Understanding the Securitization of Subprime Mortgage Credit

Securitization can be described as the process in which loans are removed from the balance sheet of the lenders and transferred into debt securities purchased by investors. The securitization process is subjected to the following key frictions:

  1. Friction between the mortgagor and the originator: predatory lending
  2. Friction between the originator and the arranger: predatory lending and borrowing
  3. Friction between the arranger and third parties: adverse selection
  4. Friction between the servicer and the mortgagor: moral hazard
  5. Friction between the servicer and third parties: moral hazard
  6. Friction between the asset manager and investors: principal-agent
  7. Friction between the investor and the credit rating agencies: model error

An Overview of Subprime Mortgage Credit

According to The interagency Expanded Guidance for Subprime Lending Programs, a subprime borrower is one who generally displays a range of credit risk characteristics. He or she should have two or more 30-day delinquencies in the past 12 months, foreclosure, repossession or charge-off in the prior 2 years, bankruptcy in the last 5 years, and a relatively high default probability (shown by a credit risk score of 660 and below).

Generally, the immediate concern is the widespread dependency of subprime borrowers on the amount of short-term funding; this leaves them vulnerable to an adverse shift in the supply of subprime credit. In this case, the uncertainty over the ability of the borrower to refinance is the main source of uncertainty about the future performance, and the impact of payment reset on the ability of borrowers to make payments is an important issue facing the subprime credit market as a whole.

How Are Subprime Loans Valued?

The value at which investors are willing to buy or sell credit protection can be influenced by a change in investor’s views on the risk of mortgage loans over time.

Back in 2006, Markit launched a series of indices that track the price of credit default insurance on a standardized bracket of home equity. This approach has five indices which are differentiated by credit rating. Each of the indices is an equal-weighted average of the price of credit insurance at a maturity of 30 years across related tranches.

Overview of Subprime MBS

The following are structural features of a typical subprime designed to protect investors from losses on underlying mortgage loans:

  • Subordination: The distribution of losses on mortgage pool is trenched into different classes. Here, losses on the mortgage loan pool are applied to the most junior class first.
  • Excesses spread: Here, 23 basis points are added to the weighted average coupon on the tranches at origination, which could be LIBOR + 23 basis points. Note that the amount of spread varies from deal to deal.
  • Shifting interest: This requires all principal payments to be applied to senior notes over a given period of time before being paid out to bondholders.
  • Performance triggers: Here, after a lockout, the o/c is released and the principal is applied from the bottom of the capital structure until target levels of subordination are reached.
  • Interest rate swap: A third-party agrees to accept a sequence of fixed payments in return for promising to send a sequence of adjustable-rate payments.

An Overview of Subprime MBS Rating

There are different ways credit rating agencies assign credit rating on tranches of a securitization. Credit rating represents an overall assessment and opinion of an obligator’s creditworthiness meant to reflect on the risk of default. Often times, most credit rating agencies will differ about what is to be assessed.

The Subprime Credit Rating Process

In a typical subprime structure, subordination and excess spread are the sources of credit enhancement. The rating process is split into two:

  1. Estimation of loss distribution
  2. Simulation of cash flows

First, in the rating process, the agency estimates the loss distribution associated with a given pool of collateral. A baseline frequency of foreclosure from historical data is the mean by which the loss of distribution is measured on. Ideally, to stimulate the loss distribution, rating agency estimates the sensitivity of loss to an area’s economic condition.

Conceptual Difference Between Corporate and ABS Credit Rating

While corporate bond rating is largely based on firm-specific risk characteristics, ABS credit rating structure represents claims on cash flow from a portfolio of underlying assets. Subprime ABS rating is the performance of a static pool instead of a dynamic corporation.

While subprime ABS rating relies on quantitative models, corporate debt ratings rely on analyst’s judgment.

ABS rating relies heavily on a forecast of economic conditions, unlike corporate credit rating. Though the volatility of loss can be different across asset classes, ABS credit rating for a given grade should have a similar expected loss to corporate credit rating.

How Through-The-Cycle Rating Could Amplify the Housing Cycle

Distribution of losses on a mortgage is greatly affected by changes in economic conditions, for instance, unemployment rate and home price appreciation have a great effect on the ability to avoid default. Pro-cyclical credit enhancement has the potential to amplify the housing cycle.

Cash Flow Analytics for Excess Spread

Simulating the cash flow to determine the credit excess spread is also an important part of the rating process. Rating agencies measure the credit attribute to excess spread focusing on subprime RBMS using the following inputs:

  1. The timing of the losses
  2. Credit enhancement for given analysis involves
  3. Prepayment rates
  4. Interest rates and index mismatch
  5. Trigger events
  6. Weighted average loan decrease
  7. Prepayment penalties
  8. Pre-funding accounts
  9. Swaps, caps, and other derivatives

Performance Monitoring

Rating agencies currently monitor the performance of lots of pools of mortgage loan collateral. All this performance data is used to identify which deals merit a detailed review. The key performance metric is the loss coverage ratio. In this monitoring, underwriting characteristics are used to estimate losses.

Home Equity ABS Rating Performance

In rating performance, rating actions are measured by following:

  1. The fraction of origination volume affected;
  2. The fraction of tranches affected; and
  3. The fraction of deals affected.

While the data from this may help rating agencies tell a reasonable story, aggregation may find a number of deals that may long be overdue for downgrade.

Fixed-Income Asset Management

The guidelines for fixed-income asset management require that:

  1. The fixed income portfolio has a target of 18% of total fund assets;
  2. The investment grade allocation be managed solely on an active basis to exploit perceived inefficiencies;
  3. The return exceeds the return on the Lehman aggregate index for a period of 3 years; and
  4. The total return of each manager should rank above the median when compared to peers in a group over a 3-year period.

Practice Questions

1) The interagency Expanded Guidance for Subprime Lending Program describes some characteristic that can be used to define subprime borrowers. Which of the following persons should be defined as a subprime borrower?

  1. Xi Yang has had his home repossessed three-and-a-half years ago
  2. Mohammad Hussein only has one 30-day delinquency in the past 12 months
  3. John Raymond has a credit score of 671
  4. Claire Rose has filed for bankruptcy 4 years ago

The correct answer is D.

According to The interagency Expanded Guidance for Subprime Lending Programs, a subprime borrower is one who generally displays a range of credit risk characteristics. He or she should have two or more 30-day delinquencies in the past 12 months, foreclosure, repossession or charge-off in the prior 2 years, bankruptcy in the last 5 years, and a relatively high default probability (shown by a credit risk score of 660 and below).

Therefore, only Claire Rose fits the description, since she has filed for bankruptcy in the last 5 years.


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