Week 8

Mortgage-backed securities

Presented by
Dr James Cummings
Discipline of Finance

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 Learning Objectives

After studying this topic, you will understand

– what a mortgage is
– who the major originators of residential mortgages are
– the borrower and property characteristics considered by a lender in
evaluating the credit risk of an applicant for a mortgage loan
– what the servicing of a residential mortgage loan involves
– the types of residential mortgage loans based on interest-rate type,
amortisation type, and credit guarantees
– the cash flow of a mortgage loan
– the risks associated with investing in mortgages
– the significance of prepayment risk

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 Learning Objectives

After studying this topic, you will understand

– what a mortgage pass-through security is
– the cash flow characteristics of mortgage pass-through securities
– the importance of prepayment projections in estimating the cash flow of a
mortgage pass-through security
– the weighted-average coupon rate and weighted-average maturity of a
pass-through security
– what the Public Securities Association prepayment benchmark is and how it
is used for determining the cash flow of a pass-through security
– the factors that affect prepayments for agency mortgage-backed securities
– what the cash flow yield is and its limitations
– how the average life of a mortgage pass-through security is calculated
– why prepayment risk can be divided into contraction risk and extension risk

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 Learning Objectives

After studying this topic, you will understand

– why and how an agency collateralised mortgage obligation (CMO) is
created
– what a sequential-pay CMO is
– how the average life of a sequential-pay CMO compares to that of the
collateral from which it is created
– what an accrual tranche is and its effect on the average life of sequential-
pay tranches in the CMO structure
– the need for credit enhancement
– originator-provided credit enhancement

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 Origination of Residential Mortgage Loans

– The original lender is called the mortgage originator.

– The principal originators of residential mortgage loans are savings
institutions, commercial banks, and mortgage bankers.
– Mortgage originators may service the mortgages they originate, for which
they obtain a servicing fee.
– Mortgage originators can:
– Hold the mortgage in their portfolio.
– Sell the mortgage to an investor who wishes to hold the mortgage or
who will place the mortgage in a pool of mortgages to be used as
collateral for the issuance of a security.
– Use the mortgage themselves as collateral for the issuance of a security.

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 Origination of Residential Mortgage Loans

– When a mortgage originator intends to sell the mortgage, it will obtain a

commitment from the potential investor (buyer).
– Two government-sponsored enterprises (GSEs) and several private
companies buy mortgages.
– Because these entities pool these mortgages and sell them to investors,
they are called conduits.
– When a mortgage is used as collateral for the issuance of a security, the
mortgage is said to be securitised.

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 Origination of Residential Mortgage Loans

– Payment-to-Income Ratio
– The payment-to-income ratio (PTI) is the ratio of monthly payments to
monthly income, which measures the ability of the applicant to make
monthly payments (both mortgage and real estate tax payments).
– The lower the PTI, the greater the likelihood that the applicant will be
able to meet the required monthly mortgage payments.

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 Origination of Residential Mortgage Loans

– Loan-to-Value Ratio
– The loan-to-value ratio (LTV) is the ratio of the amount of the loan to the
market (or appraised) value of the property.
– The lower this ratio is, the greater the protection for the lender if the
applicant defaults on the payments and the lender must repossess and
sell the property.
– The LTV has been found in numerous studies to be the single most
important determinant of the likelihood of default.
– The rationale is straightforward: Homeowners with large amounts of
equity in their properties are unlikely to default.
– Data on the behaviour of borrowers indicate that they have an
increased propensity to voluntarily stop making their mortgage
payments once the current LTV exceeds 125%, even if they can afford
making monthly payments. This behaviour is referred to as a ‘strategic
default’ behaviour.

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 Types of Residential Mortgage Loans

– Interest Rate Type

– The interest rate that the borrower agrees to pay, referred to as the
note rate, can be fixed or change over the life of the loan.
– For a fixed-rate mortgage (FRM), the interest rate is set at the closing of
the loan and remains unchanged over the life of the loan.

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 Types of Residential Mortgage Loans

– Interest Rate Type

– For an adjustable-rate mortgage (ARM), as the name implies, the note
rate changes over the life of the loan.
– The note rate is based on both the movement of an underlying rate,
called the index or reference rate, and a spread over the index called
the margin.
– Two categories of reference rates have been used in ARMs:
1) market-determined rates
2) calculated rates based on the cost of funds for savings institutions

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 Types of Residential Mortgage Loans

– Interest Rate Type

– The basic ARM is one that resets periodically and has no other terms
that affect the monthly mortgage payment.
– Typically, the mortgage rate is affected by other terms. These include:
1) periodic rate caps
2) lifetime rate cap and floor
– A periodic rate cap limits the amount that the interest rate may increase
or decrease at the reset date.
– Most ARMs have an upper limit on the mortgage rate that can be
charged over the life of the loan.
– This lifetime rate cap is expressed in terms of the initial rate.
– ARMs may also have a lower limit (floor) on the interest rate that can be
charged over the life of the loan.

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 Types of Residential Mortgage Loans

– Amortisation Type
– The amount of the monthly loan payment that represents the repayment
of the principal borrowed is called the amortisation.
– Traditionally, both FRMs and ARMs are fully amortising loans.
• What this means is that the monthly mortgage payments made by
the borrower are such that they not only provide the lender with the
contractual interest but also are sufficient to completely repay the
amount borrowed when the last monthly mortgage payment is
made.

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 Types of Residential Mortgage Loans

– Amortisation Type
– Fully amortising fixed-rate loans have a payment that is constant over
the life of the loan.
– For example, suppose a loan has an original balance of $200,000, a
note rate of 7.5%, and a term of 30 years.
• Then the monthly mortgage payment would be $1,398.43.
• The formula for calculating the monthly mortgage payment is
 i (1 + i ) n 
MP = MB0  n 
 (1 + i ) − 1 
where MP = monthly mortgage payment ($), MB0 = original
mortgage balance ($), i = note rate divided by 12 (in decimal),
and n = number of months of the mortgage loan.

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 Types of Residential Mortgage Loans

– Amortisation Type
– To calculate the remaining mortgage balance at the end of any month,
the following formula is used:
 (1 + i ) n − (1 + i )t 
MBt = MB0  n 
 (1 + i ) − 1 
where MBt = mortgage balance after t months, MB0 = original
mortgage balance ($), i = note rate divided by 12 (in decimal), and n
= number of months of the mortgage loan.

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 Types of Residential Mortgage Loans

– Amortisation Type
– To calculate the portion of the monthly mortgage payment that is the
scheduled principal payment for a month, the following formula is used:
 i (1 + i )t −1 
SPt = MB0  n 
 (1 + i ) − 1 
where SPt = scheduled principal repayment for month t, MB0 = original
mortgage balance ($), i = note rate divided by 12 (in decimal), and n
= number of months of the mortgage loan.

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 Types of Residential Mortgage Loans

– Amortisation Type
– For example, suppose that for month 12 (t = 12), we have

=MB0 $200,000;
= i 0.00625;
= n 360
– Then the scheduled principal repayment for month 12 is

 i (1 + i )t −1 
SPt = MB0  n 
 (1 + i ) − 1 
 0.00625(1.00625)12−1 
= $200,000  360 
 (1.00625) − 1 
= $158.95

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 Types of Residential Mortgage Loans

– Amortisation Type
– For an ARM, the monthly mortgage payment adjusts periodically.
• Thus, the monthly mortgage payments must be recalculated at each
reset date.
• This process of resetting the mortgage loan payment is referred to
as recasting the loan.
– During 2001–2007 , several types of non-traditional amortisation
schemes became popular in the mortgage market.
• The most popular was the interest-only product.
• With this type of loan, only interest was paid for a predetermined
period of time called the lockout period.

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 Types of Residential Mortgage Loans

– Credit Guarantees
– Mortgage loans can be classified based on whether a credit guarantee
associated with the loan is provided by the federal government, a
government-sponsored enterprise (GSE), or a private entity.
• Loans that are backed by agencies of the federal government are
referred to under the generic term of government loans and are
guaranteed by the full faith and credit of the U.S. government.
– The Department of Housing and Urban Development (HUD) oversees
two agencies that guarantee government loans:
1) Federal Housing Administration (FHA), and
2) Veterans Administration (VA).

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 Types of Residential Mortgage Loans

– Credit Guarantees
– In contrast to government loans, there are loans that have no explicit
guarantee from the federal government.
• Such loans are said to be obtained from ‘conventional financing’
and therefore are referred to in the market as conventional loans.
• Although a conventional loan might not be insured when it is
originated, a loan may qualify to be insured when it is included in a
pool of mortgage loans that backs a mortgage-backed security
(MBS).
– MBSs are those loans issued by two GSEs, Freddie Mac and
Fannie Mae.
– A conventional loan can be insured by a private mortgage insurer.

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 Risks Associated with Investing in Mortgage Loans

– Investors face four main risks by investing in residential mortgage loans:

1) credit risk
2) liquidity risk
3) price risk
4) prepayment risk

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 Risks Associated with Investing in Mortgage Loans

– Credit Risk
– Credit risk is the risk that the homeowner/borrower will default.
– For FHA- and VA-insured mortgages, this risk is minimal.
– The LTV ratio provides a useful measure of the risk of loss of principal in
case of default.
• At one time, investors considered the LTV only at the time of
origination (called the original LTV) in their analysis of credit risk.
• Because of periods in which there has been a decline in housing
prices, the current LTV has become the focus of attention.

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 Risks Associated with Investing in Mortgage Loans

– Liquidity Risk
– Although there is a secondary market for mortgage loans, the fact is
that bid-ask spreads are large compared to other debt instruments.
– That is, mortgage loans tend to be rather illiquid because they are large
and indivisible.
– Price Risk
– The price of a fixed-income instrument will move in an opposite direction
from market interest rates.
– Thus, a rise in interest rates will decrease the price of a mortgage loan.

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 Risks Associated with Investing in Mortgage Loans

– Prepayment Risk
– The three components of the cash flow are
1) interest
2) principal repayment (scheduled principal repayment or
amortisation)
3) prepayment
– Prepayment risk is the risk associated with a mortgage’s cash flow due to
prepayments.
• More specifically, investors are concerned that borrowers will pay
off a mortgage when prevailing mortgage rates fall below the
loan’s note rate.

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 General Description of an Agency Mortgage Pass-Through
Security

– A mortgage pass-through security, or simply pass-through security, is a type

of MBS created by pooling mortgage loans and issuing certificates entitling
the investor to receive a pro rata share in the cash flows of the specific pool
of mortgage loans that serves as the collateral for the security.
– Because there is only one class of bondholders, these securities are
sometimes referred to as single-class MBS.

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 General Description of an Agency Mortgage Pass-Through
Security

– When a pass-through security is first issued, the principal is known.

– Over time, because of regularly scheduled principal payments and
prepayments, the amount of the pool’s outstanding loan balance declines.
– The pool factor is the percentage of the original principal that is still
outstanding.
– At issuance, the pool factor is 1 and declines over time.
– Pool factor information is published monthly.

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 General Description of an Agency Mortgage Pass-Through
Security

– Payments are made to the security holders each month.

– However, neither the amount nor the timing of the cash flow from the
loan pool is identical to that of the cash flow passed through to
investors.
– The monthly cash flow for a pass-through security is less than the monthly
cash flow of the loan pool by an amount equal to servicing and other
fees.
– Because of prepayments, the cash flow of a pass-through is also not
known with certainty.
– Not all mortgages included in the loan pool that are securitised need to
have the same note rate and the same maturity.
– Consequently, when describing a pass-through security, the weighted-
average coupon rate and a weighted-average maturity are
determined.

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 General Description of an Agency Mortgage Pass-Through
Security

– A weighted-average coupon rate (WAC) is found by weighting the note rate

of each mortgage loan in the pool by the amount of the mortgage
outstanding at issuance.
– A weighted-average maturity (WAM) is found by weighting the remaining
number of months to maturity for each mortgage loan in the pool by the
amount of the mortgage outstanding at issuance.
– After origination of the MBS, the WAM of a pool changes. Fannie Mae and
Freddie Mac report the remaining number of months to maturity for a loan
pool, which they refer to as the weighted-average remaining maturity
(WARM).
– Both Fannie Mae and Freddie Mac also report the weighted average of the
number of months since the origination of the security for the loans in the
pool.
– This measure is called the weighted-average loan age (WALA).

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 Prepayment Conventions and Cash Flow

– To value a pass-through security, it is necessary to project its cash flow.

– The difficulty is that the cash flow is unknown because of prepayments.
– The only way to project a cash flow is to make some assumption about the
prepayment rate over the life of the underlying mortgage pool.
– The prepayment rate assumed is called the prepayment speed or, simply,
speed.
– The yield calculated based on the projected cash flow is called a cash
flow yield.

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 Prepayment Conventions and Cash Flow

– Conditional Prepayment Rate

– A benchmark for projecting prepayments and the cash flow of a pass-
through requires assuming that some fraction of the remaining principal
in the pool is prepaid each month for the remaining term of the
mortgage.
– The prepayment rate assumed for a pool, called the conditional
prepayment rate (CPR), is based on the characteristics of the pool and
the current and expected future economic environment.
– It is referred to as a conditional rate because it is conditional on the
remaining mortgage balance at the beginning of the month.

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 Prepayment Conventions and Cash Flow

– Single-Monthly Mortality Rate

– The CPR is an annual prepayment rate.
– To estimate monthly prepayments, the CPR must be converted into a
monthly prepayment rate, commonly referred to as the single-monthly
mortality rate (SMM).
– A formula can be used to determine the SMM for a given CPR:
SMM = 1 – (1 – CPR)1/12
– Suppose that the CPR used to estimate prepayments is 6%.
– The corresponding SMM is
SMM = 1 – (1 – 0.06)1/12
SMM = 1 – (0.94)1/12
SMM = 0.005143

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 Prepayment Conventions and Cash Flow

– Single-Monthly Mortality Rate and Monthly Prepayment

– An SMM of w% means that approximately w% of the remaining
mortgage balance at the beginning of the month, less the scheduled
principal payment, will prepay that month.
– That is,
prepayment for month t = SMM×(beginning mortgage
balance for month t – scheduled principal payment for month t)
– For example, suppose that an investor owns a pass-through in which the
remaining mortgage balance at the beginning of some month is $290
million. Assuming that the SMM is 0.5143% and the scheduled principal
payment is $3 million, the estimated prepayment for the month is
0.005143 ($290,000,000 – $3,000,000) = $1,476,041

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 Prepayment Conventions and Cash Flow

– Public Securities Association Prepayment Benchmark

– The Public Securities Association (PSA) prepayment benchmark is
expressed as a monthly series of annual prepayment rates.
– The PSA benchmark assumes that prepayment rates are low for newly
originated mortgages and then will speed up as the mortgages become
seasoned.
– The PSA benchmark assumes the following CPRs for 30-year mortgages:
1) a CPR of 0.2% for the first month, increased by 0.2% per year
per month for the next 30 months when it reaches 6% per year
2) a 6% CPR for the remaining years
– The benchmark, referred to as ‘100% PSA’ or simply ‘100 PSA’, is
depicted graphically over page.

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 Graphic Depiction of 100 PSA

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 Prepayment Conventions and Cash Flow

– PSA Prepayment Benchmark

– Mathematically, 100 PSA can be expressed as follows:
If t ≤ 30: CPR = 6%(t/30)
If t > 30: CPR = 6%
where t is the number of months since the mortgage originated.
– Slower or faster speeds are then referred to as some percentage of
PSA.
– For example, 150 PSA means 1.5 times the CPR of the PSA benchmark
prepayment rate.
– A prepayment rate of 0 PSA means that no prepayments are assumed.
– The CPR is converted to an SMM using
SMM = 1 – (1 – CPR)1/12

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 Prepayment Conventions and Cash Flow

– Beware of Convention
– The PSA prepayment benchmark is simply a market convention.
– It is the product of a study by the PSA based on FHA prepayment
experience.
– Data that the PSA committee examined seemed to suggest that
mortgages became seasoned (i.e., prepayment rates tended to level
off) after 30 months and the CPR tended to be 6%.
– Astute money managers recognise that the CPR is a convenient
shorthand enabling market participants to quote yield and/or price but
that, as a convention for determining value, it has many limitations.

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 Cash Flow Yield

– Bond-Equivalent Yield
– For a pass-through, the yield that makes the present value of the cash
flow equal to the price is a monthly interest rate.
• The yield on a pass-through must be calculated so as to make it
comparable to the yield to maturity for a bond.
– This is accomplished by computing the bond-equivalent yield.
• For a pass-through security, the semi-annual yield is
semi-annual cash flow yield = (1 + yM)6 – 1
where yM is the monthly interest rate that will equate the present
value of the projected monthly cash flow to the price of the pass-
through.
• The bond-equivalent yield is found by doubling the semi-annual cash
flow yield; that is,
bond-equivalent yield = 2[(1 + yM)6 – 1]

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 Cash Flow Yield

– Limitations of Cash Flow Yield Measure

– The yield corresponding to a price must be qualified by an assumption
concerning prepayments.
– A yield number without qualification as to the prepayment assumption is
meaningless.
– Even with specification of the prepayment assumption, the yield number
is meaningless in terms of the relative value of a pass-through.

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 Cash Flow Yield

– Average Life
– The average life of a mortgage-backed security is the average time to
receipt of principal payments (scheduled principal payments and
projected prepayments), weighted by the amount of principal expected.
– Mathematically, the average life is expressed as follows:
T
t × principal received at month t
average life = ∑
t =1 12(total principal)
where T is the number of months.
– The average life of a pass-through depends on the PSA prepayment
assumption.
– To see this, the average life is shown in the table over page for different
prepayment speeds for a hypothetical pass-through. The underlying
mortgages are fixed-rate level-payment mortgages with a WAC of
8.125%. The pass-through rate is 7.5%, with a WAM of 357 months.

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 Average Life of a Pass-Through Based on Different PSA
Prepayment Assumptions

PSA speed Average life

50 15.11
100 11.66
165 8.76
200 7.68
300 5.63
400 4.44
500 3.68
600 3.16
700 2.78

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 Prepayment Risk and Asset/Liability Management

– An investor who owns pass-through securities does not know what the cash
flow will be because that depends on prepayments.
– The risk associated with prepayments is called prepayment risk.
– Suppose that an investor buys a 10% coupon pass-through security at a
time when mortgage rates are 10%.
– If mortgage rates decline to 6%, there will be two adverse consequences:
1) We know from the basic property of fixed-income securities that the
price of an option-free bond will rise.
• But in the case of a pass-through security, the rise in price will not be
as large as that of an option-free bond because a fall in interest
rates increases the borrower’s incentive to prepay the loan and
refinance the debt at a lower rate.
2) The cash flow must be reinvested at a lower rate.
– These two adverse consequences when mortgage rates decline are referred
to as contraction risk.

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 Prepayment Risk and Asset/Liability Management

– If mortgage rates rise to 15%, the price of the pass-through, like the price
of any bond, will decline.
– But it will decline more because the higher rates will tend to slow down the
rate of prepayment.
– This is just the time when investors want prepayments to speed up so that
they can reinvest the prepayments at the higher market interest rate.
– This adverse consequence of rising mortgage rates is called extension risk.

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 Agency Collateralised Mortgage Obligations

– Collateralised mortgage obligations (CMOs) are bond classes created by

redirecting the cash flows of mortgage-related products so as to mitigate
prepayment risk.
– The mere creation of a CMO cannot eliminate prepayment risk; it can
only transfer the various forms of this risk among different classes of
bondholders.
– The bond classes created are commonly referred to as tranches.
– The principal payments from the underlying collateral are used to retire
the tranches on a priority basis according to terms specified in the
prospectus.

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 Agency Collateralised Mortgage Obligations

– Sequential-Pay Tranches
– The first CMO was created in 1983 and was structured so that each
class of bond would be retired sequentially.
• Such structures are referred to as sequential-pay CMOs.
– A CMO is created by redistributing the cash flow—interest and
principal—to the different tranches based on payment rules.
• The payment rules at the bottom of the table over page describe
how the cash flow from the pass-through (i.e., collateral) is to be
distributed to the four tranches.
• There are separate rules for the payment of the coupon interest and
the payment of principal, the principal being the total of the
regularly scheduled principal payment and any prepayments.

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 FJF-01: Hypothetical Four-Tranche Sequential-Pay Structurea

Tranche Par Amount Coupon Rate (%)

A $194,500,000 7.5
B 36,000,000 7.5
C 96,500,000 7.5
D 73,000,000 7.5
$400,000,000
aPayment rules:
1. For payment of periodic coupon interest: Disburse periodic coupon interest to each tranche on
the basis of the amount of principal outstanding at the beginning of the period.
2. For disbursement of principal payments: Disburse principal payments to tranche A until it is
paid off completely. After tranche A is paid off completely, disburse principal payments to
tranche B until it is paid off completely. After tranche B is paid off completely, disburse
principal payments to tranche C until it is paid off completely. After tranche C is paid off
completely, disburse principal payments to tranche D until it is paid off completely.

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 Agency Collateralised Mortgage Obligations

– Sequential-Pay Tranches
– Each tranche receives periodic coupon interest payments based on the
amount of the outstanding balance at the beginning of the month.
• The disbursement of the principal, however, is made in a special
way.
• A tranche is not entitled to receive principal until the entire principal
of the preceding tranche has been paid off.
– The principal pay-down window for a tranche is the time period between
the beginning and the ending of the principal payments to that tranche.
• Tranches can have average lives that are both shorter and longer
than the collateral, thereby attracting investors who have a
preference for an average life different from that of the collateral.

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 Average Life for the Collateral and the Four Tranches of FJF-01

Average Life for

Prepayment
Speed (PSA) Collateral Tranche A Tranche B Tranche C Tranche D
50 15.11 7.48 15.98 21.02 27.24
100 11.66 4.90 10.86 15.78 24.58
165 8.76 3.48 7.49 11.19 20.27
200 7.68 3.05 6.42 9.60 18.11
300 5.63 2.32 4.64 6.81 13.36
400 4.44 1.94 3.70 5.31 10.34
500 3.68 1.69 3.12 4.38 8.35
600 3.16 1.51 2.74 3.75 6.96
700 2.78 1.38 2.47 3.30 5.95

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 Agency Collateralised Mortgage Obligations

– Sequential-Pay Tranches
– There is considerable variability of the average life for the tranches.
– However, there is some protection provided for each tranche against
prepayment risk.
• This is because prioritising the distribution of principal (i.e.,
establishing the payment rules for principal) effectively protects the
shorter-term tranche A in this structure against extension risk.
• This protection must come from somewhere, so it comes from the
three other tranches.
• Similarly, tranches C and D provide protection against extension risk
for tranches A and B.
• At the same time, tranches C and D are provided protection against
contraction risk.

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 Agency Collateralised Mortgage Obligations

– Accrual Bonds
– In many sequential-pay CMO structures, at least one tranche does not
receive current interest.
– Instead, the interest for that tranche would accrue and be added to the
principal balance.
– Such a bond class is commonly referred to as an accrual tranche, or a Z
bond (because the bond is similar to a zero-coupon bond).
– The interest that would have been paid to the accrual bond class is then
used to speed up the paydown of the principal balance of earlier bond
classes.
• To see this, consider FJF-02, a hypothetical CMO structure with the
same collateral as FJF-01 and with four tranches, each with a
coupon rate of 7.5%.
• The difference is in the last tranche, Z, which is an accrual.
• The structure for FJF-02 is shown in the table over page.

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 FJF-02: Hypothetical Four-Tranche Sequential-Pay Structure
with an Accrual Bond Classa

Tranche Par Amount Coupon Rate (%)

A $194,500,000 7.5
B 36,000,000 7.5
C 96,500,000 7.5
Z (accrual) 73,000,000 7.5
$400,000,000
aPayment rules:
1. For payment of periodic coupon interest: Disburse periodic coupon interest to tranches A, B,
and C on the basis of the amount of principal outstanding at the beginning of the period. For
tranche Z, accrue the interest based on the principal plus accrued interest in the preceding
period. The interest for tranche Z is to be paid to the earlier tranches as a principal pay down.
2. For disbursement of principal payments: Disburse principal payments to tranche A until it is
completely paid off. After tranche A is paid off completely, disburse principal payments to
tranche B until it is paid off completely. After tranche B is paid off completely, disburse
principal payments to tranche C until it is paid off completely. After tranche C is paid off
completely, disburse principal payments to tranche Z, until the original principal balance plus
accrued interest is paid off completely.

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 Agency Collateralised Mortgage Obligations

The average lives for tranches A, B, and C are shorter in FJF-02 than in FJF-01
because of the inclusion of the accrual bond. For example, at 165 PSA, the
average lives are as follows:

Structure Tranche A Tranche B Tranche C

FJF-01 3.48 7.49 11.19
FJF-02 2.90 5.86 7.87

The reason for the shortening of the non-accrual tranches is that the interest that
would be paid to the accrual bond is being allocated to the other tranches.
Tranche Z in FJF-02 will have a longer average life than that of tranche D in
FJF-01.

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 Credit Enhancement

– Securities without a government guarantee or a GSE guarantee must be

structured with additional credit support to receive an investment-grade
rating.
– This credit support is needed to absorb expected losses from the underlying
loan pool due to defaults.
– This additional credit support is referred to as a credit enhancement.

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 Credit Enhancement

– When rating agencies assign a rating to the bond classes in a non-agency

MBS deal, they must analyse the credit risk associated with a bond class.
– Basically, that analysis begins by looking at the credit quality of the
underlying pool of loans.
– Given the credit quality of the borrowers in the pool and other factors, such
as the structure of the transaction, a rating agency will determine the dollar
amount of the credit enhancement needed for a particular bond class to
receive a specific credit rating.
– The process by which the rating agencies determine the amount of credit
enhancement needed is referred to as sizing the transaction.

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 Credit Enhancement

– Originator/Seller-Provided Credit Enhancement

– The originator/seller of the collateral to the special purpose entity (SPE)
can provide credit support for the transaction in one or a combination of
three ways: excess spread, cash collateral and over-collateralisation.
– The most natural form of credit enhancement is the interest from the
collateral that is not used to satisfy the liabilities (i.e., the interest
payments to the bond classes in the structure) and the fees (such as
mortgage servicing and administrative fees).
– The amount by which the interest payment from the collateral exceeds
what has to be paid to the bond classes as interest and the fees that
must be paid is called excess spread or excess interest.

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 Credit Enhancement

– Originator/Seller-Provided Credit Enhancement

– The monthly excess spread can be
1) distributed to the seller of the collateral to the SPE,
2) used to pay any losses realised by the collateral for the month,
3) retained by the SPE 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 other three options.

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 Credit Enhancement

– Originator/Seller-Provided Credit Enhancement

– The 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 other ways.
1) By depositing at the time of the sale of the collateral to the SPE
cash that can be utilised if the other forms of credit enhancement
are insufficient to meet collateral losses.
2) By providing a subordinated loan to the SPE.
– If the amount of the collateral exceeds the liabilities, the excess
collateral is referred to as over-collateralisation and can be used to
absorb any collateral losses.

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 Required reading

– Fabozzi, F.J. and Fabozzi, F.A. (2021), Bond Markets, Analysis, and
Strategies, 10th edition, MIT Press
– Chapters 11 to 14
– Schwartz, C. (2023), ‘Australian Securitisation Markets: Responding to
Change’, Speech to the Australian Securitisation Conference, Reserve Bank
of Australia, 21 November.

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 Homework problems

– Fabozzi and Fabozzi (2021)

– Chapter 11
• Questions 13, 14
– Chapter 12
• Questions 11, 13, 15, 16, 22
– Chapter 13
• Questions 3, 4

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