how resilient are mbs to cdo market disruptions

n teg ra ted Financial Engineering I

How Resilient Are MBS to CDO Market Disruptions?By Joseph Mason

Joshua Rosner

Discussion by

Tyler Yang, IFE GroupFebruary 15, 2007

The Paper Reviews recent changes in primary mortgage

market operations => entering into riskier products

Introduces various MBS and CDO structures => complex securities

Establishes link among CDO and MBS and mortgage lending => leverage effect

Recommends tighter regulation and more extensive disclosure

Comments

Impact of CDO on home mortgage lending

Policy and regulation implications

Recent issues of primary mortgage markets

Possible next steps

Typical Private MBS (REMIC) Structure

Tranche A1

Tranche A2

Tranche BBB

Tranche Residual

Prepaid Principal

Default Loss

First Loss

Default Loss

Mezzanine Loss

AA

Sup

port

Lev

el

Mortgage Pool

CDO Buys

REMIC needs to have junior tranche to support senior tranches

CDO is a main buyer of REMIC junior tranches

Therefore, if CDO pulls out

there could be a shortage

of funds to home mortgage

market

From Home Mortgage to CDO

Borrower Lender/

Issuer

REMIC

Tranches

CDO

Junior tranches

Mortgage pool

Mortgage loan

$$$

Magnitude of Impact CDO purchased $140B of MBS junior tranches in 2005

The subordination level for AA rated tranche is about 10%

Therefore, CDO supported about $1,400B private label MBSs issuance (> $1,326B actual issuance)

If CDO pulls out, there will be no private label MBS issuances

CDO Investors

Borrower Lender/

Issuer

REMIC

Tranches

CDO

Junior tranches

Mortgage pool

Mortgage loan

$$$

Foreign Investors

Mutual Fund

Hedge Fund

What Happens if CDO Disappear? Prior to CDO, there are other buyers of the junior

tranches, down to non-rated tranche

Borrower Lender/

Issuer

REMIC

Tranches

CDO

Junior tranches

Mortgage pool

Mortgage loan

$$$

Foreign Investors

Mortgage REIT

Mutual Fund

Hedge Fund

Alternative Outlays of Private Mortgages Alternative funding or credit risk management tools for

jumbo/subprime loans

Borrower Lender/

Issuer

REMIC

Tranches

CDO

Junior tranches

Mortgage pool

Mortgage loan

$$$

Fund by Capital

Purchase PMI

Sell as MBB/PT

Cross hedge

Other credit

enhancements

Other Credit Enhancement Methods Credit derivatives helps lenders proactively

manage portfolio credit risk lower funding cost and mortgage rates

Senior-Sub is only one of many credit enhancement methods to achieve AA+ rating

Bond insurer Over-collateralization Wrap around Pool insurance Synthetic swap Credit lined note (e.g. MODERNs)

MORDERNs 1998 Freddie Mac, US$20B US RMs, use mortgage

default recourse notes to insure first loss and mezzanine credit risk

US$20B US seasoned

RM

G-3 SPV

Insurance Premium

Default Claims

Collateral ($520M)

Issue ProceedsP&LIBOR rate

Freddie Mac

A, 60M, BBB, 1%

B, 30M BBB-, 1.3%

C, 50M, BB, 2.85%

D, 46M, B, 6.5%

E, 64M, NR, 20%*

P&LIBOR+Spread

Issue Proceeds

* Only $57.3M of class E was actually issued.

Why CDOs? CDO offers the cheapest capital to fund MBSs The question should therefore be: If CDO pulls out, how much additional cost (rate)

will borrowers need to pay? Higher spread required by alternative investors Higher PMI insurance premium Less favorable selling prices of MBB/PT Higher funding cost by bank debt and capital Less efficient hedge of credit risk via conforming loan CD

swaps

The authors could try to quantify the impact by analyzing the execution cost of these alternatives

BBB Trache Is Riskier than BBB Bond

Tranche A1

Tranche A2

Tranche BBB

Tranche Residual

Prepaid Principal

Default Loss

First Loss

Default Loss

Mezzanine Loss

AA

A S

uppo

rt L

evel

Mortgage Pool

PassThrough

BBB

Over Collateral

Principal

& Interest

Default Loss

First Loss

Tranche BBB And PT Gets Same Rating

Tranche A1

Tranche A2

Tranche BBB

Tranche Residual

Mortgage Pool

PassThrough

BBB

Over CollateralLoss

Cliff!

Tranche A1

Tranche A2

Tranche BBB

Tranche Residual

Mortgage Pool

PassThrough

BBB

Over Collateral

Loss

Return = -100%

Return = -20%

Understand CDO CDO builds double Cliff! Even more concentrated

default risk What’s the impact?

Need to understand BBB tranche CDO is much riskier than BBB pass through (corporate bond)

Rating agency only measures the probability of not recoverprincipal

No LGD indicator, no interest income risk indication Backward looking (rating change only after credit event) Investors clearly understand it by the much higher spread they

require for tranche

Need a forward looking credit score (similar to KMV or CreditMatrics)?

How Much to Disclose? REMICs currently disclose

Pool level distribution of LTV, FICO, location, loan size, contract rate, and sometimes cross tabulation among variables

Some subprime REMICs even provide loan level disclose Structure and payment sequences Numerical examples of payment to individual sequences Monthly prepayment, default, or even delinquency experience

via Intex

Due diligence by major auditors

Need more financial disclosure? What specific information?

Who Should Government Protection? The authors should clearly analyze who in the process

should be protected by the government.

Typically only institutional investors purchases junior tranche CDOs

Pursue higher return by knowingly invest in high credit risk securities

Financial loss does not affect national economy or individual savers or households

Need to prevent pension funds, life insurance companies, and small individual investors from heavily invest in these high credit risk securities

Avoid hurting insurees, retirees, average savers

Risk Based Capital Regulation

Basel II IRB approach will accurately reflect the higher

default risk into higher capital requirement Standardized approach specifies different capital

requirement for different structured tranches (B or NR tranche required 1250% risk weight, BB tranche requires 200% risk weight)

Pillar II government supervision allow closer scrutiny Pillar III market discipline

What additional regulations are needed? On which party? By which agency? Why?

Mortgage Lending: Higher Risk Products Extremely high total LTV Historically low interest rate environment IO or option ARM with teaser (income constraint)

Introduced payment shocks much higher than income growth Borrower could roll over using teaser (if rate remains low and

house price does not fall) But prepayment penalty made roll over impossible

Lead to high default rates Is a problem, with or without CDO This issue is less relevant to government and

conforming loans High default rate is particular sever in private markets Government needs to educate home buyers about the risk

entering into these loans

Probability of Income Shortage

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

1 9 17 25 33 41 49 57 65 73 81 89 97 105 113 121 129 137 145 153 161 169 177 185 193 201 209 217 225 233

FRM_20_PSHORT ARM_PSHORT ARM511_PSHORT ARM511TR_PSHORT OPTIONARM_PSHORT

Yang, Ling, and Cho, 2006, “Balancing Credit and Interest Rate Risks: Choice between Fixed- and Adjustable- Rate Mortgages”, presented at 2006 International AREUEA coference

Relative Default Risks

0

0.005

0.01

0.015

0.02

0.025

0.03

0.035

0.04

0.045

1 18 35 52 69 86 103 120 137 154 171 188 205 222 239

FRM_20_PBOTH ARM_PBOTH ARM511_PBOTHARM511TR_PBOTH OPTIONARM_PBOTH

Encourage Home Ownership

High Income Household

Poor Household

Homeless

current rentersyoung professionalsmoderate-income

households

seniorsperson with disabilities

No Yes

No

Yes

Wealth Constrained?

Inco

me

Con

stra

ined

?

Conclusions Made good inventory check and established basic link

of CDO and primary mortgage market Possible contributions to make

More clearly describe the linkage between CDO and mortgage borrowers

Focus on the marginal impact of CDO on the MBS market Be more specific about what the government has done; what

additional regulations are needed from which agency; and on which group

The high default rate is caused by the aggressive underwriting and product design, with or without CDO

Any implication of the balance between affordable housing objective and financial stability

Housing Market Forecast

Follain and Follain, “Searching for Clues About the Future of House Prices”, 2007 Cyberhomes.com

how resilient are mbs to cdo market disruptions

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