rates. It assumes that prepayment rates are low for newly originated mortgage loans and speeds up as loans become seasoned. The PSA benchmark assumes the following CPRs for 30-year mortgage loans: a CPR of 0.2% for the first month, increased by 0.2%

16 _{Thrifts are savings and loans institutions, and are similar to building societies in other countries.} 17 _{SMM = 1 – (1 – CPR)1/12}

per month for the next 30 months until it reaches 6% per year, and then a 6% CPR for the remaining years. This benchmark, which is referred to as 100% PSA or simply “100 PSA”, can be expressed as follows:

If t ≤ 30: CPR = 6 %(t/30)

If t > 30: CPR = 6%, where t is the number of months since the loan was originated.

Slower or faster speeds are then referred to as some percentage of PSA, e.g. 50 PSA means half the CPR of the PSA benchmark prepayment rate, 300 is three times the CPR of the benchmark prepayment rate, and 0 PSA means that no prepayments are assumed.

The CPR is converted to a monthly prepayment rate using the SMM formula18_.

Using the WAC, WAM and SMM, assuming a certain PSA, a monthly cash flow can be constructed. In agency pass-through securities, the cash flow is not affected by defaults and delinquencies. For private label pass-throughs, however, the effect of defaults and delinquencies must be considered. The PSA Standard Default Assumption (SDA) benchmark gives the annual default rate for a mortgage loan pool as a function of the seasoning of the loans. The PSA SDA benchmark, or 100 SDA, specifies the conditions set out below.

− The default rate in month one is 0.02% and increases by 0.02% per month up to 0.60% in month 30.

− From month 30 to month 60 the default rate remains at 0.60%.

− From month 61 to month 120 the default rate declines from 0.60% to 0.03%.

18_{Example: Assuming a 165 PSA, the SMMs for month 5 and months 31 – 360 are calculated as follows:}

Month 5: CPR = 6%(5/30) = 1% = 0.01 = 1.65(0.01) = 0.0165 SMM = 1 – (1 – 0.0165)1/12 = 0.001386 Month 31 - 360: CPR = 6% = 0.06 = 1.65(0.06) = 0.099 SMM = 1 – (1 – 0.099)1/12 = 0.007828

− From month 121 on the default rate remains constant at 0.03%.

As with the PSA prepayment benchmark, multiples of the benchmark are determined by multiplying the default rate by the assumed multiple. A 0 SDA means that no defaults are assumed.

Mortgage pass-through securities backed by fixed-rate loans are vulnerable to prepayment risk. Suppose an investor buys a 10% fixed coupon Ginnie Mae pass-through at a time when interest rates are 10%. If interest rates now decline to 6% there will be two adverse consequences. Firstly, when interest rates decline, the price of a fixed-rate option-free bond will rise. However, in the case of a pass-through security, the rise in price will not be as considerable as that of a normal bond because a fall in interest rates increases a borrower’s incentive to prepay the mortgage loan and refinance the debt at a lower interest rate. The upside price potential of a pass-through is thus limited because of prepayments, a characteristic that is referred to as negative convexity. The second adverse consequence is that the investor must now reinvest the prepayment cash flow at a lower interest rate. These two adverse consequences are referred to as contraction risk. On the other hand, if interest rates rise, the price of a pass-through will decline like any other bond. However, a pass-through will decline more than a normal bond because the higher interest rates will slow down prepayments, in effect increasing the amount the investor has invested at the coupon rate, which is now lower than the market interest rate. Prepayments will slow down because homeowners will not refinance or prepay their mortgage loans when interest rates are higher than their contract interest rate of 10%. This is, however, just the time that investors want prepayments to speed up so that they can reinvest the prepayments at the higher market interest rates. The adverse consequence of rising interest rates is called extension risk. Prepayment risk thus encompasses contraction risk and extension risk, which make pass-through securities unattractive for some institutional investors.

7.1.2 Collateralised Mortgage Obligations

Collateralised mortgage obligations (CMOs) are bond classes created by redirecting the cash flows from mortgage-related instruments so as to mitigate pre-payment risk. CMOs do not eliminate prepayment risk, but transfer the various forms of prepayment risk to different classes of instruments with varying risk-return characteristics, thereby broadening their appeal. A CMO is a security backed by a pool of pass-throughs or mortgage loans, and is so structured that there are several classes, commonly referred to as tranches, of bonds with varying stated maturities (Fabozzi, 1996:260). The principal payments from the underlying collateral are used to retire the tranches according to the priority of payments specified in the structure. CMOs issued by Ginnie Mae, Freddie Mac and

Fannie Mae are referred to as agency CMOs. A private entity that issues a CMO where the underlying collateral consists of a pool of pass-throughs guaranteed by an agency is called a private- label CMO. If the collateral for the CMO is a pool of unsecuritised mortgage loans, it is called a whole-loan CMO. The various types of CMOs as described by Fabozzi (1996: 260 to 285) are listed below.

7.1.2.1 Sequential-Pay CMOs

The first CMO was created in 1983 and was so structured that each bond tranche would be retired sequentially. The result is that the tranches have average lives that are different from that of the collateral; the senior tranches that are paid off first have shorter average lives, and the junior tranches have longer average lives. By prioritising the distribution of principal to the senior short-term tranche, a CMO is protected from extension risk. The protection comes from the longer-term junior tranches. At the same time the short-term tranche protects the longer-term tranches against contraction risk.

7.1.2.2 Accrual Bonds

In many sequential-pay CMO structures, at least one tranche does not receive current interest. Instead, the interest for that tranche would accrue and be added to the principal balance of that tranche. Such a tranche is called an accrual tranche or Z bond because it is similar to a zero-coupon bond. The interest that would have been paid on the accrual tranche is then used to speed up the repayment of the principal balance on the other tranches higher up in the payment waterfall. Thus the inclusion of a Z bond in the structure creates shorter-term tranches and a longer-term tranche, the Z bond itself. Since in a Z bond there are no coupons to reinvest, reinvestment risk is eliminated until the other tranches are paid off, and accrual bonds are therefore attractive to investors who are concerned with reinvestment risk.

7.1.2.3 Planned Amortisation Class Bonds

Investors’ requirements for CMOs with the characteristics of a corporate bond, namely either a bullet maturity or a sinking fund type schedule of principal repayment, have led to the development of planned amortisation class (PAC) bonds. In a PAC bond the cash flow pattern is known, provided prepayments are within a specified range of PSA speeds. The greater predictability of cash flows from PAC bonds occurs because PAC bondholders have priority over all other classes in receiving

principal payments from the underlying collateral. The greater certainty of the cash flow for the PAC bonds comes at the expense of the non-PAC classes, called support or companion bonds, which absorb the prepayment risk. Because PAC bonds have protection against both extension risk and contraction risk, they are said to provide two-sided prepayment protection.

7.1.2.4 Targeted Amortisation Class Bonds

A targeted amortisation (TAC) class bond resembles a PAC bond in that it also has a schedule of principal repayment. The difference between a PAC bond and a TAC bond, however, is that the PAC bond has a wide PSA range over which repayment of principal is protected against contraction risk and extension risk. A TAC bond, by contrast, has a single PSA rate from which principal repayment is protected, and as a result the prepayment protection afforded to a TAC bond is less than that for a PAC bond. The creation of a bond with a schedule of principal repayments based on a single PSA rate results in protection against contraction risk, but not extension risk. Thus, while PAC bonds have two-sided prepayment protection, TAC bonds only have one-sided prepayment protection. TAC bonds are therefore acceptable to investors who are more concerned about contraction risk than extension risk. Conversely, some investors are more concerned with extension risk and are willing to take contraction risk. Reverse TAC bonds have been created to provide such protection instead.

7.1.2.5 Very Accurately Determined Maturity Bonds

Guaranteed final maturity or very accurately determined maturity (VADM) bonds use accrual or Z bonds as their support. They are created by using the interest accruing on the companion Z bond to pay interest and principal on the VADM bond. This effectively provides protection against extension risk even if prepayments slow down, since the interest accruing on the Z bond will be sufficient to make scheduled interest and principal repayments on the VADM bond. The maximum final maturity of the VADM bond can therefore be determined with a high degree of certainty. However, if prepayments are high, resulting in the supporting Z bond tranche being paid off faster, a VADM bond’s term can shorten.

7.1.2.6 Support Bonds

Support bonds are the bonds that provide prepayment protection for the PAC tranches, and

as a sequential-pay bond, an accrual bond, or even portioned into a PAC bond with its own support bond. In a structure with a PAC bond and a support bond with a PAC schedule of principal repayments, the former is called a PAC I bond and the latter a PAC II bond.

7.1.2.7 Notional Interest-Only Bonds

In earlier CMO transactions, all of the excess interest between the interest received on the underlying collateral and the coupon interest on the bond tranches was paid to an equity class referred to as the CMO residual. However, this is no longer the practice, and instead, a tranche is created that receives the excess interest, called a notional interest-only (IO) tranche. An IO tranche has no par amount. Its notional amount is the amount on which the interest payments are calculated, not the amount that will be paid out to the holder of the bond. Mathematically, the notional amount is found in terms of a formula19_.

7.1.2.8 Stripped Mortgage-Backed Securities

Stripped mortgage-backed securities were introduced by Fannie Mae in 1986. Unlike a pass-through that divides the cash flow from the underlying pool of mortgages on a pro rata basis across bondholders, a stripped mortgage-backed security has an unequal distribution of principal and interest. The three types of stripped mortgage-backed securities (synthetic-coupon pass-throughs, interest-only strips and principal-only strips) are described in the section below.

7.1.2.8.1 Synthetic-Coupon Pass-Throughs

The first generation of stripped mortgage-backed securities was called synthetic-coupon pass- throughs because of the unequal distribution of coupon and principal results in a synthetic coupon rate that is different from the interest on the underlying collateral.

19_{Assume a tranche B of R194 million and a coupon rate of 6%. The interest on the underlying loans is 7.5% so that the}

excess interest is 1.5%. An IO with an interest coupon of 1.5% and a notional amount of R194 million can thus be created, which is equivalent to an IO with a 7.5% coupon and a notional amount of R38,8 million. Notional amount for r % IO = (tranche’s par value x excess interest)/r %. In this example an IO tranche with a 10% coupon would result in: Notional amount for 10% IO = (194,000,000 x 1,5%)/10% = R29,100,000

7.1.2.8.2 Interest-Only/Principal-Only Strips

In the case of these securities all the interest is allocated to the interest-only (IO) class, which has no par value, and all principal to the principal-only (PO) class, which has no interest coupon. The PO bond is purchased at a substantial discount to par value. The yield a bondholder will realise depends on the speed at which prepayments are made. The more frequent the prepayments, the higher the yield the bondholder will realise20_.

Since pre-payments are determined by changes in the market interest rate, the price of a PO will change as interest rates change. When interest rates decline, prepayments speed up, accelerating principal repayments to the PO holder. This cash flow will be discounted at the now lower market interest rate. The result is that the price of a PO will increase when interest rates decline. On the other hand, if interest rates increase, prepayments will slow down and it will take longer to recover principal repayments. Coupled with a now higher discount rate, the price of a PO will fall when