Reading 65

A defining characteristic of mortgage-backed securities (MBSs) is prepayment risk. Prepayments are principal repayments by mortgage borrowers in excess of the scheduled principal repayments on amortizing loans. In any pool of mortgages, some borrowers are likely to prepay—typically because they sell their homes or refinance their mortgages.

MBS valuation is based on an assumed prepayment rate for the underlying mortgages. Prepayment risk is the risk that realized prepayment speeds differ from the speeds assumed when investors bought the MBS:

• Extension risk — prepayments are slower than expected, so MBS investors wait longer than originally anticipated for their cash flows.
• Contraction risk — prepayments are faster than expected, so cash flows arrive sooner than expected.

The key driver of prepayment speeds is the prevailing level of interest rates. When rates fall, borrowers often refinance at the lower rate, repaying the original higher-rate loans early. Prepayment speeds rise and the average life of the MBS contracts. This is bad for MBS investors for two reasons:

• They receive cash flows sooner than expected in a low-rate environment and face lower reinvestment returns.
• Because MBS prices already reflect prepayment expectations in low-rate environments, MBS prices rise less in response to falling rates than do otherwise comparable fixed-income instruments without an embedded prepayment option.

When interest rates rise, refinancing activity slows, prepayments are slower than expected, and the average life of the MBS extends. This is also bad for MBS investors because cash flows are now discounted by more periods at a higher discount rate.

One way to reapportion the prepayment risk inherent in the underlying mortgage pool is to use time tranching. An MBS structured with time tranching contains different bond classes with different maturities. Contraction and extension risk still exist, but they are redistributed across the tranches:

• Tranches that mature first offer relatively more protection against extension risk.
• Tranches with longer maturities offer relatively more protection against contraction risk.

One specific form of time tranching—sequential pay tranching—is described later in this reading.

A residential mortgage loan is a loan whose collateral is residential real estate. If the borrower defaults, the lender holds a legal claim on the property (a first lien), and may take possession and sell the property to recover losses—a process known as foreclosure.

Common features of residential mortgage loans include:

• Prepayment penalties. An additional payment that borrowers must make to compensate lenders if principal is prepaid when interest rates decline. Common in Europe but rare in the United States; designed to reduce prepayment risk for lenders.
• Recourse vs. nonrecourse loans. A nonrecourse loan has only the specified property as collateral. A recourse loan also gives the lender a claim on other assets of the borrower for any shortfall after foreclosure. When the property's value falls below the outstanding mortgage balance (an underwater mortgage, or negative equity), borrowers with nonrecourse loans are more likely to strategically default—accepting foreclosure and a damaged credit score rather than continuing to pay on a loan that exceeds the property's value. In Europe, most residential mortgages are recourse loans; in the United States, most are nonrecourse, with state-by-state variation.

Loan-to-value (LTV) is the percentage of the property's value that is loaned to the borrower. A lower LTV means higher borrower equity in the property, making the loan less risky for the lender: the borrower has more to lose in default and there is more equity cushion to recover the loan amount on foreclosure.

Debt-to-income (DTI) is the borrower's monthly debt payments as a percentage of monthly pretax gross income. A lower DTI implies a lower probability of default.

In the United States, mortgages made to borrowers with strong credit, low LTV, and low DTI are termed prime loans. Mortgages to borrowers of lower credit quality, higher DTI, higher LTV, or with a lower-priority claim on the collateral, are termed subprime loans.

Agency vs. non-agency RMBSs. In the United States:

• Agency RMBSs are guaranteed either by the federal government or by a government-sponsored enterprise (GSE)—a company created by the government. Because GSEs are technically distinct from the government, GSE-guaranteed securities carry only the GSE's guarantee, not the full faith and credit of the government. Mortgages must meet minimum underwriting standards to qualify as collateral for an agency RMBS.
• Non-agency RMBSs are issued by private entities such as banks, with no government or GSE guarantee. They typically include credit enhancements—external insurance, letters of credit, tranching, and private guarantees. Non-agency RMBSs were a catalyst for the 2007–2009 global financial crisis: investment-grade senior tranches backed by subprime mortgages suffered large losses when underlying defaults rose. Issuance effectively ceased after the crisis owing to regulatory changes.

A mortgage pass-through security represents a claim on the cash flows from a pool of mortgages, net of administration fees. Any number of mortgages may form the pool, and any mortgage included is referred to as a securitized mortgage.

The mortgages in a pool typically have different maturities and different mortgage rates:

• Weighted average maturity (WAM) — weighted average of the final maturities of all mortgages in the pool, weighted by each mortgage's outstanding principal balance as a proportion of the pool total.
• Weighted average coupon (WAC) — weighted average of the interest rates of all mortgages in the pool, weighted in the same way.

Investors in pass-through securities receive the monthly cash flows generated by the underlying pool, less servicing and guarantee/insurance fees. These fees explain why the pass-through rate (the coupon on the MBS, also called its net interest or net coupon) is less than the WAC of the underlying pool.

Collateralized mortgage obligations (CMOs) are securities collateralized by pass-through MBSs and pools of mortgages. Each CMO has multiple bond classes (CMO tranches) with different exposures to prepayment risk. The total prepayment risk of the underlying RMBS is unchanged—it is reapportioned among the tranches.

Different institutional investors have different tolerances for prepayment risk—some focus on extension risk, others on contraction risk. By partitioning the cash flows generated by RMBSs into different risk packages tailored to investor preferences, CMOs broaden the market for securitized mortgages and may reduce funding costs.

Common CMO structures include sequential pay tranches, planned amortization class tranches, support tranches, and floating-rate tranches.

In a sequential pay CMO, principal payments from the collateral flow to tranches in a prespecified order. Once the first tranche has been fully paid, principal flows to the next tranche, and so on.

For example, consider a simple CMO with two tranches. Both tranches receive interest at a stated coupon rate, but principal payments (both scheduled and prepayments) flow to Tranche 1 (the "short" tranche) until its principal is repaid; principal then flows to Tranche 2 until its principal is repaid.

Contraction and extension risk both still exist, but have been redistributed: the short tranche has more protection against extension risk; the longer tranche has more protection against contraction risk. Investors who prefer shorter-term securities will prefer the tranches paid back first, since they have a lower expected average life.

Other CMO structures:

• Z-tranches (also called accrual or accretion bonds) receive no interest payments during a specified accrual period—instead, accrued interest is added to principal. For example, a Z-tranche with a 5% coupon and $100 outstanding has its principal grown to $105 after the first period (rather than paying $5 cash interest). Once the accrual period ends, regular interest and principal payments begin. The Z-tranche is typically the lowest-ranking tranche in the CMO.
• Principal-only (PO) securities receive only principal from the collateral pool—effectively zero-coupon securities. Falling rates and faster prepayments benefit PO holders, whose return is the difference between price paid and principal repaid; the sooner principal is repaid, the higher the annualized return.
• Interest-only (IO) securities receive only interest from the collateral pool. Falling rates and faster prepayments hurt IO holders, whose return depends on coupon payments on outstanding principal; the sooner principal is repaid, the fewer coupon payments they collect.
• Floating-rate tranches pay a coupon linked to a variable market reference rate, often subject to a cap and a floor. Some are structured as inverse floaters, whose coupon rises (falls) as rates fall (rise).
• Residual tranches rank junior to all other CMO tranches, similar to the equity tranche of an ABS.
• Planned amortization class (PAC) tranches and support tranches. A PAC tranche is structured to make predictable payments to investors as long as prepayment speeds remain within a specified range. If prepayment speeds rise, the support tranche absorbs principal repayments in excess of those allocated to PAC tranches. If prepayments slow, principal repayments to the support tranche are curtailed so that scheduled PAC payments can still be made. Both contraction and extension risk for PAC investors are reduced—but only within the range over which the support tranche can absorb variability. Outside that range, PAC tranches will not receive payments according to the planned schedule.

Commercial mortgage-backed securities (CMBSs) are backed by pools of commercial mortgages on income-producing real estate—typically apartments (multifamily), industrial property (e.g., warehouses), shopping centers, office buildings, health care facilities (e.g., senior housing), and hotels.

CMBSs typically contain fewer mortgages in the collateral pool than RMBSs—in some cases a CMBS can be backed by a single mortgage on a high-value, well-known property in a major city. Diversification against default risk is therefore lower. CMBSs may be backed by mortgages from a single lender, or by multiple commercial mortgages by one borrower. They are common in the United States (where coupons are typically fixed) and growing in Europe (where they typically have floating coupons).

An important difference between RMBSs and CMBSs lies in the obligations of the borrowers of the underlying loans. RMBS loans are repaid by the owners or occupiers of the property; CMBS loans are repaid by real estate investors who, in turn, rely on tenants (usually businesses) and their customers to provide the cash flow to service the mortgage. The regular income from CMBS collateral is the weighted average proceeds from the mortgages (WAMP)—the CMBS analog of WAC.

For these reasons, CMBS analysis focuses on the credit risk of the property, not the credit of the borrower. Two key ratios are used:

1. Debt service coverage ratio (DSCR)—a basic cash flow coverage ratio of the cash flow from a commercial property available for debt service to the required debt service:

   \[ \text{DSCR} = \frac{\text{net operating income}}{\text{debt service}} \]

   Net operating income is rental income less cash operating expenses and a noncash replacement reserve representing depreciation of the property. A higher DSCR offers greater protection to the lender.

2. Loan-to-value ratio (LTV)—compares the loan amount on the property to its current fair-market or appraised value:

   \[ \text{LTV} = \frac{\text{current mortgage amount}}{\text{current appraised value}} \]

   This is the same ratio discussed under residential mortgages: a higher LTV indicates higher default risk.

Two further differences between CMBSs and the RMBSs discussed earlier are call protection and balloon maturity provisions.

Call protection is the CMBS equivalent of prepayment protection (restrictions on early return of principal). CMBSs provide call protection in two ways: (i) loan-level call protection from the terms of the individual mortgages, and (ii) call protection provided by the CMBS structure.

Loan-level call protection is created by:

• Prepayment lockout — for a specific period (typically 2–5 years) the borrower may not prepay the loan.
• Prepayment penalty points — a penalty fee in points (1 point = 1% of principal prepaid) charged to borrowers who prepay.
• Defeasance — the borrower uses excess payments to buy a portfolio of government securities sufficient to cover the remaining scheduled principal and interest payments. The lender continues to receive the originally scheduled cash flows, and the borrower can lift the lender's lien on the property—useful if the borrower wishes to sell the property before mortgage maturity.

To create CMBS-level call protection, loan pools may be subjected to sequential pay tranching, similarly to CMOs.

Commercial mortgages are typically not fully amortizing—at the end of the loan term, some principal remains outstanding and must be paid as a balloon payment. If the borrower cannot arrange refinancing to make this payment, the borrower is in default. This possibility is called balloon risk. The lender may extend the loan term during a workout period under modified terms. Because balloon risk entails extending the loan term, it is a form of extension risk for CMBS investors.