Description
This is a presentation explaining definition of home equity loan, loan characteristics, amortization types, prepayment penalties, performance drivers, interest rates fluctutation, involuntary prepayments, deal waterfall payment mechanics, residual tranche, mortgages
HOME EQUITY LOANS
Winterland Asset Management
DEFINITION
? Home
equity loan (HEL) can be defined as a subprime first-lien mortgage ? Other smaller loan types are sometimes included in this definition
Subprime first-lien mortgages comprise over 95% of loan originations ? Closed-end second liens: Second-lien mortgage used by the borrower to cash out the equity in the house. This was the traditional definition of a home equity loan in the early-1990s. ? High loan-to-value loans (HLTV): Mortgages with LTVs in excess of 100%, often up to 125%, taken to add/improve existing property.
?
LOAN CHARACTERISTICS
?
HEL borrowers can choose between different combinations of interest payment options, amortization types and loan terms:
?
Interest payment types:
?
Fixed-rate (30% by issuance): These are fixed coupon, level pay mortgages with typical loan terms of 30 years. They formed the greater proportion of market share before 1996. Hybrid adjustable rate mortgages: These mortgages have a fixed coupon for an initial period and a floating-rate coupon after a specified reset date. Example, a very common one is the 2/28 hybrid (60% by issuance), which has a 2-year fixedrate period and a 28-year floating-rate period. Hybrids are the dominant loan type for subprime mortgages since borrowers typically have a short time horizon, hoping to refinance into a lower-rate prime mortgage due to improvement in their credit file.
?
AMORTIZATION TYPES
?
Two amortization styles
?
?
Level Pay: These are fully-amortizing mortgages where the length of the amortization period is same as the term of the mortgage. Most fixed-rate and around 90% of hybrids are level-pay mortgages. Interest-only (IO) loans: The borrower pays interest only for an initial period (typically ranging from 2-10 years) with the amortization of principal over the remaining 20-28 years of the mortgage. For example, for a 5-year IO loan, the borrower only makes interest payments for the first five years with no principal amortization. At the end of five years, the borrower faces an increase in monthly payments since principal begins to amortize based on a 25-year schedule. They are generally used as a means of taxadvantage to borrowers.
PREPAYMENT PENALTIES & INTEREST RATE CAPS/FLOOR
Most subprime mortgages are originated with prepayment penalties during the first few years, which limit borrower prepayments and protect the lender’s interests. ? Hybrid loans are embedded with various interest rate caps to protect borrowers from large increases in interest rates:
?
? ?
?
Initial caps limit the increase in coupon at the first-reset date over the initial fixedrate (typically 1.5%-3%). Periodic caps limit the change in rate from the last period’s coupon to a specified amount (typically 1%). Lifetime caps limit the absolute level of interest rates to a specified maximum over the life of the loan (typically 6% over the initial fixed rate).
KEY PERFORMANCE DRIVERS
? ?
?
?
Voluntary Prepayments Involuntary Prepayments Delinquencies Severity rates
? ?
Voluntary prepayments can result from rate refinancing, cashout refinancing, credit curing and housing turnover. These components have different drivers:
Rate refinancing: Caused by borrower prepayments due to a decline in prevailing HEL loan rates. ? Cashout refinancing: Prepayments where borrowers tap the built up equity in the house by taking a larger loan. ? Credit curing: An improvement in borrower credit can enable homeowners to refinance in to a lower mortgage rate even as market rates remain constant. ? Turnover: Caused by borrowers shifting residence and prepaying the mortgage on the existing home.
?
?
Empirical data suggests that the shape of the voluntary prepayment curve is largely dependent on loan type.
VOLUNTARY PREPAYMENTS: DRIVERS
?
?
?
?
Borrower Characteristics: Rate-refinancing sensitivity is smaller for lower-credit borrowers than it is for better-credit borrowers due to fewer financing alternatives and lower sophistication. Prepayment Penalties: Loans with prepayments pay more slowly because of the penalty disincentive of nearly 2.5-3.0 point. Hybrid prepayments display a sharp spike after the prepayment penalty period. Loan Size: Prepayments sensitivity to interest rates is higher for larger loan sizes because dollar refinancing incentive increases with higher loan sizes Loan Age/Seasoning: Voluntary prepayments increase with loan age for the following three reasons:
cash out refinancing activity increases over time as borrowers build up equity due to accumulated home price appreciation. ? credit curing becomes viable after the borrower establishes a history of good credit for 2-3 years. ? turnover increases with loan age as most homeowners do not shift within the first few years of taking a new mortgage.
?
DRIVERS CONTD.
?
Interest rates: Voluntary prepayments increase with falling interest rates.
?
Prepayments of premium mortgages are a function of the amount of rate incentive, defined as the difference between the origination and the current market rate. Subprime prepayments are less sensitive to a change in interest rates than conventional prime mortgages.
?
Home Price Appreciation: Voluntary prepayments increase with home price appreciation. Cashout refinancings increase during periods of strong home price appreciation, as borrowers tap the built up equity in the house to retire more expensive debt or meet big ticket expenses. In addition, strong home price appreciation allows borrowers to reduce their mortgage rate even with unchanged market rates by lowering the loan to value (LTV).
?
Other Economic Variables: An improving credit environment with low unemployment and strong income growth would boost turnover due to higher economic activity and the increased ability to trade up to bigger houses.
INVOLUNTARY PREPAYMENTS, DEFAULTS
? Involuntary
prepayments (defaults) is critical for the credit analysis of subordinate and mezzanine HEL securities. Delinquency levels are particularly important in HELs, since delinquency triggers are a key determinant of the deal principal paydown are driven by:
? Drivers and delinquencies ? Borrower characteristics ? Loan/age seasoning ? Home price appreciation ? Economic Conditions
DEFAULTS & DELINQUENCIES: DRIVERS
?
Borrower Characteristics: Indicators of borrower credit quality such as length of employment, credit history, debt-to-income ratio etc. provide an indication of expected default rates. Borrowers who have previously experienced major derogatories on their credit reports are more likely to default Loan Age/Seasoning: Total delinquencies rise over time and stabilize around three years of deal age Home Price Appreciation: Home price appreciation is an important driver of defaults and delinquencies since it determines the current loan-to-value ratio. At higher current LTVs, borrowers have less equity in the home, and the incentive to default becomes greater Economic Conditions: Decrease in local employment growth is expected to increase defaults and delinquencies.
?
?
?
SEVERITY RATES
?
Loss severity rates, which measure the percentage loss on liquidations are driven by three key components
1. 2.
3.
Liquidation expenses (legal fees, foreclosure fees etc.) Delinquent principal and interest (P&I) advanced by the servicer, and Property market value decline (if any)
SUBPRIME SERVICING ENTITIES
?
The HEL sector has three types of servicing entities with different responsibilities:
?
Primary servicer: Responsible for the different aspects of loan administration – payment collection, loss mitigation, foreclosure, liquidation etc. The primary servicer is also responsible for submitting monthly remittance reports and advancing principal and interest to the trust. Most transactions have more than one primary servicer.
Special servicer: Performs the specialized function of handling seriously delinquent loans. Thus, the special servicer focuses on loss mitigation, managing defaults and REO (real estate owned) properties. Master servicer: Responsible for overseeing the different sub-servicers (primary and special) present on the transaction. Thus, the master servicer monitors the monthly remittance reporting and aggregation, tracks the movement of funds between the different accounts. In addition, the master servicer handles the event of a sub-servicer bankruptcy/inability to service by handling servicing for an interim period before assigning a new sub-servicer.
?
?
DEAL WATERFALL PAYMENT MECHANICS
INTEREST WATERFALL Bonds are paid interest to stated coupon
Collateral Interest Cashflow Gross interest + delinquent advancing + liquidation recover Servicing + MI premium + bond insurance fee Bond Coupon Payments EXCESS CASHFLOW WATERFALL Excess cashflow is used to cover losses, meet basis risk shortfalls and recoup bond losses
HEL Collateral
Excess interest flows into excess cashflow waterfall
Turbo principal to attain target OC
Residual cashflow
Residual Holder / NIM
Cover basis risk Shortfalls
Cover Bond Losses
Collateral Principal Cashflow Scheduled and prepaid principal + delinquent advancing + liquidation recovery Hedge cashflow not used for basis risk shortfalls and bond losses flows to the residual holder/NIM AAA BBB AA A
PRINCIPAL WATERFALL Bonds are paid principal in order of credit priority
Embedded Hedges ( Interest rate corridors / Swaps)
Hedge cashflow is available for basis risk shortfalls and bond losses not covered by excess interest
NIM SECURITIZATION STRUCTURE
Issuance of a net interest margin security (NIM) allows the issuer to monetize a portion of the residual position while still maintaining Collateral Balance economic exposure to the securitization through a smaller secondary residual position. Thus, a NIM represents the resecuritization of the more senior tranche of the residual
AAA
AAA
AA A BBB OC
AA A BBB OC NIM
Residual
Residual
MORTGAGE INSURANCE
?
?
Some HEL deals utilize mortgage insurance (MI) as an additional form of credit enhancement. Mortgage insurance policies protect the trust against a limited amount of loss (specified by the policy) in an event of default by the homeowner. There are two levels of MI policies used by HEL transactions:
?
Bulk / Lender-paid: This is the more common form of MI used in HEL transactions. The trust purchases mortgage insurance to lower severity rates on defaults. Since these are purchased by the trust, the mortgage insurance premium is paid from the cashflow received by the trust (typically senior in the waterfall). Bulk policies are also referred to as “lender-paid” policies since the insurancepremiums are paid by the holder of the loans (trust) instead of the borrower. Borrower-paid: At the time of making the loan, the lender sometimes requires a mortgage insurance policy before extending credit to the homeowner. While origination level policies are commonly used by prime mortgage originators, they are not very common among subprime lenders. These are typically referred to as “borrower-paid” MI policies since the borrower explicitly agrees to pay the insurance premium to the insurance provider.
?
Trust HC–11 – HEL Securitized Product
Characteristics of HEL mortgages in pool
Initial principal Number of individual mortgages Maturity Principal payment schedule $1.0 billion 6,500 10 years Balloon at maturity
Characteristics of ABS bonds issued in Trust HC-11 securitization
Initial total bond principal Initial over collateralization Maturity Type Floating rate index Reset Average ABS spread over Treasury Available funds cap Private mortgage insurance $990 million $10 million 10 years Floating 1 year Treasury Annually 1.5 percent per annum Actual mortgage interest received net of fees None
Initial prepay freeze-out window
Type Length of initial fixed rate period Weighted average initial fixed rate Floating index rate Reset Average floating rate spread Floor on floating rate Servicing fee
3 years
Fixed-floating hybrid 3 years 7.31% 1 year Treasury Annually 5% Initial fixed rate at origination 50 basis points
Residual Tranche
Excess Spread is because of: 1. The high initial interest rates on HEL mortgages relative to ABS bond coupons 2. The Trust’s initial over collateralization, i.e., the starting mortgage principal balance is greater than the starting bond principal balance
Residual Tranche - Waterfall
• Interest from Mortgages • Early payments of principal due to voluntary prepayments • Recoveries of principal from involuntary defaults
Servicing Fee
TRUST HC -11
• Coupons to ABS Bonds • Occasional Principal payments to ABS bonds Excess Spread to the residual tranche
Dynamics of payment to residual tranche depend on..
› Difference between the outstanding principal balances on the underlying mortgages and the ABS bonds
Mortgages
Mt = Mt-1 - [full principal from prepayments] – [full principal from defaulted mortgages] Bt = max{0, Bt-1 - [full principal from prepayments] [recovered principal from defaulted mortgages] – min{lost principal from defaults, Mortgage interest received – Bond interest due} }
Bonds
Key Features
The available excess spread is first used, if needed, to offset losses from current defaults
Every dollar of default loss reduces the mortgage balance Mt by a dollar. In contrast, defaults, if the excess spread is insufficient, reduce the bond principal Bt by less than dollar-for-dollar
The above leads to the shrinking of the over-collateralization in the trust
In the event of there being enough defaults, the ABS bonds are not paid off in full even with the excess spread
The waterfall dynamics is simplified by the absence of a catch up provision which in effect means that any excess spread not needed to defray losses from current defaults is disbursed to the residual tranche
Determinants of size and timing of payments to residual tranche
Interest Rate Fluctuation
Waterfall Rule
Residual Tranche
Voluntary Mortgage Prepayment
Defaults on Mortgages
Interest Rate Fluctuation
Initially, excess spread is positive and large
Given the fact that ABS bonds are floating, while the HEL mortgages are fixed over the first three years : -> Rising Treasury rates shrinks the excess spread and falling treasury rates have the opposite effect
The resulting interest rate fluctuation is a significant determinant of the payment to the residual tranche
Interest Rate fluctuations also have an impact on the mortgage prepayment rates and default rates, which have an impact on the payment to the residual tranche
Voluntary Mortgage Prepayment
Homeowners have an option to prepay the home equity loans after an initial 3-year freeze-out window
Prepayment is mainly driven motivation to refinance, due to an improvement in the rate because of:
•Improved credit score •Reference rate refinancing
Since the HELs switch to floating rates after the prepayment freeze, prepayments will not be sensitive to Treasury rate changes unless the floor binds
Another motive for mortgage prepayment is home price appreciation, due to:
•Increase in the loan-to-value ratio, allowing refinancing at a lower rate •Drive to borrow more against increased home equity via a new larger mortgage
Default On Mortgages
HEL Mortgages do not qualify for FNMA or GNMA insurance
The danger of default is significant given the impaired credit of the borrowers and high loan-to value ratios
The default rate changes with the mortgages season and home price appreciation and hence is not constant • As the pool seasons, the credit quality tends to deteriorate, as homeowners with improved credit tend to refinance, leaving behind owners with unchanged or worsened credit
THANK YOU
doc_704664617.ppt
This is a presentation explaining definition of home equity loan, loan characteristics, amortization types, prepayment penalties, performance drivers, interest rates fluctutation, involuntary prepayments, deal waterfall payment mechanics, residual tranche, mortgages
HOME EQUITY LOANS
Winterland Asset Management
DEFINITION
? Home
equity loan (HEL) can be defined as a subprime first-lien mortgage ? Other smaller loan types are sometimes included in this definition
Subprime first-lien mortgages comprise over 95% of loan originations ? Closed-end second liens: Second-lien mortgage used by the borrower to cash out the equity in the house. This was the traditional definition of a home equity loan in the early-1990s. ? High loan-to-value loans (HLTV): Mortgages with LTVs in excess of 100%, often up to 125%, taken to add/improve existing property.
?
LOAN CHARACTERISTICS
?
HEL borrowers can choose between different combinations of interest payment options, amortization types and loan terms:
?
Interest payment types:
?
Fixed-rate (30% by issuance): These are fixed coupon, level pay mortgages with typical loan terms of 30 years. They formed the greater proportion of market share before 1996. Hybrid adjustable rate mortgages: These mortgages have a fixed coupon for an initial period and a floating-rate coupon after a specified reset date. Example, a very common one is the 2/28 hybrid (60% by issuance), which has a 2-year fixedrate period and a 28-year floating-rate period. Hybrids are the dominant loan type for subprime mortgages since borrowers typically have a short time horizon, hoping to refinance into a lower-rate prime mortgage due to improvement in their credit file.
?
AMORTIZATION TYPES
?
Two amortization styles
?
?
Level Pay: These are fully-amortizing mortgages where the length of the amortization period is same as the term of the mortgage. Most fixed-rate and around 90% of hybrids are level-pay mortgages. Interest-only (IO) loans: The borrower pays interest only for an initial period (typically ranging from 2-10 years) with the amortization of principal over the remaining 20-28 years of the mortgage. For example, for a 5-year IO loan, the borrower only makes interest payments for the first five years with no principal amortization. At the end of five years, the borrower faces an increase in monthly payments since principal begins to amortize based on a 25-year schedule. They are generally used as a means of taxadvantage to borrowers.
PREPAYMENT PENALTIES & INTEREST RATE CAPS/FLOOR
Most subprime mortgages are originated with prepayment penalties during the first few years, which limit borrower prepayments and protect the lender’s interests. ? Hybrid loans are embedded with various interest rate caps to protect borrowers from large increases in interest rates:
?
? ?
?
Initial caps limit the increase in coupon at the first-reset date over the initial fixedrate (typically 1.5%-3%). Periodic caps limit the change in rate from the last period’s coupon to a specified amount (typically 1%). Lifetime caps limit the absolute level of interest rates to a specified maximum over the life of the loan (typically 6% over the initial fixed rate).
KEY PERFORMANCE DRIVERS
? ?
?
?
Voluntary Prepayments Involuntary Prepayments Delinquencies Severity rates
? ?
Voluntary prepayments can result from rate refinancing, cashout refinancing, credit curing and housing turnover. These components have different drivers:
Rate refinancing: Caused by borrower prepayments due to a decline in prevailing HEL loan rates. ? Cashout refinancing: Prepayments where borrowers tap the built up equity in the house by taking a larger loan. ? Credit curing: An improvement in borrower credit can enable homeowners to refinance in to a lower mortgage rate even as market rates remain constant. ? Turnover: Caused by borrowers shifting residence and prepaying the mortgage on the existing home.
?
?
Empirical data suggests that the shape of the voluntary prepayment curve is largely dependent on loan type.
VOLUNTARY PREPAYMENTS: DRIVERS
?
?
?
?
Borrower Characteristics: Rate-refinancing sensitivity is smaller for lower-credit borrowers than it is for better-credit borrowers due to fewer financing alternatives and lower sophistication. Prepayment Penalties: Loans with prepayments pay more slowly because of the penalty disincentive of nearly 2.5-3.0 point. Hybrid prepayments display a sharp spike after the prepayment penalty period. Loan Size: Prepayments sensitivity to interest rates is higher for larger loan sizes because dollar refinancing incentive increases with higher loan sizes Loan Age/Seasoning: Voluntary prepayments increase with loan age for the following three reasons:
cash out refinancing activity increases over time as borrowers build up equity due to accumulated home price appreciation. ? credit curing becomes viable after the borrower establishes a history of good credit for 2-3 years. ? turnover increases with loan age as most homeowners do not shift within the first few years of taking a new mortgage.
?
DRIVERS CONTD.
?
Interest rates: Voluntary prepayments increase with falling interest rates.
?
Prepayments of premium mortgages are a function of the amount of rate incentive, defined as the difference between the origination and the current market rate. Subprime prepayments are less sensitive to a change in interest rates than conventional prime mortgages.
?
Home Price Appreciation: Voluntary prepayments increase with home price appreciation. Cashout refinancings increase during periods of strong home price appreciation, as borrowers tap the built up equity in the house to retire more expensive debt or meet big ticket expenses. In addition, strong home price appreciation allows borrowers to reduce their mortgage rate even with unchanged market rates by lowering the loan to value (LTV).
?
Other Economic Variables: An improving credit environment with low unemployment and strong income growth would boost turnover due to higher economic activity and the increased ability to trade up to bigger houses.
INVOLUNTARY PREPAYMENTS, DEFAULTS
? Involuntary
prepayments (defaults) is critical for the credit analysis of subordinate and mezzanine HEL securities. Delinquency levels are particularly important in HELs, since delinquency triggers are a key determinant of the deal principal paydown are driven by:
? Drivers and delinquencies ? Borrower characteristics ? Loan/age seasoning ? Home price appreciation ? Economic Conditions
DEFAULTS & DELINQUENCIES: DRIVERS
?
Borrower Characteristics: Indicators of borrower credit quality such as length of employment, credit history, debt-to-income ratio etc. provide an indication of expected default rates. Borrowers who have previously experienced major derogatories on their credit reports are more likely to default Loan Age/Seasoning: Total delinquencies rise over time and stabilize around three years of deal age Home Price Appreciation: Home price appreciation is an important driver of defaults and delinquencies since it determines the current loan-to-value ratio. At higher current LTVs, borrowers have less equity in the home, and the incentive to default becomes greater Economic Conditions: Decrease in local employment growth is expected to increase defaults and delinquencies.
?
?
?
SEVERITY RATES
?
Loss severity rates, which measure the percentage loss on liquidations are driven by three key components
1. 2.
3.
Liquidation expenses (legal fees, foreclosure fees etc.) Delinquent principal and interest (P&I) advanced by the servicer, and Property market value decline (if any)
SUBPRIME SERVICING ENTITIES
?
The HEL sector has three types of servicing entities with different responsibilities:
?
Primary servicer: Responsible for the different aspects of loan administration – payment collection, loss mitigation, foreclosure, liquidation etc. The primary servicer is also responsible for submitting monthly remittance reports and advancing principal and interest to the trust. Most transactions have more than one primary servicer.
Special servicer: Performs the specialized function of handling seriously delinquent loans. Thus, the special servicer focuses on loss mitigation, managing defaults and REO (real estate owned) properties. Master servicer: Responsible for overseeing the different sub-servicers (primary and special) present on the transaction. Thus, the master servicer monitors the monthly remittance reporting and aggregation, tracks the movement of funds between the different accounts. In addition, the master servicer handles the event of a sub-servicer bankruptcy/inability to service by handling servicing for an interim period before assigning a new sub-servicer.
?
?
DEAL WATERFALL PAYMENT MECHANICS
INTEREST WATERFALL Bonds are paid interest to stated coupon
Collateral Interest Cashflow Gross interest + delinquent advancing + liquidation recover Servicing + MI premium + bond insurance fee Bond Coupon Payments EXCESS CASHFLOW WATERFALL Excess cashflow is used to cover losses, meet basis risk shortfalls and recoup bond losses
HEL Collateral
Excess interest flows into excess cashflow waterfall
Turbo principal to attain target OC
Residual cashflow
Residual Holder / NIM
Cover basis risk Shortfalls
Cover Bond Losses
Collateral Principal Cashflow Scheduled and prepaid principal + delinquent advancing + liquidation recovery Hedge cashflow not used for basis risk shortfalls and bond losses flows to the residual holder/NIM AAA BBB AA A
PRINCIPAL WATERFALL Bonds are paid principal in order of credit priority
Embedded Hedges ( Interest rate corridors / Swaps)
Hedge cashflow is available for basis risk shortfalls and bond losses not covered by excess interest
NIM SECURITIZATION STRUCTURE
Issuance of a net interest margin security (NIM) allows the issuer to monetize a portion of the residual position while still maintaining Collateral Balance economic exposure to the securitization through a smaller secondary residual position. Thus, a NIM represents the resecuritization of the more senior tranche of the residual
AAA
AAA
AA A BBB OC
AA A BBB OC NIM
Residual
Residual
MORTGAGE INSURANCE
?
?
Some HEL deals utilize mortgage insurance (MI) as an additional form of credit enhancement. Mortgage insurance policies protect the trust against a limited amount of loss (specified by the policy) in an event of default by the homeowner. There are two levels of MI policies used by HEL transactions:
?
Bulk / Lender-paid: This is the more common form of MI used in HEL transactions. The trust purchases mortgage insurance to lower severity rates on defaults. Since these are purchased by the trust, the mortgage insurance premium is paid from the cashflow received by the trust (typically senior in the waterfall). Bulk policies are also referred to as “lender-paid” policies since the insurancepremiums are paid by the holder of the loans (trust) instead of the borrower. Borrower-paid: At the time of making the loan, the lender sometimes requires a mortgage insurance policy before extending credit to the homeowner. While origination level policies are commonly used by prime mortgage originators, they are not very common among subprime lenders. These are typically referred to as “borrower-paid” MI policies since the borrower explicitly agrees to pay the insurance premium to the insurance provider.
?
Trust HC–11 – HEL Securitized Product
Characteristics of HEL mortgages in pool
Initial principal Number of individual mortgages Maturity Principal payment schedule $1.0 billion 6,500 10 years Balloon at maturity
Characteristics of ABS bonds issued in Trust HC-11 securitization
Initial total bond principal Initial over collateralization Maturity Type Floating rate index Reset Average ABS spread over Treasury Available funds cap Private mortgage insurance $990 million $10 million 10 years Floating 1 year Treasury Annually 1.5 percent per annum Actual mortgage interest received net of fees None
Initial prepay freeze-out window
Type Length of initial fixed rate period Weighted average initial fixed rate Floating index rate Reset Average floating rate spread Floor on floating rate Servicing fee
3 years
Fixed-floating hybrid 3 years 7.31% 1 year Treasury Annually 5% Initial fixed rate at origination 50 basis points
Residual Tranche
Excess Spread is because of: 1. The high initial interest rates on HEL mortgages relative to ABS bond coupons 2. The Trust’s initial over collateralization, i.e., the starting mortgage principal balance is greater than the starting bond principal balance
Residual Tranche - Waterfall
• Interest from Mortgages • Early payments of principal due to voluntary prepayments • Recoveries of principal from involuntary defaults
Servicing Fee
TRUST HC -11
• Coupons to ABS Bonds • Occasional Principal payments to ABS bonds Excess Spread to the residual tranche
Dynamics of payment to residual tranche depend on..
› Difference between the outstanding principal balances on the underlying mortgages and the ABS bonds
Mortgages
Mt = Mt-1 - [full principal from prepayments] – [full principal from defaulted mortgages] Bt = max{0, Bt-1 - [full principal from prepayments] [recovered principal from defaulted mortgages] – min{lost principal from defaults, Mortgage interest received – Bond interest due} }
Bonds
Key Features
The available excess spread is first used, if needed, to offset losses from current defaults
Every dollar of default loss reduces the mortgage balance Mt by a dollar. In contrast, defaults, if the excess spread is insufficient, reduce the bond principal Bt by less than dollar-for-dollar
The above leads to the shrinking of the over-collateralization in the trust
In the event of there being enough defaults, the ABS bonds are not paid off in full even with the excess spread
The waterfall dynamics is simplified by the absence of a catch up provision which in effect means that any excess spread not needed to defray losses from current defaults is disbursed to the residual tranche
Determinants of size and timing of payments to residual tranche
Interest Rate Fluctuation
Waterfall Rule
Residual Tranche
Voluntary Mortgage Prepayment
Defaults on Mortgages
Interest Rate Fluctuation
Initially, excess spread is positive and large
Given the fact that ABS bonds are floating, while the HEL mortgages are fixed over the first three years : -> Rising Treasury rates shrinks the excess spread and falling treasury rates have the opposite effect
The resulting interest rate fluctuation is a significant determinant of the payment to the residual tranche
Interest Rate fluctuations also have an impact on the mortgage prepayment rates and default rates, which have an impact on the payment to the residual tranche
Voluntary Mortgage Prepayment
Homeowners have an option to prepay the home equity loans after an initial 3-year freeze-out window
Prepayment is mainly driven motivation to refinance, due to an improvement in the rate because of:
•Improved credit score •Reference rate refinancing
Since the HELs switch to floating rates after the prepayment freeze, prepayments will not be sensitive to Treasury rate changes unless the floor binds
Another motive for mortgage prepayment is home price appreciation, due to:
•Increase in the loan-to-value ratio, allowing refinancing at a lower rate •Drive to borrow more against increased home equity via a new larger mortgage
Default On Mortgages
HEL Mortgages do not qualify for FNMA or GNMA insurance
The danger of default is significant given the impaired credit of the borrowers and high loan-to value ratios
The default rate changes with the mortgages season and home price appreciation and hence is not constant • As the pool seasons, the credit quality tends to deteriorate, as homeowners with improved credit tend to refinance, leaving behind owners with unchanged or worsened credit
THANK YOU
doc_704664617.ppt