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Understanding the Securitization of Subprime Mortgage Credit

Understanding the Securitization of Subprime Mortgage Credit

After completing this reading, you should be able to:

  • Explain the subprime mortgage credit securitization process in the United States.
  • Identify and describe key frictions in subprime mortgage securitization and assess the relative contribution of each factor to the subprime mortgage problems.
  • Compare predatory lending and borrowing.

Key Frictions in Subprime Mortgage Securitization

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

Friction between the Mortgagor and the Originator

The typical subprime borrower is not financially sophisticated and may lack the financial skills to analyze all the borrowing alternatives tabled by a lender. As such, a lender may “make the most” out of the situation and steer the borrower toward products that do not suit them.

Friction between the Originator and the Issuer

The issuer purchases the underlying pool of assets from the originator with the sole purpose of selling them as securitized assets. Although they will exercise due diligence, the issuer will still not be privy to some crucial information about the borrower. The originator may, for example, paint an overly positive financial condition of the borrower.

Friction between the Issuer and Third Parties

The issuer possesses better information about the borrower than a host of third parties including rating agencies, underwriters, and servicers. As such, the issuer may keep higher credit quality notes to themselves while securitizing lower quality notes (lemons).

Friction between the Servicer and the Mortgagor

Servicers are actively involved in the collection of interest and principal from the underlying portfolio. Besides, they are also charged with making key decisions on delinquent loans. For such loans, the mortgagor may no longer have an incentive to maintain a property or keep tax and home insurance payments up-to-date.

Friction between the Asset Manager and Investors

Due to the complexity of the securitization process, an investor may hire an asset manager to identify the best investments that are in line with the investor’s goals. However, because the investor is financially unsophisticated and may not comprehend the investment strategy itself, they may be unable to assess the manager’s effort objectively and informatively.

Friction between the Investor and the Credit Rating Agencies

The fact that rating agencies are compensated by the originators means that they have an incentive not to act in the best interest of an investor. They may be tempted to provide a favorable rating even when there are serious issues regarding the credit quality of the structure as doing so may help “keep the client.”

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 2 years preceding the transaction, 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 a borrower to refinance is the main source of uncertainty about future performance. The impact of payment reset on the ability of borrowers to make payments is, indeed, an important issue facing the subprime credit market as a whole.

Subprime MBS Rating

There are different ways credit rating agencies assign credit ratings on tranches of securitization. The credit rating represents an overall assessment and opinion of an obligator’s creditworthiness meant to project the risk of default. Oftentimes, most credit rating agencies will differ on 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. Ideally, to stimulate the loss distribution, the rating agency estimates the sensitivity of loss to an area’s economic condition.

Conceptual Differences between Corporate and ABS Credit Ratings

While the 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 the 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

The 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 a 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 the deals which 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 the following:

  1. The fraction of origination volume affected.
  2. The fraction of tranches affected.
  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.

Predatory Lending and Borrowing

Predatory lending is any lending practice that results in unfair or abusive loan terms on a borrower. A lender, in this instance, employs deceptive, coercive, exploitative, or unscrupulous actions that leave a borrower with no choice but to accept the unfair terms of the loan. The borrower, consequently, ends up with a loan they don’t need, don’t want, or one they cannot afford.

Predatory borrowing is any attempt by a borrower to extract unfair terms of a loan, often through misrepresentation in mortgage application and deceit at some point during the appraisal process. Attempts to give inaccurate information may be motivated by expectations that housing prices will keep going up and, therefore, the value of their house will always exceed the size of their debt, paving the way for favorable refinancing.

Practice Question

The Interagency Expanded Guidance for Subprime Lending Program describes some characteristics that can be used to define subprime borrowers. Which of the following applicants should be defined as a subprime borrower?

A. Xi Yang’s home was repossessed three-and-a-half years ago.

B. Mohammad Hussein only has one 30-day delinquency in the past 12 months.

C. John Raymond has a credit score of 671.

D. Claire Rose 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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