Mortgage-Backed Sector of the Bond market 1
Overview of Mortgage-Backed Securities • Securities backed by a pool of loans or receivables. • Residential mortgage-backed securities, commercial mortgagebacked securities, asset-backed securities • Agency mortgage-backed securities, nonagency mortgagebacked securities. 2
Overview of Mortgage-Backed Securities (Continued) • MBS: securities backed by residential mortgage loans • MBS include (1) mortgage passthrough securities (2) collateralized mortgage obligations (CMO) (3) stripped mortgage-backed securities • In the United States, the MBSs are divided into two sectors: (1) those issued by federal agencies (agency MBS) (2) those issued by private entities (nonagency MBS) • CMBS: securities backed by commercial loans • ABS: securities backed by loans other than traditional residential mortgage loans, or commercial mortgage loans and backed by receivables 3
Agency vs. Nonagency • In the United States, the three major types of passthrough securities are guaranteed by agencies. (Ginnie Mae, Freddie Mac, and Fannie Mae) • Credit risk does not exist for agency mortgage-backed securities issued by a federally related institution. (Ginnie Mae) • Credit risk is viewed as minimal for securities issued b government sponsored enterprises. (Freddie Mac and Fannie Mae) • In order for a loan to be included in a pool of loans backing an agency security, it must meet specified underwriting standards, and is called a conforming mortgage. 4
Nonagency • Jumbo Prime: Loans carrying agency credit and meeting all other agency credit criteria except size are referred to as jumbo prime loans. (Often they are referred to as either “jumbo” or “prime”). • A subprime: Subprime loans are a type of loan granted to individuals with poor credit histories (often below 600), who, as a result of their deficient credit ratings, would not be able to qualify for conventional mortgages. • An Alt-A: The short for Alternative A-paper, is a type of U. S. mortgage that, for various reasons, is considered riskier than "prime", and less risky than “subprime“. 5
Outstanding Mortgage Securities Year 1 -4 Mtg Agency Outstanding Nonagency %Agency %Nonagency MBS as % of 1 -4 Mtg 2000 5, 126, 531 2, 625, 453 385, 501 87 13 59 2001 5, 677, 996 2, 974, 531 463, 217 87 13 61 2002 6, 436, 575 3, 312, 600 544, 055 86 14 60 2003 7, 226, 763 3, 394, 021 664, 005 84 16 56 2004 8, 284, 980 3, 467, 453 1, 049, 767 77 23 55 2005 9, 323, 217 3, 607, 949 1, 536, 627 70 30 55 2006 10, 359, 047 3, 904, 911 1, 991, 459 66 34 57 2007 -Q 2 10, 749, 703 4, 148, 691 2, 120, 175 66 34 58 6
Out of the 34% Nonagency Alt-A 13% Jumbo Prime 8% Subprime 13% 7
The Different Characteristics between Agency and Nonagency • • • loan size average FICO score average LTV and CLTV occupancy (owner versus investor) documentation (full versus nonfull) loan purpose (purchase, cash-out refi, or rate refi) the percent in adjustable rate mortgages the IO percent debt-to-income (DTI) ratio. 8
Loan Characteristics • loan size - Smaller loans are less prepayment-sensitive than loans with larger balances. - Smaller loans also tend to have higher losses than larger loans, reflecting the higher fixed costs of liquidation. • average FICO score - FICO scores are tabulated by an independent credit bureaus, using a model created by Fair Isaac Corporation (FISO). - These scores range from 350 to 900, with higher scores denoting lower risk. • average LTV and CLTV - The loan-to-value (LTV) ration refers to the loan amount divided by the value of a home. The CLTV ration is the sum of the first and second mortgages divided by the home’s value. - Loans with higher CLTV ratios have higher delinquencies and higher loss severities. 9
Loan Characteristics • Occupancy - Loans with a higher percentage of investor properties tend to default more often, and they also experience higher loss severities when they default. - Investor properties also tend to have somewhat more stable prepayment profiles. - It is widely believed that many investors stated that their properties were owneroccupied, when in fact they were not, causing an underestimate of investor share. • Documentation - Full documentation generally involves the verification of income and assets. - With limited documentation, either income or assets are not verified. - Limited documentation loans tend to have higher default rates than full documentation loans. - However, from 2004 -2006, documentation standards were relaxed considerably, without requiring any type of compensating factors. 10
Loan Characteristics • loan purpose - Historically, loan purpose has not been that important in determining either default or prepayment behavior. - However, in the 2004 -2006 period, purchase loans had much more risk layering than did either refi or cash-out refis. • the percent in adjustable rate mortgages - The standard adjustable rate mortgage (ARM) is fixed for a period of time, and floats thereafter. - Borrowers taking out ARMs are generally looking to lower their monthly payment. - ARM borrowers generally have more risk layering than their fixed rate counterparts, and hence have higher defaults. - ARM borrowers have historically prepaid faster than their fixed rate counterparts. 11
Loan Characteristics. • the IO percent - Interest-only mortgages are mortgages in which the borrower does not pay principal for a period of time. - Borrowers taking out interest-only mortgages or 40 -year mortgages tend to have higher defaults than those who use conventional 30 -year mortgages. - Prepayment behavior on interest-only mortgages tends to be fairly similar to that on amortizing mortgages. • debt-to-income (DTI) ratio. - DTI is used as a measure of their ability to repay it. 12
Roots of the 2007 – 2009 subprime crisis • The decline in agency issuance during 2004 – 2006, mirrored by a rise in subprime and Alt-A issuance, reflected the drop in housing affordability during this period. In order to maintain market share, originators began to relax origination standards. Combined loan-to-value (CLTVs) rose, the interest-only share rose, and documentation dropped. - A rise in interest rates from mid - 2003 through 2006. - The large run-up in home price appreciation during 2003 – 2005. - As a result, housing affordability dropped sharply. • The relaxation in origination standards was fine as long home prices were appreciating. When a borrower ran into difficulty, selling the home at a profit was a much better option than defaulting. However, in mid-2006 housing began to weaken. Existing home sales fell; home prices were stagnant and then began to decline. 13
Loan and Borrower Characteristics by Product Type Agency Lien Jumbo Prime Alt-A Subprime 1 st 1 st <= Agency > Agency None Average Loan Sice 221, 301 509, 013 293, 719 185, 451 Credit Agency A A/A- A-/C Average FICO 725 739 712 628 Average LTV 71 69 74 81 - 71 75 86 Occupancy 9 owner) 96% 99% 85% 95% Full documentation - 50% 23% 60% Purchase 39% 46% 40% Cash out 59% 23% 36% 53% 30% 18% 7% 9% 45% 43% 20% 12% 52% 63% 73% - 33% 36% 41% Loan Limit Average CLTV Loan purpose Rate refi IO ARMs DTI 14
Characteristics of Residential Mortgages • A fixed-rate, level-payment, fully amortized mortgage. • The mortgage rate is fixed. • The dollar amount of each monthly payments is the same for the life of the mortgage loan. • When the last scheduled monthly mortgage payment is made the remaining mortgage balance is zero. 15
An Example of fixed-rate, level-payment, fully amortized mortgage • • Mortgage loan: $100, 000 Monthly payment: $742. 50 Mortgage rate: 8. 125% Term of loans: 30 years (360 months) 16
Month Balance (Beginning ) Mortgage Payment Interest Scheduled Repayment Balance (End) 1 $100, 000. 00 742. 50 677. 08 65. 41 $99, 934. 59 2 99, 934. 59 742. 50 676. 64 65. 86 99. 868. 73 3 99. 868. 73 742. 50 676. 19 66. 30 99, 802. 43 4 99, 802. 43 742. 50 675. 73 66. 75 99, 735. 68 … … … 358 2, 197. 66 742. 50 14. 88 727. 62 1, 470. 05 359 1, 470. 05 742. 50 9. 95 732. 54 737. 50 360 737. 70 742. 50 4. 99 737. 50 0. 00 17
The Process of Securitization 18
Cash Flow Characteristics of Passthrough • The cash flow of a mortgage pasthrough security depends on the cash flow of the underlying pool of mortgages. • Payments are made to security holders each month. • The monthly cash flow for a passthrough is less than the monthly cash flow of the underlying pool of mortgages by the amount equal to servicing and other fees. • A passthrough is described by a weighted average coupon rate (WAC) and a weighted average maturity (WAM). 19
An Example of WAC and WAM Loan Outstanding Mortgage Balance Weight in Pool Mortgage Rate Months Remaining 1 $125, 000 22. 12% 7. 50% 275 2 $85, 000 15. 04% 7. 20% 260 3 $175, 000 30. 97% 7. 00% 290 4 $110, 000 19. 47% 7. 80% 285 5 $70, 000 12. 39% 6. 90% 270 Total $565, 000 100. 00% 7. 28% 279 20
WAC and WAM • WAC: 0. 2212 * 7. 5% + 0. 1504 * 7. 20% + 0. 3097 * 7. 00% + 0. 1947 * 7. 80% + 0. 1239 * 6. 90% = 7. 28% • WAM 0. 2212 * 275+ 0. 1504 * 260+ 0. 3097 * 290 + 0. 1947 * 285 + 0. 1239 * 270 = 279 months 21
Prepayment Risk • A payment made in excess of the monthly mortgage payment is called a prepayment. • Most of residential mortgages have no prepayment penalty. • The effect of prepayments is that the amount and timing of the cash flow from a mortgage loan are not known with certainty. • There are ways to redistribute prepayment risk among the different bond classes created. 22
Measuring the Prepayment Rate • Single Monthly Mortality Rate (SMM) Given the prepayment for a month for a mortgage pool, an investor can calculate the SMM. • Conditional Prepayment Rate Given an assumed SMM, an investor will use it to project the prepayment for a month. The prepayment for a month will then be used to determine the cash flow of a mortgage pool for the month. • PSA Prepayment Benchmark 23
Single Monthly Mortality Rate (SMM) • = Prepayment in month t / (Beginning mortgage balance for month t – Scheduled principal payment in month t ) • Assume the following: Beginning mortgage balance in month 33 = $358, 326, 766 Scheduled principal payment in month 33 = $297, 835 Prepayment in month 33 = $1, 841, 347 / ($358, 326, 766 - $297, 835) = 0. 5143% It is interpreted as follows: In month 33, 0. 5143% of the outstanding mortgage available to prepay in month 33 prepaid. 24
Conditional Prepayment Rate • Market participants prefer to talk about prepayment rates on an annual basis rather than a monthly basis. • Given the SMM for a given month, the CPR can be calculated to be • Given a CPR, the corresponding SMM can be computed as follows: 25
PSA Prepayment Benchmark • The model is designed by the Public Securities Association (PSA), later renamed the Bond Market Association, in early 1980 s. • The PSA benchmark assumes that prepayment rates are low for newly originated mortgages and then will speed up as the mortgages become seasoned. • “ 100% PSA” or simply “ 100 PSA” can be expressed as follows: if t < 30 then CPR = 6%*(t/30) if t >= 30 then CPR = 6% • Slower or faster speeds are then referred to as some percentage of PSA. For example, “ 50 PSA”, “ 200 PSA”. 26
An Example of PSA Benchmark--the SMMs for month 5 • Assuming 100 PSA CPR = 6% * (5/30) = 1% • Assuming 165 PSA CPR = 1%, 165 PSA = 1. 65 * 1% = 0. 0165 27
An Example of PSA Benchmark--the SMMs for month 31 • Assuming 100 PSA CPR = 6% • Assuming 165 PSA CPR = 6%, 165 PSA = 1. 65 * 6% = 9. 9% 28
Example: Monthly Cash Flow with Prepayments Assume - $400 million Passthrough with - 7. 5% passthrough rate - A WAC of 8. 125% - A WAM of 357 months (the loans are seasoned an average of 3 months) - 100 PSA 29
Months from Now (1) Months Seasone d (2) Outstanding. Balance (3) SMM (4) Mortgage Net Interest Scheduled Prepaym Payment(5) (6) Principal ent (8) (7) Cash Flow (9) 1 4 $400, 000 0. 00067 $2, 975, 868 $2, 500, 000 $267, 535 $267, 470 3, 035, 005 2 5 399, 464, 995 0. 00084 2, 973, 877 2, 496, 656 269, 166 334, 198 3, 100, 020 3 6 398, 861, 631 0. 00101 2, 971, 387 2, 492, 688 270, 762 400, 800 3, 164, 447 --- --- --- 356 359 1, 004, 191 0. 00514 507, 201 6, 276 500, 401 2, 591 509, 269 357 360 501, 199 0. 00514 504, 592 3, 132 501, 199 0 504, 331 30
Illustration (cash flow in month 1) • Column 4: SMM CPR = 6% (4/30) = 0. 8%, SMM = 0. 000669 • • Column 5: the total monthly mortgage payment, which is declining as prepayments reduce the balance outstanding. Column 6: the net monthly interest outstanding balance (beginning) * passthrough rate * (1/12) = $400, 000 * 7. 5% * (1/12) = $2, 500, 000 • Column 7: the scheduled principal repayment total monthly mortgage – outstanding balance (beginning) * 8. 125% * (1/12) = $2, 975, 868 - $400, 000 * 8. 125% * *1/12) = $267, 535 • Column 8: the prepayment for the month [outstanding balance (beginning) – scheduled principal repayment] * SMM = ($400, 000 - $267, 535) * 0. 00066912 = $267, 470 • Column 9: the projected monthly cash flow monthly interest + scheduled principal repayment + prepayment = $2, 500, 000 + $267, 535 + $256, 470 = $3, 035, 005 31
Cash Flow Yield • The cash flow yield is the discount rate which equates the sum of the present values of expected cash flows to the market price. : the expected cash flow at time t y: the cash flow yield 32
Average Life • Average life = • The average life of a passthrough depends on the prepayment assumption. • The higher (lower) the speed, the shorter (longer) the average life. 33
Factors Affecting Prepayment Behavior • Prevailing mortgage rate - The spread between the prevailing mortgage rate in the market and the paid by the homeowner affects the incentive to refinance. rate - The path of mortgage rates also affect prepayments. • Housing turnover - Without interest rate changes, there is a normal amount of housing turnover. - The housing turnover is higher (lower) in a growing (weak) economy. • Characteristics of the underlying residential mortgage loans - the amount of seasoning - the geographical location 34
Contraction Risk and Extension Risk • Prepayment risk encompasses contraction risk and extension risk. • Contraction risk: (when mortgage rates decline) - Prepayment will speed up. - The reinvestment risk becomes higher. - The price is compressed. (The price will increase less than the option-free bonds. ) - There is a decline in the average life (shortening). • Extension risk: (when mortgage rates increase) - Prepayment will slow down. - Less cash flows than expected to reinvest at the higher interest rates. - The price will decrease more than the option-free bonds. - There is an increase in the average life (lengthening). 35
Collateralized Mortgage Obligations • There is prepayment risk associated with investing in a mortgage passthrough security. • Some institutional investors are concerned with extension risk and others with contraction risk. • This problem can be mitigated by redirecting the cash flows of mortgage-related products to different bond classes, called tranches. • When the cash flows of mortgage-related products are redistributed to different bond classes, the resulting securities are called collateralized mortgage obligations (CMO). • There is a wide range of CMO structures. 36
Sequential-Pay Tranches F 01 Payment rules: 1. For payment of monthly coupon interest Disburse monthly coupon interest to each tranche on the basis of the amount of principal outstanding for each tranche at the beginning of the month. 2. For disbursement of principal payments Disburse principal payments to tranche A until it is complete paid off. After tranche A is completely paid off, disburse principal payments to tranche B, and so on. 37
A Hypothetical 4 -Tranches Sequential-Pay Structures F 01 Tranche Par Amount ($) Coupon Rate (%) A 194, 500, 000 7. 5 B 36, 000 7. 5 C 96, 500, 000 7. 5 D 73, 000 7. 5 Total 400, 000 38
Average Life for F 01 Average Life for Speed (SPA) Collateral Tranche A Tranche B Tranche C Tranche D 50 15. 11 7. 48 15. 98 21. 02 27. 24 100 11. 66 4. 90 10. 86 15. 78 24. 58 200 7. 68 3. 05 6. 42 9. 60 18. 11 400 4. 44 1. 94 3. 70 5. 31 10. 34 600 3. 16 1. 51 2. 74 3. 75 6. 96 39
Prepayment Risk for F 01 • Tranche A exposes to contraction risk. • Tranche D exposes to extension risk. 40
Sequential-Pay with an Accrual Tranches F 02 Payment rules: 1. For payment of monthly coupon interest Disburse monthly coupon interest to tranche A, B, and C on the basis of the amount of principal outstanding for each tranche at the beginning of the month. For tranche Z, accrue the interest based on the principal plus accured interest in the previous month. The interest for tranche Z is to be paid to the earlier tranches as a principal paydown. 2. For disbursement of principal payments Disburse principal payments to tranche A until it is complete paid off. After tranche A is completely paid off, disburse principal payments to tranche B, and then disburse trahcne C. After trnache C is completely paid off, disburse principal payments to tranche Z. 41
A Hypothetical 4 -Tranches Sequential-Pay with an Accrual Structures F 02 Tranche Par Amount ($) Coupon Rate (%) A 194, 500, 000 7. 5 B 36, 000 7. 5 C 96, 500, 000 7. 5 Z (Accrual) 73, 000 7. 5 Total 400, 000 42
Average Life for F 91 and F 02 at 165 PSA Structure Tranche A Tranche B Tranche C F 02 2. 90 5. 80 7. 87 F 01 3. 48 7. 49 11. 19 43
5 -Tranche Sequential-Pay Structure with Floater, Inverse Floater, and Accrual Bond Tranches F 03 Payment rules: 1. For payment of monthly coupon interest Disburse monthly coupon interest to tranche A, B, FL and IFL on the basis of the amount of principal outstanding for each tranche at the beginning of the month. For tranche Z, accrue the interest based on the principal plus accured interest in the previous month. The interest for tranche Z is to be paid to the earlier tranches as a principal paydown. The maximum coupon rate for FL is 10%; the minimum coupon rate for IFL is 0%. 2. For disbursement of principal payments Disburse principal payments to tranche A until it is complete paid off. After tranche A is completely paid off, disburse principal payments to tranche B, and then disburse trahcnes FL and IFL. After trnache I FL and IFL are completely paid off, disburse principal payments to tranche Z. 44
5 -Tranche Sequential-Pay Structure with Floater, Inverse Floater, and Accrual Bond Tranches F 03 Tranche Par Amount ($) Coupon Rate (%) A 194, 500, 000 7. 5 B 36, 000 7. 5 FL 72, 375, 999 1 -mon LIBOR +0. 5 IFL 24, 125, 000 Z (Accrual) 73, 000 28. 5 – 3 * (1 -mon LIBOR) 7. 5 Total 400, 000 45
FL and IFL • Trahcne C: 96, 500, 000 (coupon rate 7. 5%) – FL: 72, 375, 000 (75%) – IFL: 24, 125, 000 (25%) • IFL cannot be negative. Thus the minimum rate for IFL is 0%. K – L * (1 -mon LIBOR) = 0% - 1 -mon LIBOR = K/L=28. 5/3 = 9. 5% - the maximum of FL is 9. 5% +0. 5% = 10% • The maximum rate for IFL is K = 28. 5%, when 1 -mon LIBOR = 0%. The minimum rate for FL is therefore 0. 5%. 46
A 5 -Tranche Sequential Pay with an Accrual , an Interest-Only, and a Residual Class F 04 • • CMO structures can be created so that a tranche receives only interest. Interest only (IO) tranches in a CMO ctructure are referred to as structured IOs. It is the excess interest that is used to create one or more structured IOs. Excess interest = Collateral tranche’s coupon rate – Tranche coupon rate For example, for tranche A: Excess interest = 7. 5% - 6% = 1. 5% Tranche’s par value = $194, 500, 000 Notional amount for 7. 5% IO = (Original tranche’s par value * Excess interest) / 0. 075 = ($194, 500, 000 * 0. 015) / 0. 075 = $38, 900, 000 47
A 5 -Tranche Sequential Pay with an Accrual , an Interest-Only, and a Residual Class F 04 Payment rules: 1. For payment of monthly coupon interest Disburse monthly coupon interest to tranche A, B, and C on the basis of the amount of principal outstanding for each tranche at the beginning of the month. For tranche Z, accrue the interest based on the principal plus accured interest in the previous month. The interest for tranche Z is to be paid to the earlier tranches as a principal paydown. Disburse periodic interest to the IO tranche based on the notional amount for all tranches at the beginning of the month. The maximum coupon rate for FL is 10%; the minimum coupon rate for IFL is 0%. 2. For disbursement of principal payments 3. Disburse principal payments to tranche A until it is complete paid off. After tranche A is completely paid off, disburse principal payments to tranche B, and then disburse trahcnes C. After trnache C are completely paid off, disburse principal payments to tranche Z. No principal is to be paid to the IO tranche. 48
A 5 -Tranche Sequential Pay with an Accrual , an Interest-Only, and a Residual Class F 04 Tranche Par Amount ($) Coupon Rate (%) A 194, 500, 000 6. 00 B 36, 000 6. 50 C 96, 500, 000 7. 00 Z 73, 000 7. 25 IO 52, 566, 667 (Notional) 400, 000 7. 50 Total 49
Creating a Notional IO Tranche Par Amount Excess Interest (%) Notional Amount for a 7. 5% IO A 194, 500, 000 1. 50 $38, 900, 000 B 36, 000 1. 00 4, 800, 000 C 96, 500, 000 0. 50 6, 433, 333 Z 73, 000 0. 25 2, 433, 333 Notional amount for 7. 5% IO = $52, 566, 667 50
Planned Amortization Class Tranches (PAC) • If the prepayment speed is within a specified band over the collateral’s life, the cash flow pattern is known. • The greater certainty of the cash flow for the PAC bonds comes at the expense of the non-PAC tranches, called the support tranches or companion tranches. • PAC tranches have protection against both extension risk and contraction risk, they are said to provide two-sided prepayment protection. 51
CMO Structure with One PAC Tranche and one Support Trance F 05 Payment rules: 1. For payment of monthly coupon interest Disburse monthly coupon interest to each tranche. 2. For disbursement of principal payments - Disburse principal payments to tranche P. - Any excess principal payments in a month over the amount necessary to ssatisfy the schedule for tranche P are paid to tranche S. - When tranche S is completely paid off, all principal payments are to be made to tranche P regardless of the schedule. 52
CMO Structure with One PAC Tranche and one Support Trance F 05 Tranche Par Amount Coupon Rate P (PAC) 243, 800, 000 7. 5 S (Support) 156, 200, 000 7. 5 Total 400, 000 53
PAC Assuming 90 PSA and 300 PSA Month At 90 PSA At 300 PSA Minimum Principal Payment Available to PAC 1 508, 169 1, 073, 931 508, 169 2 569, 843 1, 279, 412 569, 843 3 631, 377 1, 482, 194 631, 377 --- --- 211 949, 482 213, 309 212 946, 933 209, 409 --- --- 54
Average Life for PAC F 05 Prepayment Rate (PSA) PAC Bond Support Bond 0 15. 97 27. 26 50 9. 44 24. 00 90 7. 26 20. 06 100 7. 26 18. 56 200 7. 26 8. 38 250 7. 26 5. 37 300 7. 26 3. 13 350 6. 56 2. 51 400 5. 92 2. 17 500 4. 93 1. 77 55
Stripped Mortgage-Backed Securities • There are only two bond classes, one bond class receives all of the principal and one bond class receives all of the interest. • The bond class that receives all of the principal is called the principal-only class or PO class. • The bond class that receives all of the interest is called the interest-only class or IO class. 56
Principal-Only Strips • The PO security is purchased at a substantial discount from par value. • The yield an investor will realize depends on the speed at which prepayments are made. • The faster the prepayments, the higher the yield the investor will realize. • The price of a PO will increase when mortgage rates decline. (Cash flows improve and are discounted at a lower interest rate. ) 57
Interest-Only Strips • When an IO is purchased there is no par vale. • The IO suffers from a fast prepayment. • If mortgage rates decline below the coupon rate, prepayments are expected to accelerate, which leads to a deterioration of the expected cash flow for an IO. However, the cash flow will be discounted at a lower rate. • The net effect may be either a rise or a fall for the IO. 58
Commercial Mortgage-Backed Securities (CMBSs) • Commercial mortgage-backed securities are backed by a pool of commercial mortgage loans on income-producing property. • These properties include: multifamily properties, office buildings, industrial properties, shopping centers, hotels, health care facilities etc. 59
Credit Risk of CMBSs • Unlike residential mortgage loans, commercial mortgage loans are nonrecourse loans. • “Non-recourse loans” means that the lender can only look to the incomeproducing property backing the loan for interest and principal repayment, and has no recourse to the borrower for any unpaid balance. • Two indicators of potential credit performance are the debt-to-service coverage ratio and the loan-to-value ratio. • The debt-to-service coverage ratio is the ratio of a property’s net operating income divided by the debt service. • Credit analysis be performed on a loan-by-loan basis not only at the time of issuance, but monitored on an ongoing basis. 60
Basic CMBS Structure • A rating agency will determine the necessary level of credit enhancement to achieve a desired rating level. • The rating agencies will require that the CMBS transaction be retired sequentially, with the highest-rated bonds paying off first. • Losses arising from loan defaults will be charged against the principal balance of the lowest-rated CMBS. 61
Call Protection • A critical investment feature that distinguishes residential MBS and commercial MBS is the call protection afforded an investor. • An investor in a residential MBS is exposed to considerable prepayment risk because the borrower has the right to prepay a loan without any penalty. • With CMBS, there considerable call protection afforded investors. This protection makes CMBS trading in the market more like corporate bonds than residential MBS. • Call protection comes in two forms : (1) call protection at the loan level and (2) call protection at the structure level. 62
Protection at the Loan Level • At the commercial loan level, call protection can take the following forms: 1. prepayment lockout 2. defeasance The borrow provides sufficient funds for the servicer to invest in a portfolio of Treasury securities that replicates the cash flows that would exist in the absence of prepayments. 3. prepayment penalty points 4. yield maintenance charges It is designed to make it uneconomical to refinance solely to get a lower mortgage rate. 63
Structural Protection • Because the CMBS bond structures are sequential-pay (by rating), the AA-rated tranche cannot pay down until the AAA is completely retired, and the AA-rated bonds must be paid off before the A-rated bonds, and so on. 64
Balloon Maturity Provisions • Many commercial loans backing CMBS transactions are balloon loans that require substantial principal payment at the end of the term of the loan. • If the borrower fails to make the balloon payment, the lender may extend the loan, and in so doing may modify the original loan terms. This is called balloon risk. • The balloon risk is a type of “extension risk. ” 65
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