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
Page 2
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
Page 3
Comments
Impact of CDO on home mortgage lending
Policy and regulation implications
Recent issues of primary mortgage markets
Possible next steps
Page 4
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
Page 5
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
$$$
Page 6
Magnitude of Impact CDO purchased $140B of MBS junior tranches in 2005
The subordination level for AA rated tranche is about 10%
Therefore, CDO supported about $1,400B private label MBSs issuance (> $1,326B actual issuance)
If CDO pulls out, there will be no private label MBS issuances
Page 7
CDO Investors
Borrower Lender/
Issuer
REMIC
Tranches
CDO
Junior tranches
Mortgage pool
Mortgage loan
$$$
Foreign Investors
Mutual Fund
Hedge Fund
Page 8
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
$$$
Foreign Investors
Mortgage REIT
Mutual Fund
Hedge Fund
Page 9
Alternative Outlays of Private Mortgages Alternative funding or credit risk management tools for
jumbo/subprime loans
Borrower Lender/
Issuer
REMIC
Tranches
CDO
Junior tranches
Mortgage pool
Mortgage loan
$$$
Fund by Capital
Purchase PMI
Sell as MBB/PT
Cross hedge
Other credit
enhancements
Page 10
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)
Page 11
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.
Page 12
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
Page 13
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
Page 14
Tranche BBB And PT Gets Same Rating
Tranche A1
Tranche A2
Tranche BBB
Tranche Residual
Mortgage Pool
PassThrough
BBB
Over CollateralLoss
Page 15
Cliff!
Tranche A1
Tranche A2
Tranche BBB
Tranche Residual
Mortgage Pool
PassThrough
BBB
Over Collateral
Loss
Return = -100%
Return = -20%
Page 16
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)?
Page 17
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?
Page 18
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
Page 19
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?
Page 20
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
Page 21
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
Page 22
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
Page 23
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
?
Page 24
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
Page 25
Housing Market Forecast
Follain and Follain, “Searching for Clues About the Future of House Prices”, 2007 Cyberhomes.com
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