CHAPTER 13
NONAGENCY RESIDENTIAL
MORTGAGE-BACKED SECURITIES
CHAPTER SUMMARY
In this chapter, we discuss the nonagency RMBS market, focusing on the structure of the
securities created, particularly on credit enhancement. We will describe the different forms of
COLLATERALIZED TYPES
Conforming mortgages are typically collateral for agency RMBS while nonconforming
mortgages are for nonagency RMBS. The collateral backing a nonagency RMBS is set forth in
the prospectus as illustrated in an actual deal. Typically a deal will be backed by a combination
of collateral types.
CREDIT ENHANCEMENT
Because there is no government guarantee or guarantee by a GSE, to receive an investment-grade
rating, these securities must be structured with additional credit support. The credit support is
needed to absorb expected losses from the underlying loan pool due to defaults. This additional
rating. The process by which the rating agencies determine the amount of credit enhancement
needed is referred to as sizing the transaction.
Structural Credit Enhancement
Structural credit enhancement refers to the redistribution of credit risks among the bond
classes comprising the structure in such a way as to provide credit enhancements by one bond
class to the other bond classes in the structure. This is achieved by creating bond classes with
The bond class in the capital structure with the highest rating is referred to as the senior bond
class. The subordinated bond classes in the capital structure are those below the senior
Most AAA bond classes have been downgraded since 2007. As of year-end 2010, only a small
amount of outstanding nonagency RMBS have an investment-grade rating.
Shifting Interest Mechanism in a Senior-Subordinated Structure
Because of the major credit concerns in subprime RMBS deals and the need to protect the senior
bond class, almost all senior-subordinated structures backed by subprime loans incorporate
The prospectus will specify how different scheduled principal payments and prepayments will be
allocated between the senior bond class and the subordinated bond class. The scheduled principal
payments are allocated based on the senior percentage. The senior percentage, also called the
and if the collateral or structure fails any of the tests, this will trigger an override of the base
schedule.
Deal Step-Down Provisions
An important feature in analyzing senior-subordinated bond classes or deals backed by
residential mortgages is the deal’s step-down provisions. These provisions allow for the
In addition to triggers based on the performance of the collateral, there is a balance test. This test
involves comparing the change in the senior interest from the closing of the deal to the current
month. If the senior interest has increased, the balance test is failed, triggering a revision of the
base schedule for the allocation of principal pay-ments from the subordinated bond classes to the
senior bond class.
(2) used to pay any losses realized by the collateral for the month, (3) retained by the SPV and
accumulated in a reserve account and used to offset not only current losses experienced by the
collateral but also future losses, or (4) some combination of the others.
In terms of cash collateral, excess spread that we have just described is one of three ways that
an originator/seller of the collateral can provide cash to absorb collateral losses. There are two
Today, few, if any, deals are done with insurance by monoline insurers, bank letters of credit,
and related-party guarantees. Risk-based capital requirements have made letters of credit for
banks unattractive. Third-party related guarantors are rare because the parent of the
originator/seller is typically not triple A rated.
CASH FLOW FOR NONAGENCY MORTGAGE-BACKED SECURITIES
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agency as part of its guarantee. For a nonagency RMBS, one or more bond classes may be
affected by defaults, and therefore, defaults must be taken into account in estimating the cash
flow of a bond class.
Prior to the subprime mortgage crisis, investors assumed that the triple A senior bonds of
nonagency RMBS were exposed to minimal credit risk. The performance of loans backing
nonagency RMBS deals demonstrated the critical importance of assessing the factors that impact
defaults.
What the subprime mortgage crisis clearly showed is that defaults are not just tied to the level of
economic activity but also housing prices. Economic difficulties faced by borrowers that
followed a period of rising prices provided lenders with a strong position in the collateral as long
as the loan-to-value ratio (LTV) was not high.
The opportunity to sell the property to repay the loan is not available if the property declines
below the outstanding mortgage balance (i.e., the current LTV exceeds 1 or, equivalently, the
as the recovered principal. The servicer must report separately traditional prepayments (which
are called voluntary prepayments) and credit-related prepayments (which are called
involuntary prepayments).
Delinquency Measures
A delinquency is requirement before a loan can be classified as in default. Loans are classified as
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month. The calculation begins with computing the monthly default rate (MDD) for the month
as shown below:
Monthly default rate for month t
MMDt =
defaulted loan balance in month t
beginningbalance for month t scheduled principal payment in month t−
Then, this is annualized as follows to get the CDR:
multiple.
Prepayment Measures
Prepayments are measured in terms of the conditional prepayment rate (CPR). Borrower
characteristics and the seasoning process must be kept in mind when trying to assess
prepayments for a particular deal. In the prospectus of an offering, a base-case prepayment
In a nonagency RMBS deal the servicer has an important function, not only with respect to
collecting payments due from borrowers in the loan pool and repossessing and then selling the
property when there are defaults, but also in advancing principal and interest on delinquent loans.
There are specific conditions as to when a servicer need not make such advance payments. In
most deals, the servicer is not required to advance any amount that it deems “nonrecoverable”
saw it as the inevitable bursting of the “housing bubble” that had characterized the housing
market in prior years. Others viewed it as the product of unsavory practices by mortgage lenders
who deceived subprime borrowers into purchasing homes that they could not afford. Moreover,
specific mortgage designs such as hybrid loans made it possible for a subprime borrower to
obtain a loan that could have been expected to cause financial difficulties in the future when loan
The securitization of subprime loans works by dividing pools of credit into classes, or bond
classes, separated by the amount of risk each class represents. Naturally, the classes with less risk
offer lower potential returns while the classes with more risk offer higher potential returns.
The more junior, riskier classes are purchased by sophisticated institutional investors who
understand that they may incur losses but hope for high enough returns over a long period of
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Rating agencies were also viewed by some market observers as being a major contributor to the
crisis. Recall that to aid investors in comparing the relative credit risk of securities, issuers
generally ask one or more rating agencies to assign a credit rating to the securitization. The
accuracy of ratings, like any other indicator of credit risk, can only be assessed on a statistical
basis over a long period of time.
What is surprising to market observers is why the crisis occurred in July 2007. There was no new
information in the market at the time. Investors knew well before that time all about the potential
defaults. Moreover, since 2005, the rating agencies took action that was transparent to the
market. Specifically, rating agencies adjusted their criteria and assumptions regarding how they
RMBS and traded in separate markets, following the subprime mortgage crisis in 2007 and
the meltdown of the housing market, these two sectors are no longer viewed differently.
• Although there has been very little issuance since 2008, there is a considerable amount of
nonagency RMBS outstanding backed by prime loans, subprime loans, Alt-A loans, second
lien loans, and option ARM loans.
(2) originator provided (excess spread, cash reserve, overcollateralization), and (3) third-party
provided.
• The cash flow of a nonagency RMBS depends on defaults and prepayments.
• Default rates are measured in terms of the conditional default rate and the cumulative default
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• Voluntary prepayments and involuntary prepayments must be projected in projecting the
collateral’s cash flow.
• The treatment of advances and modified loans by mortgage services has an impact on the
bond classes in a nonagency RMBS deal.
ANSWERS TO QUESTIONS FOR CHAPTER 13
(Questions are in bold print followed by answers.)
1. Answer the below questions.
a. Why is it necessary for a nonagency mortgage-backed security to have credit
enhancement?
and (4) monoline insurance. Common in structures with subprime mortgage loans for senior-
subordinated structures is the shifting interest mechanism. The cash flow of a nonagency MBS
depends on defaults and prepayments. Default rates are measured in terms of the conditional
default rate and the cumulative default rate. A standardized benchmark for default rates was
formulated by PSA.
We can compare what is being done to distribute credit risk in a nonagency MBS with what is
done in an agency CMO. In an agency CMO, there is no credit risk for Ginnie Mae issued
structures and the credit risk of the loan pool for Fannie Mae and Freddie Mac issued structure is
viewed until recent years as small. What is being done in creating the different bond classes in an
agency CMO is the redistribution of prepayment risk. In contrast, in a nonagency MBS, there is
both credit risk and prepayment risk. By creating the senior-subordinated bond classes, credit
risk is being redistributed among the bond classes in the structure. Hence, what is being done is
credit tranching.
b. Who determines the amount of credit enhancement needed?
Credit enhancement is a key part of the securitization transaction in structured finance, and is
important for credit rating agencies when rating a securitization. Credit enhancement is the
process of reducing credit risk by requiring collateral, insurance, or other agreements to provide
the lender with reassurance that it will be compensated if the borrower defaulted. When rating
2. What is the difference between a private label and subprime mortgage-backed security?
Be sure to mention how they differ in terms of credit enhancement.
The residential mortgage-backed securities (RMBS) market is divided into two sectors: agency
MBS and nonagency MBS. RMBS issued in the nonagency MBS market require that credit
enhancement be provided to protect against losses from the loan pool. The nonagency MBS market
3. Answer the below questions.
a. What is an option ARM loan?
A type of adjustable-rate mortgage (ARM) loans popular during the period between 2001 and
2007 (when ARM issuance reached its peak) was hybrid ARM loans, also referred to as option
b. Why is it unlikely that this loan type will be originated in the future?
The 2007 subprime mortgage crisis, it is not likely that this loan type will continue due to the
risks that were brought out with this crisis. This is explained below.
While the flexibility built into option ARM loans come with risks. First, investors can not
increase their equity unless the make the larger amortizing payments. Most investors choose
4. Answer the below questions.
a. At one time, prime and subprime RMBS were traded in separate markets. Why?
The nonagency RMBS market is divided into the private label RMBS market and subprime RMBS
market. Private label RMBS, also referred to as prime or residential deals, are backed by prime
mortgage loans; subprime RMBS are backed by subprime loans and prior to 2007 commonly
b. Why after 2007 are prime and subprime RMBS treated as one asset type?
5. Answer the below questions.
a. What is meant by a senior-subordinated structure?
A senior-subordinated structure refers to a structure that is created with two general categories of
bond classes: a senior bond class and subordinated bond classes.
b. Why is the senior-subordinated structure a form of credit enhancement?
Credit enhancement is the process of reducing credit risk by requiring collateral, insurance, or
other agreements to provide the lender with reassurance that it will be compensated if the
within the structure. For example, the senior bond class is being protected against losses by the
subordinated bond class.
We can compare what is being done to distribute credit risk in a nonagency MBS with what is
done in an agency CMO. In an agency CMO, there is no credit risk for Ginnie Mae issued
structures and the credit risk of the loan pool for Fannie Mae and Freddie Mac issued structure is
6. Calculate the Excess Spread with the following information:
Weighted Average Interest Rate: 10%
7. Answer the below questions.
a. What is the difference between credit tranching and prepayment tranching?
Credit tranching refers to redistributing credit risk among bond classes in the structure, while
prepayment tranching refers to redistributing prepayment risk among bond classes.
b. Why would there be both types of tranching in a nonagency deal but only one type of
tranching in an agency deal?
8. Answer the below questions.
a. What is meant by conditional default rate and cumulative default rate?
The conditional default rate (CDR) is the annualized value of the unpaid principal balance of
newly defaulted loans over the course of a month as a percentage of the unpaid balance of the
pool (before scheduled principal payment) at the beginning of the month.
333333.0
000,100000,000,1
000,30 =
−
=
t
MMD
Then, this is annualized as follows to get the CDR:
33424.0)0333333.01(1 12 =−−=
t
CDR
, which is about 33.42%
9. Why was the PSA Standard Default curve introduced?
A standardized benchmark for default rates was formulated by the Public Securities Association
(PSA). The PSA standard default assumption (SDA) benchmark gives the annual default rate for
a mortgage pool as a function of the seasoning of the mortgages. As with the PSA prepayment
10. Why might an interest rate derivative such as an interest rate swap or interest rate cap
be used in a securitization transaction for residential mortgage loans?
Securitization is the process of taking an illiquid asset, or group of assets, and through financial
engineering, transforming them into a security. There are standard mechanisms for providing credit
enhancement in nonagency MBS. When prime loans are securitized, the credit enhancement
11. Why is a shifting interest mechanism included in a securitization where the collateral is
residential mortgage loans?
Almost all existing senior-subordinated structures backed by residential mortgage loans also
incorporate a shifting interest mechanism. This mechanism redirects prepayments disproportionately
12. Suppose that for a securitization with a shifting interest mechanism, you are given the
following information for some month:
subordinate interest = 30%
shifting interest percentage = 75%
regularly scheduled principal payment = $2,000,000
prepayments = $1,200,000
a. What is the senior prepayment percentage for the month?
The prospectus will specify how different scheduled principal payments and prepayments will be
allocated between the senior bond class and the subordinate bond class. The scheduled principal
payments are allocated based on the senior percentage. The senior percentage, also called the
b. How much of the $2,000,000 regularly scheduled principal payment is distributed to the
senior class?
0.70($2,000,000) = $1,400,000. Thus, the subordinate bond class will get 0.30($2,000,000) =
$600,000 (or the difference of $2,000,000 – $1,400,000 = $600,000).
c. How much of the $1,200,000 is distributed to the senior class?
then 0.9250($1,200,000) = $1,110,000 is allocated to the senior bond class. The subordinate
bond class will get the remainder of $1,200,000 – $1,110,000 = $90,000.
13. What kind of provisions allow for the reduction in credit support over time in a
securitization?
classes are diverted to the senior bond class if a trigger is reached. The diversion of principal
varies from issuer to issuer. The most conservative approach is to stop all principal payments
from being distributed to the subordinate bond classes. Alternatively, some issuers allow the
subordinate bond classes to receive regularly scheduled principal (amortization) on a pro rata
basis but divert all prepayments to the senior bond class.
14. What is meant by the prospectus prepayment curve?
First, we note that repayments are measured in terms of the conditional prepayment rate (CPR).
Borrower characteristics and the seasoning process must be kept in mind when trying to assess
pre-payments for a particular deal. In the prospectus of an offering, a base-case prepayment
assumption is made—the initial speed and the amount of time until the collateral is expected to
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comparisons among deals can be difficult because PPC may be defined differently in each
security’s prospectus.
15. Answer the below questions.
a. What is meant by an involuntary prepayment?
In regards to the reporting of nonagency RMBS, once a loan moves from the delinquent category
to the default category, the borrower loses possession of the property and the mortgage servicer
takes possession with the purpose of selling the property. The proceeds received by the servicer
b. Why is the distinction between a voluntary and involuntary prepayment important in
nonagency RMBS?
16.When will a mortgage servicer not advance payments for principal and interest?
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Because a property’s projected recovered principal depends on its current LTV, servicers
typically cease advancing on loans where the current LTV is greater than a specified threshold.
17. Why does the treatment of modified loans in a nonagency RMBS deal impact the bond
classes?
A modified loan is one in which the terms have been altered in order to help the borrower satisfy
the monthly mortgage obligation. Prior to the problems in the market, deal transactions gave the
18. There are some mortgage loans that are balloon loans. This means that when the loan
matures, there is a mortgage balance that will require financing. It is the responsibility of
the borrower to obtain the refinancing. What is the added risk associated with a pool of
loans backed by balloon loans?
A balloon loan is a long-term loan, often a mortgage, which has one large payment (the balloon
payment) due upon maturity. A balloon loan will often have the advantage of very low interest
payments, thus requiring very little capital outlay during the life of the loan. Since most of the
19. Suppose that the loans in the collateral pool for a nonagency RMBS deal have a floating
rate. What is the risk associated with issued fixed-rate bond classes?
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loans in the collateral pool for a nonagency RMBS deal have a floating rate and the bond classes
are fixed rate. The risk can be handled by interest rate derivatives such as interest rate swaps and
interest rate caps. While these are often employed in nonagency RMBS structures, they are not
allowed in agency RMBS structures. Since we do not cover interest rate derivatives until later
chapters, we merely point out for now that they are used when there is a mismatch between the
character of the cash flows for the loan pool and the character of the cash payments that must be
made to the bond classes.
20. What is the concern with the inclusion of fixed-rate mortgage loans in the collateral
pool when the liabilities are floating rate?
21. An interest rate cap allows the buyer of the cap to be compensated if interest rates rise
above a reference rate. The buyer has to pay a periodic premium to obtain this protection.
When an RMBS transaction has a pool of floating-rate loans, what type of protections does
an interest rate cap provide?