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IFT Notes for Level I CFA® Program

LM04 An Introduction to Asset-Backed Securities

Part 4


ESG Risk for RMBS

In recent times, rating agencies have started incorporating ESG factors in their assessments of RMBS. For example:

  • The ratings process for a new securitization now includes the potential loss of mortgage principal due to natural disasters.
  • Several RMBS backed by subprime mortgages were downgraded because of a potential decline in interest income due to the adverse impact of the COVID-19 pandemic.

6. Collateralized Mortgage Obligation and Non-Agency RMBS

The prepayment risk seen in mortgage pass-through securities can be reduced by distributing the cash flows of these mortgage products to different classes or tranches through a process called structuring.

Collateralized mortgage obligation (CMO) is one such security created based on this principle of structuring where the cash flows (interest and principal) are redistributed to different tranches based on a set of rules. The different classes of bondholders in a CMO have different exposures to prepayment risk. The collateral for a CMO is a pool of mortgage pass-through securities and not a pool of mortgage loans.

Advantages of a CMO

Following are the key benefits of a CMO:

  • CMOs can be created to closely satisfy the asset/liability needs of institutional investors, thereby broadening the appeal of mortgage-backed products.
  • Some investors may want to increase their exposure to prepayment risk, while some may want to reduce. Based on their individual needs and risk appetite, investors can choose the CMO.

The most common types of CMO tranches are sequential-pay tranches, planned amortization class (PAC) tranches, support tranches, and floating-rate tranches.

6.1 Sequential-Pay CMO Structures

Each class/tranche of bond in this CMO structure is retired sequentially. Let us consider a CMO with four tranches. Note that this example is for simplicity. The coupon rate usually varies by tranche.

Tranche Par amount(US $) Coupon rate (%)
A 389,000,000 5.5
B 72,000,000 5.5
C 193,000,000 5.5
D 146,000,000 5.5
Total 800,000,000  

The prepayment risk is mitigated in this CMO by following these interest and principal repayment rules:

For payment of monthly coupon interest: Disburse monthly coupon interest to each tranche on the basis of the amount of principal outstanding for each tranche at the beginning of the month.

For disbursement of principal payments:

Disburse principal payments to tranche A until it is completely paid off.

After tranche A is completely paid off, disburse principal payments to tranche B until it is completely paid off.

After tranche B is completely paid off, disburse principal payments to tranche C until it is completely paid off.

After tranche C is completely paid off, disburse principal payments to tranche D until it is completely paid off.

The table below shows the average life of the collateral and different tranches at various prepayment rates. For instance, at a prepayment rate of 165 PSA, the average life of the collateral is 8.6 years, while it is 3.4 years and 19.8 years for tranches A and D respectively. At higher levels of prepayment, the average life of tranche A falls to 1.6 years and to 7 years for tranche D.

PSA Collateral Tranche A Tranche B Tranche C Tranche D
100 11.2 4.7 10.4 15.1 24.0
125 10.1 4.1 8.9 13.2 22.4
165 8.6 3.4 7.3 10.9 19.8
250 6.4 2.7 5.3 7.9 15.2
400 4.5 2.0 3.8 5.3 10.3
600 3.2 1.6 2.8 3.8 7.0
  • Tranche A has the highest contraction risk while tranche D has the highest extension risk.
  • Tranches A and B provide protection against contraction risk for tranches C and D.
  • Similarly, tranches C and D provide protection against extension risk for tranches A and B respectively.

6.2 CMO Structures Including Planned Amortization Class and Support Tranches

In a CMO with a sequential pay-structure, there was a great variability in average life/prepayment risk based on the prepayment rate. This is partly overcome with a CMO structure called the planned amortization class (PAC) tranches. PAC tranches offer great predictability as long as the prepayment rate is within a specified band over the collateral’s life. PACs offer protection against both extension risk and contraction risk.

Two PSA prepayment rates must be specified to create a PAC tranche. The two prepayment speeds used to create a PAC bond is called the PAC collar. The lower and upper PSA prepayment assumptions are called the “initial PAC collar”, or the “initial PAC bond”.

The greater certainty of the cash flow for the PAC tranches comes at the expense of the non-PAC tranches (called support tranches). The support tranches provide protection against both contraction and extension risk by absorbing excess principal paid or forgoing principal payment, if the collateral payments are slow.

The table below illustrates the life of PAC and support tranches at various prepayment rates. As you can see, for a prepayment rate between 100 PSA and 250 PSA, the average life of the PAC tranche is 7.7 years. Whereas, the average life of support tranche varies from 20 years to 3.3 years. The prepayment speeds of 100 PSA and 250 PSA create the initial PAC collar.

PSA Life of PAC Life of Support
50 10.2 24.9
75 8.6 22.7
100 7.7 20.0
165 7.7 10.7
250 7.7 3.3
400 5.5 1.9
600 4.0 1.4

The support tranches defer principal payments to the PAC tranches if the collateral prepayments are slow; support tranches do not receive any principal until the PAC tranches receive their scheduled principal repayment.

Support tranches absorb any principal prepayments in excess of the scheduled principal repayments that are made. This rule reduces the contraction risk of the PAC tranches. If the support tranches are paid off quickly because of faster-than-expected prepayments, they no longer provide any protection for the PAC tranches.

For example, a mortgage pass-through security has a greater average life variability than a PAC tranche, but lesser than that of a support tranche. The bond classes in a CMO can either be riskier or less risky than a mortgage pass-through security.

6.3 Other CMO Structures

Although the collateral pays a fixed rate, we can create tranches that pay floating rates. To do this a floater and an inverse floater combination is constructed from any of the fixed-rate tranches in the CMO structure. These tranches are sold to separate sets of investors with opposing views on interest rate movements. If interest rates go up, the floating rate tranche will pay a higher rate but the inverse floater tranche will pay a lower rate. Thus, the two tranches offset each other and the effective rate paid will be equal to rate on original fixed rate tranche.

6.4 Non-agency Residential Mortgage-Backed Securities

Unlike agency residential mortgage-backed securities (RMBS), non-agency RMBS is not backed by the government or a by a GSE; so, credit risk is a major concern for investors. For agency RMBS, when the principal will be repaid (prepayment risk) was a major concern. For non-agency RMBS, if and when (credit risk + prepayment risk) the principal will be paid is a concern.

Based on the credit quality of the mortgage loans in the pool, the securities can be classified into two:

  • Prime loans: Borrower has high credit quality, strong credit history, sufficient income to service the loan, and equity in the underlying property.
  • Subprime loan: Borrower has low credit quality.

The two complementary mechanisms required in structuring a non-agency RMBS are:

  1. The cash flows are distributed by rules, such as the waterfall, that dictate the allocation of interest payments and principal repayments to different tranches with various degrees of seniority/priority. Each tranche has a varying exposure to prepayment and credit risk.
  2. There are rules for the allocation of realized losses, which specify that subordinated bond classes have lower payment priority than senior classes.

Two factors to consider when forecasting the future cash flows of a non-agency RMBS:

  • Default rate for the collateral.
  • Recovery rate. Since some part of the mortgage may be seized and sold, the recovery rate is considered.

In order to obtain a favorable credit rating and to ensure some protection against losses in the pool, non-agency RMBS and non-mortgage ABS often require one or more credit enhancements.

  • Internal credit enhancements include senior/subordinated structures, cash reserve funds, overcollateralization, and excess spread accounts.
  • External credit enhancements include third party guarantee, such as a monoline insurance company.

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