securitization

Securitisation Masterclass Sept 20061

What is securitisation?What is securitisation?

In traditional methods of corporate finance, a corporationraises equity/obligations to own assets.In securitisation, a corporation creates and ‘securitises’ assets - that is, transfers assets. In form of securities.The claim is on assets, and not on the entityHence, asset-based fundingSecuritisation and traditional funding: is the difference skin-deep or superficial?

All claims are, eventually, claims on assets: question is one of stacking order: securitisation puts investors on the top of the stacking order by isolationBroader the periphery of assets backing up the claims, more the volatility, risksAsset-backed funding narrows down asset definition and hence reduces volatilityHence, reduces credit enhancementCrux of asset backed funding lies in reducing the equity, and increasing the leverage

2

Securitisation and corporate financeSecuritisation and corporate finance

Nature General claim against the assets of an entity

Claim against specific assets of an entity, on mutually exclusive basis

Objective To harness the strengths of the corporate's balance sheet to raise funding

To strip the excess spread inherent in assets and service them on off-balance sheet basis

Investor risks Subject to entity-wide risks Isolated from entity risks

Structured funding

Less amenable to structured funding

More amenable to structured funding, since assets are hived off into a separate entity

Leverage Leverage limited to entity-wide prudential/regulatory limits

Leverage based on portfolio risks - usually quite high

3

Basic process of securitisation

Originator

Obligors

SPVspecial purpose

entity

2.Assigns Cash flow

Investors

1. Cash flow before securitisation

4. Proceeds of issue of securities

3. Issues securities/ notes

5.Collection and servicing

6.Passes over to SPV, less fees

Reinvestment

7. Reinvestment/liquiditybuffer

8. Reinvestmentproceeds/liquidity

facility

9. Payments to investors

10. Originator’s residuary

profit

4. Proceedsof sale of

receivables

Securitytrustee

Class AClass B

Class C

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Essential securitisation processEssential securitisation process

BankBank Mortgages

Equity

Public Savings

OriginationCredit enhancementFundingServicing

BankBank Mortgages

Equity

BankBank Mortgages

Equity

Bank Mortgages

Equity

Debt

Mortgages

Equity

Bank Mortgages

Equity

DebtPublic Savings

OriginationCredit enhancementServicing

SPVs

Mortgage-backed Securities

Traditionalframework

Securitisationframework

Class AClass B

Retained class

Residualinterest

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The economic substance of securitisationThe economic substance of securitisation

The key economic driver of securitisation is lower cost, resulting out of:

Lower credit enhancement, due to insulation of the transaction from originator risksHigher ratings, due to originator bankruptcy remoteness

Bankruptcy remoteness:The essential premise is that the assets are put beyond the control of the selling entityThe buying entity is a special purpose entity, unlikely to go into bankruptcy

Hence, legal structure, that is, achieving a bankruptcy remote transfer, and insulating the transaction from originator risks, is key to every securitisationOther spin offs – off balance sheet, capital relief, etc. are consequences, not cause of the isolation process

6

Key features of securitisationKey features of securitisation

Capital market funding

Use of special purpose vehicles as a transformation device

Structured financeMeaning of structured financial products: product structured or made-to-needs of the investor

Key structuring principles:What are investors rating needs

What are investors payback needs/ paydown needs

What is investors’ appetite for interest rate risk, prepayment risk?

Securitised instruments reorganise investors’ rights to suit their needs

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The economic substance of securitisationThe economic substance of securitisation

The key economic driver of securitisation is lower cost, resulting out of:

Lower credit enhancement, due to insulation of the transaction from originator risksHigher ratings, due to originator bankruptcy remoteness

Bankruptcy remoteness:The essential premise is that the assets are put beyond the control of the selling entityThe buying entity is a special purpose entity, unlikely to go into bankruptcy

Hence, legal structure, that is, achieving a bankruptcy remote transfer, and insulating the transaction from originator risks, is key to every securitisationOther spin offs – off balance sheet, capital relief, etc. are consequences, not cause of the isolation process

8

Key features of securitisationKey features of securitisation

Capital market funding

Use of special purpose vehicles as a transformation device

Structured financeMeaning of structured financial products: product structured or made-to-needs of the investor

Key structuring principles:What are investors rating needs

What are investors payback needs/ paydown needs

What is investors’ appetite for interest rate risk, prepayment risk?

Securitised instruments reorganise investors’ rights to suit their needs

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ABS types based on collateralABS types based on collateral

Securitisation

Existing assetFuture asset Risk

Mortgagebacked

Assetbacked

Credit risk Insurancerisk

Operatingrevenues

RMBS

CMBSRetailassets

CDOs

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ABS types based on other parametersABS types based on other parameters

Securitisation

Purpose Nature of asset transfer Term of

paper

Balance sheet

Arbitrage

Syntheticstructures

Commercialpaper

Cashstructures

TermpaperTrue

sale structure

Securedloan structure

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Parties to securitisation transactionParties to securitisation transaction

Originator/ sellerObligorsSpecial purpose vehicle: single/ multipleServicerBack up servicerTrusteesInvestorsCollecting and paying bankDepositorySwap counterpartiesLiquidity providerCredit enhancement provider

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Typical originatorsTypical originators

Application of securitisation techniques has greatly expanded recently.Typical users of securitisation are:

Mortgage financiersBank loansFinance companiesCredit card companiesHoteliers, rentiersPublic utilitiesIntellectual property holdersinsurance companiesaviation companiesexporters of unprocessed materialsplantationsGovernments

Interactive:Can you think of other asset classes?

13

Typical assets securitisedTypical assets securitised

Financial assetslong-term assets

short term assets

revolving assets

Physical assetsusing transformation devices

using secured loan structures

Whole business transactions

Future flow transactions

Structured investment vehicles:CDOs of investment products such as hedge funds, private equity funds, etc.

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Trustee Trustee A logistic requirement, later made a statutory obligation in public offerings of debt instruments

Fiduciary for the investors

Holder and administrator of security interests and safeguarding collateral documents

Traditional functions:

Acting as registrar and transfer agent for the securities

Distribution of principal and interest payments

oversight of the conduct of the transaction, particularly payments, co-mingling, compliance with respective agreements

monitoring covenant compliance and reporting - regular loan level and bond level reports

monitoring principal and interest payments

Enforcement of seller representations and warranties

monitoring of triggers and withholding distributions

Timely, decisive action

Ability and willingness to act as backup servicer or organise succession

15

Securitisation and borrowingSecuritisation and borrowingLegal nature of the transaction

Transfer of an asset/ several assets of the originator

Normal monetary obligation of the originator

Parties to the transaction

To allow the pool of receivables to be aggregated and kept intact, a collective investment medium, the SPV is formed. Hence, there are 3 parties to the transaction - the Originator, SPV (issuer) and the investors

There are two parties to the transaction - the borrower and the lender. In case of participation of several persons in the loan, there might be an indenture trustee acting as a trustee for the investors.

Relation with the debtors of the originator

Transfers claims against debtors/ customers of the originator

No connection with the debtors of the originator

Nature of instrument acquired by investors

Either a fractional interest in the pool of receivables held by the SPV, or a debt obligation of the SPV

Debt obligation of the originator

Legal rights of the investors

Exercisable against the SPV, or through the SPV against the debtors of the originator

Exercisable against the originator

16

Treatment for regulatory purposes

Not treated as borrowing from public

Treated as borrowing from public

Effect on regulatory capital requirement

Normally frees up regulatory capital

Does not free regulatory capital

Bankruptcy of the originator

Investors beneficially own the pool of assets transferred to the SPV

Investors have a claim against the originator; usual bankruptcy/ distressed company protection available to the originator

Failure of the debtors of the originator

Depends upon recourse features; normally investors will suffer a loss

Investors will not be affected; they have a claim against the originator

Any other difference?

Securitisation and borrowing - 2Securitisation and borrowing - 2

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Why securitisationWhy securitisation

Lower cost - inherent cost and weighted average cost The best example of economics of securitisation is an arbitrage CDO

Alternative investor base -institutional and retailMatching of assets and liabilities Issuer rating irrelevantMultiplies asset creation abilityNon-conventional source; may allow higher fundingOff-balance sheet financing - removal of accountsFrees up regulatory capitalImproves capital structureHigher trading on equity with no increased risk

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Why securitisation - 2Why securitisation - 2

Extends credit pool

Not regulated as loan

Reduces credit concentration

Risk management by risk transfers

Arbitraging opportunities - repackaging transactions

Avoids interest rate risk

Improves accounting profits

Interactive: do you think there are other merits?

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Lower cost due to securitisationLower cost due to securitisation

Increased leverage: lower use of equity: leverage arbitrage

Capital market source – reduces agency costs

Better rated product: ratings arbitrage

Aligns investment with investor objective: structural arbitrage

Studies of whether securitisation has reduced funding costs:

Mortgage market is cited as an example

Arbitraging profits in the securitisation market

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Limitations/ disadvantages of securitisationLimitations/ disadvantages of securitisation

What are the disadvantages/limitations of securitisation?

Session 2Session 2

Principal structures in securitisation


Basic elements of securitisation structuresBasic elements of securitisation structures

Transfer of assets to bankruptcy-remote entities:Cash versus synthetic structures

secured loan structures

Two-tier transactions

Cash inflow and outflows:pass-throughs and bond structures

Determination and form of credit enhancements

Classes of securities and coupon of each

Profit extraction devices

Liquidity enhancements

Structural protections: early payment or de-leverage triggers

Pay down methods:normal

abnormal - in case of triggers


Securitisation structures:Transaction features

viewpoint

Syntheticstructures

Cashstructures

Truesale

structure

Securedloan

structure

Pass-through structure

Collateralstructure

Simplepass-

throughMastertrust

Securitisation structuresSecuritisation structures


Cashflow schematics of securitisationCashflow schematics of securitisation

We will model the cashflow structure of a dummy securitisation transaction

And iterate it with respect to:Simple pass-through

Reinvestment of principal into passive financial instruments

Reinvestment of principal into the original asset

To see the impact on:Residual returns

Weighted average maturity


CollectInterest

(plus other revenue)

CollectActual Principal

(Scheduled)

Collect allPrepayment

Deduct allSenior Expenses

Is Actual Principal <Scheduled Principal?

Debit Deliqnent Principal Ledger

Pay SeniorCoupon

Excess Spread

Principal Waterfall

Transfer toDeliqnentPrincipal

Is excess spread>delinquentPrincipal ?

Pay PrincipalPay JuniorCoupon

No

Yes

No

YesGraphics

© Vinod Kothari

Cash Flow Scheme of Securitisation

Session 3Session 3

Understanding cashflow structure of securitisations


Basic ingredients of securitisation structuresBasic ingredients of securitisation structures

Analysis of the collateral pool:Retail, equal payment poolRetail, revolving payment poolWhole-sale pools

Asset liability mismatches:No mismatch – pass-through transactionsRevolving/reinvesting transactions:

Revolving cash back into assetsReinvesting cash externally

Nature and form of credit enhancementsPayback tranching of securities:Default allocationSpecial triggers:

Early amortisation triggers to curtail reinvestmentTriggers to use over-collateralisation

Profit extraction devices


Key features of a securitised assetKey features of a securitised asset

Typically an equated payment asset amortizing over a period of time

Full payout structures

Deviations between scheduled and actual cashflows:

Delayed paymentsDefaults

Prepayments


Understanding the impact of prepaymentUnderstanding the impact of prepayment

Prepones principal, reduces interest

Reduces the weighted average maturity of the pool

Impacts the quality of the pool?

Introduces callability risk in asset backed securities


Default rate or Expected lossesDefault rate or Expected losses

Credit enhancement workings for retail portfolios (ABS) and wholesale loans (CDOs) differ:

The former are based on expected losses, while the latter are typically based on simulation studies.

Expected loss:Dynamic pool: the current loss rate as % of the portfolio outstanding

Static pool: the cumulative loss rate of a static pool originated at the same time over its life

Static pool analysis is more representative of asset backed transactions which generally have a static pool


Analysis of the cumulative loss curveAnalysis of the cumulative loss curve

The cumulative loss curve plots the cumulative losses/charge offs to the initial outstanding balance of the pool

Relation between prepayment and expected loss:As obligors prepay, even though the charge off rate rises, the cumulative loss rate slows down

In such cases, it is important to examine the hazard rate, that is, the rate of charge off relative to the then-outstanding portfolio balance

To smoothen the impact of periodic ups and downs, a 6-monthly moving average may be used

For a typical portfolio, the hazard rate ascends as the portfolio seasons; however, the cumulative loss rate tends to flatten as the impact of ascending hazard rate is reduced by reducing pool size


Risks and risk mitigants in securitisationRisks and risk mitigants in securitisation

Sources of risks:PrepaymentDelayed paymentLossesMismatch in pay-in and pay-out scheduleInterest rate riskExchange rate riskRisk on reinvestments

Risk mitigants:Prepayment:

PO/ IO structures, reinvestment structures

Delays and losses:Credit enhancements

Cashflow mismatches:Liquidity support

Interest rate and other risks:Interest rate derivativesInverse floater


Concept of credit enhancementConcept of credit enhancement

Credit enhancement is to securitisation what economic capital is to corporate finance, and loan to value ratio is in lendingFunction of economic capital: protect the enterprise from bankruptcy at a certain “confidence level”: the confidence level itself is a product of target rating for the enterprise

In securitisation too, credit enhancement is to protect the structure from default at a target rating level

Need for relatively more careful credit enhancement setting in securitisation:

Isolation works on a mutually exclusive basis – investors, solely, have a sole claim on the assets isolatedNo scope for inviting fresh equity or support to protect a transactionNo scope for discretion on the part of the investors


Credit enhancementsCredit enhancements

The needed enhancement is a product of desired ratings. Size of enhancement based on expected losses.

Expected loss times a multiplier decide the enhancement levels

The multiplier is related to the target ratings

Key factors:Expected loss/ probability of default/ default severit

Diversification of the portfolio

Reliability of data

Factors affecting the extent of credit enhancement:Quality of the collateral

Diversification of the portfolio

Historical performance

LTV ratio

Seasoning: for example, in mortgages, S&P says 90% of all defaults occur up to the 10th year.

Originator/ third-party enhancement - domestic investors normally content with originator enhancement, but international investors prefer third party enhancements


Originator credit enhancementOriginator credit enhancement

Originator credit support:Direct recourse or repurchase agreement:

Legal issues

Credit rating

Problems in bankruptcy

Retained profit - most common in cases of high spread, as auto loans:

Over-collateralisation – in-kind reserve

Cash reserve

Loan from a bank repaid by excess servicing fees

Full or partial recourse

Substitution

Representation/warranties : current quality/ subsequent quality

Advancing mechanism - advances against delinquent pmts


Structural credit supportStructural credit support

Structural credit enhancement: stratified structureSenior/ junior structure: the inferior bonds provide protection to superior bonds

Third party credit supportDirect recourse or Guarantees

letters of credit

InsuranceMono-line insurers

Multi-line insurers

political risk insurance

Credit derivatives


Excess spread and credit enhancementExcess spread and credit enhancement

Excess spread provides the most basic, natural credit enhancement to a transaction

The economic substance of excess spread is the same as debt/income in traditional lending

Due to static pool nature, excess spread comes down as pool factor reduces:

Tendency towards prepayment is higher in pools with higher excess spread:Within the pool, loans with higher interest rates may prepay faster, thus reducing the average APR as well

Further reduces due to charge offs

Combined effect may sharply reduce the excess spread

Uses of excess spread in securitisation transactions:Returned periodically as service fees/junior coupon

Used to meet defaults on assets and paid to investors

Used to create reserves for defaulted assets; retained by the SPV


Profit extraction devices and excess spreadProfit extraction devices and excess spread

Whether and to what extent will a transaction be benefited by excess spread depends on profit extraction devicesCertain transactions strip the profits upfront and do not allow excess spread to go to the SPV:

Excess spread serves as a credit enhancement only if it is routed through the SPV; ANDIts payout is subordinated to the claims of investors

If excess spread is retained, it becomes a cash reserve


Over collateralisationOver collateralisationOver-collateralisation is similar to LTV ratio in traditional lending

Substantively similar to excess spread or subordinated investment by the originator

Differences:Unlike excess spread, not subject to distinctive prepayment risk

Unlike excess spread, may not be returned to the originator until after some time

Unlike subordinated investment, may be held by the originator as originated loan and not investment


Cash reserveCash reserve

Strongest form of credit enhancementUnlike excess spread and over-collateralisation, cash reserve is both credit and liquidity enhancerAvailable upfront and not over period of timeReduces economic efficiency: reinvestment has negative carryAmong other things, cash reserve also ensures performance when servicing is suspended for any reason:

The extent of cash reserve, among other things, is impacted by the transition from servicer to backup servicer


Liquidity supportLiquidity support

Liquidity support is to cover temporary mismatches in cash flows

Sources of liquidity support:Servicer advances

Third party liquidity facility

Zero coupon bond

Cash reserve


Paydown structurePaydown structure

Paydown structure is an important feature of seniority:seniority in bankruptcy can lose its meaning if the junior security retires faster

Sequential paydown structure:senior tranches retired first before junior ones;increasing proportion of junior tranches over time; therefore, increasing credit enhancementIncreases weighted average cost of funding

Pro rata allocationAll classes retired in proportion to their outstanding balancesMaintains credit enhancement levelsMaintains weighted average cost of the transaction

Fast pay/ slow pay structure:principal is distributed for fast pay for senior tranches, slow pay for junior tranches

Paydown by collateral coverage tests:Over-collateralisation testInterest coverage test


Fixing paydown structureFixing paydown structure

Ideally, except in abnormal circumstances, a transaction should provide for a pro-rata repayment:

However, the paydown structure is related to the shape of the cumulative loss curve

If the loss curve has a tendency of increasing slope, it is necessary to increase the level of enhancement over time

This is answered by increasing the CE to a target level by sequential payout

thereafter, the structure pay provide for a pro-rata payout

Also called shifting interest structure

When the structure returns to pro-rata, it would still provide for sequential payment in the event of certain triggers


Waterfall structureWaterfall structure

Basic fees and expenses including trustee, custodian, paying agent fees

Net periodic coupon to any swap counterparty

Servicer fee ??

Interest on class A

Paydown of class A as per paydown structure

Interest on class B

Paydown of class B as per paydown structure

so on

Any excess service fee

retained interest

Where appropriate, there may be separate waterfalls for interest and principal inflows


Computation of credit enhancementComputation of credit enhancement

Rating agencies construct a benchmark pool to test:Weighted average default frequency or default probabilityDefault correlationWeighted average loss severity

The methods to use for computing credit enhancement depend on

diversity of the portfolioavailability of the data

For diversified portfolios with established history, statistical methods such as standard deviation are often used.For concentric portfolios, highest loss over last 5 years, or other subjective yardsticks are used.


Covering other risks: Interest rate, exchange risks etcCovering other risks: Interest rate, exchange risks etc

Asset pool may have an actual or embedded interest rate risk

Necessary to convert a fixed rate collateral into floating rate notes or vice versa

Originator swap in the most convenient way, butoriginator rating may be a constraint

rating agencies go by the “weak link” theory and give rating based on the rating of the weakest of all connected parties

Other swaps

Inverse floating securities


Credit enhancements and the cost of the transactionCredit enhancements and the cost of the transaction

All credit enhancements carry a cost:External credit enhancements: explicit cost

Structural enhancement: spreads on junior classes

Originator enhancement: higher cost of originator support :Equity type treatment for regulatory/analytical purposes

Credit enhancements and resulting ratings have mutually conflicting impact on the weighted average cost of the transaction

Objective is to reach an equilibrium where economic waste is avoided, and transaction becomes protected.

Session 4Session 4

Prepayment and default risks in ABS


Risk attributes of asset backed securitiesRisk attributes of asset backed securities

Prepayment sensitive:Principal payout risk in case of pools subject to high degree of prepayment risk, such as mortgages and home equityEarly amortization riskDifferential prepayment sensitivity:

Due to structuring, as in case of IO/POs, PACs/TACs and support classesDue to sequential payment structures

Credit sensitive:High degree of leverage built on determinate credit supportDefault allocation risk:

Differential allocation due to subordination structures

Correlation sensitive:Correlation products, such as CDOs, are highly correlation sensitive


Prepayment as a riskPrepayment as a riskPrepayment is not a credit risk:

It is risk of callability; similar to a callable bond

Impact of prepayment:Interest rate risk:

You have less money to reinvest when you can reinvest at better rates; more money to reinvest when you can reinvest at lower rates

Yield:Affects yields when investors’ yield < coupon rate

Duration:Introduces contraction/extension risk

Negative convexity:Introduces negative convexity on price/rate relationship

Investors NPV:Reduces investors’ NPVIntroduces negative convexity

Impact on interest-rate sensitive products:Prices of IOs, support classes crash when prepayments rise

Impact of prepayment on the pool:Reduces excess spreadAdversely affects quality of the pool; increases default rateIntroduces risk of over-hedging


Quantifying and pricing prepayment riskQuantifying and pricing prepayment risk

The standard industry measure of knocking-off the prepayment impact is the computation of option-adjusted spread that values the contingent, path-dependent cashflowsThe classical approach includes:

Simulating term structure behavior:Interest rate process models

Relating interest rates to prepayment rates:Dynamic Prepayment models

Simulating prepayment paths:If number of periods be m, and the simulated yield curves be n, we have mXn paths

Feed these paths into a transaction cashflow model to get the interest and principal cashflows under each pathDiscount these cashflows with a fixed z spread over the yield curveThis volatility-adjusted z spread is the option-adjusted spread


Prepayment behavior Prepayment behavior

Reasons for prepayment:Economic: refinancingsNon-economic: simple factors such as homeowner shifting, unemployment, etc

Accordingly, prepayment may be classed into:Turnover, that is, prepayment taking place for non-economic reasons:

Turnover is taken as close to 75 to 100 PSAAs turnover is not necessarily detrimental to investors (it can happen as much during periods of high interest rates as during low interest rates), it is not a risk

Refinancings, which is function of interest ratesDetriment investors to the benefit of the homeowners:

– Comparable to a typical option – homeowners have bought a put option written by the mortgage investors

What complicates prepayment models:Rational behavior: the mortgagor will prepay the loan when it is cheaper to refinanceIrrational behavior: not all mortgagors act rationallyPrepayment rates have a geographical variation – in mortgage pools, it becomes difficult to aggregate different geographic sensitivities


Interest rate risk and prepayment behaviorInterest rate risk and prepayment behavior

As one of the prime causative factors in prepayment is refinancing motive, there is an adverse relation between prepayment rates and interest rates:

Borne out by empirical evidence: prepayment rates shot through the roof in 2002 and 2003

Like other interest-rate sensitive products, it is necessary to take into account the interest rate risk:

Swap options, callable bonds, structured notes, MBS have common features

Interest rate modeling is a key part of understanding MBS/ABS risks


Bond Market Association forecast of prepayment ratesBond Market Association forecast of prepayment rates

BMA predictions of prepayment rates

0

500

1000

1500

2000

2500Conv 5.5% 30year

GNMA 5.5% 30-year


Prepayment models – commonly static modelsPrepayment models – commonly static models

Commonly used static models:PSA:

Linear increase in prepayment rate over 30 months of originationCPR:

Constant prepayment rate. Typically used for HELs and student loansMPR:

Monthly payment rate used for non amortizing pools such as credit cards. A payment rate, not prepayment rate

ABS:Absolute prepayment speed, which is commonly used for auto loans, etc. The rate is applied on the original pool balance.

HEP:Home equity prepayment curve – 10-step linear increase culminating at 20%

MHP:Manufactured housing prepayment speed. 24-month ramp up starting from 3.7% and reaching 6% in the 24th month


Prepayment Dynamic modelsPrepayment Dynamic models

Econometric models:OLS regression methods, where the CPR takes the following form:

CPR = + 1x1 + 2x2 + 3x3+

Option-theoretic models, based on option pricing or contingent claims approach

May also be classified as structural and reduced form modelsThe Schwartz Torous model is an example of the reduced form approach

Studies in prepayment behavior vis-à-vis interest rates:Scores of models, such as:

Asay, Guillaume and Mattu model (1987)– CPR= .3 -.16 arctan (123.11*(spread +.02))

Chinloy Model:– .0813+-1.7951(0.6735)r +.9063 (.0688) +.0012 (.0024) t

– Where r is the current rate for fixed rate mortgages, is the rate at which the mortgage was originated, and t is the seasoning term (parantheses are standard error terms)


More prepayment modelsMore prepayment models

Schwartz and Torous model:• CPR = {lp (lt)^(p-1)/ (1+lt)^p }* exp(S 1to 4 bh *vh)• where • l=0.01496• p=2.31217• b1 = .38089• b2=.00333• b3=3.57673• b4=.26570• v1 = c - 1(t -s ), where c is the contracted mortgage rate, t is the current long term treasury

rate with a lag of s (standard taken as 3) • v2- v1^3• v 3 Is the ln of the actual mortgage pool outstanding, divided by the outstanding that would

have been there had there been no prepayments (tracks the history of prepayments in the pool)

• Goldman Sachs model:• RI (refinancing related prepayment rate) = .31234 - .20252*atn (8.157* { - (c+s)/(p+f) +1.20761}• where c is average MBS coupon rate and S is the servicing fee taken out (which means C + S is the

weighted average rate for the loans in the pool• p is the refinancing rate and F is the additional refinancing cost associated with refinancing

• Stanton’s model is an example of the structural approach


Structural approach to defaults and prepaymentsStructural approach to defaults and prepayments

The structural approach takes its basic inspiration from the seminal work of Merton on default being seen as an option of the equity holders to put the assets on debtLikewise, a mortgagor has the option to either default or prepay a loan.Thus, the value of the mortgage liability is:

PV of mortgage cashflows – value of default option – value of prepayment option

Default option:The option to default will arise if the house price is less than the PV of Mortgage payments

Prepayment option:Will arise where the refinancing cost is less than the mortgage cost


Default risk in MBSDefault risk in MBS

Prepayment and defaults: competing or compounding risks:

Both are dependent on common factors:Interest ratesHouse pricesGeneral economic conditions

Static default model:The SDA model:

Linear increase in default rates upto the 30th month, staying flat for the next 30 months, and then declines until maturity


Default modelsDefault modelsScoring models:

FICO scores:NextGen FICO scores

Option theoretic models:Kau etc (1985) proposed a model that looks at default as an option to default if the LTV exceeds 100%

However, no empirical evidence as default rates for LTV<100% are still lowHowever, there is an evidence that default rates are high where LTV ratios are high

– The model should, in fact, look at not only LTV but also debt coverage ratio

Intensity approach:Looks at default as a hazard rate function


Default risk in retail loan poolsDefault risk in retail loan poolsDefault risk in non-mortgage pools is dependant on:

Collateralised loans, such as auto loansNon-collateralised loans, such as credit cards

In the former, the LTV ratio is still an important guideIn the latter, default is driven by non-economic factors:

Systemic factors, such as economic cycle, unemployment, etcAdversities faced on account of bad credit historyLegal hassles of defaulting, etc


Computation of default-adjusted spreadComputation of default-adjusted spread

Like OAS, one may compute default adjusted spread by computing the expected value of losses on account of default:

Computed PV of mortgage payments under different scenarios of defaults (a)Assign probability to each scenario (b)The expected value of the payments is (ab)The difference between the expected value at no defaults and ab is the cost of the default option (d)The market price + the cost of the default option is the default-adjusted priceThe yield computed on the default adjusted price is the default adjusted yield; likewise, default adjusted spread may be computed

securitization

Economy & Finance

investors rating needs

investors payback

investors appetite

investors rights

special purpose entity

lower credit enhancement

risks asset

credit risk insurance