Mortgages transactions

Losses in master trust mortgage transactions can be recorded as an annualised charge-off rate in a similar manner to the standard method in credit card transactions. However, losses on prime mortgages are generally very small and intermittent so this measure will tend to be relatively volatile. The results for the Holmes Financing transaction provide a good illnstra-tion of this point (see Exhibit 11.16). 

There are two basic forms of pooled commercial mortgage transactions the true sale and the synthetic structures. The true sale mechanism, as its name suggests, involves the sale of assets from the originator s balance sheet to an SPV, which are then used as security for the issue of notes to investors. Synthetic structures, by contrast, involve the creation of a credit derivative linked to the performance of a pool of loans. The loans themselves remain on the balance sheet of the originator but the credit risks associated with these loans are transferred through the credit derivative to investors. Synthetic structures can simplify the issuance process and avoid many of the complexities (and costs) associated with the sale of assets in many jurisdictions. 

Due to the counterparty risk inherent in an HIC repo, it is rare to see it transacted either in the US market or elsewhere. Certain securities are not suitable for delivery for example, the class of mortgage securities known as whole loans in the United States, and these are often funded using HIC repo (termed whole-loan repo). 

In addition to the emergence of the nonconforming sector, the United Kingdom has also seen the development of an active buy-to-let market, flexible mortgages, and a reverse mortgage market, all of which have been used as collateral for MBS transactions. 

The challenge facing the designers of RMBS transactions is to provide a structure that will provide an attractive investment while being able to handle the uncertain nature of the cash flows generated by the underlying mortgages. A transaction will usually be structured into several classes of notes with different expected maturities and different risk profiles to appeal to a variety of investors. 

European RMBS transactions contain a combination of various features designed to protect investors from the impact of defaults on mortgages in the underlying collateral pool, including excess spread, reserve fund, and subordination of any lower priority notes. 

Principal and interest are separated and the principal component may be used to redeem notes, to purchase additional collateral or returned to the mortgage originator depending on the type of structure involved. The nonprincipal amount, or revenue component, is used to pay any necessary fees and expenses for the transaction, the interest on the notes, and to cover losses. 

In a pass-through transaction, the notes will normally be split into a number of classes that will be redeemed in order of priority. The actual speed at which the notes are redeemed will depend on the underlying repayment schedule of the mortgages in the pool and the rate at which the borrowers prepay their mortgages. (See Exhibit 11.8 for a generic example.)... 

Transactions may include a substitution period during which the issuer is allowed to use principal receipts to purchase additional mortgages. This, in effect, allows the issuer to prevent the collateral pool (and therefore the notes) paying down, giving noteholders certainty of cash flows during this period. However, at the end of the substitution period, principal payments will be used to redeem notes in the normal manner. 

Prepayments are the most important factor in determining the redemption profile of the notes in a pass-through transaction. The prepayment rate is usually measured as an annualised Conditional Prepayment Rate (CPR), which is defined as the proportion of the outstanding balance of the mortgages that is paid down ahead of schedule during the period. Exhibit 11.10 illustrates the paydown profile for the same example transaction as in Exhibit 11.9, but with an increased prepayment rate of 35% CPR. 

Flexible and offset account mortgages present a significant challenge to pass-through transaction structures. This arises because the borrowers requests to redraw previous prepayments could in aggregate exceed the principal receipts. The experiences of Australian mortgage lenders. 

There are two main types of reverse mortgage. The shared appreciation mortgage is structured so the mortgage lender receives back the original loan amount and a proportion of the increase in property value. This has certain advantages but does mean that the proceeds are entirely dependent on house prices. The Millshaw SAMS No.l transaction is backed by this type of mortgage collateral. The notes do not pay interest but pass these cash flows directly on to investors. 

The second type of reverse mortgage, securitised in Equity Release Funding (ERF) transactions, accrue interest at a rate set out in the mortgage agreement. The notes in these transactions pay interest, but in the early stages of the transaction these payments are met by borrowing... 

Reverse mortgages differ from standard RMBS transactions by their increased dependence on house-price movements and sensitivity to borrowers life expectancy and health. 

The combination of this redemption profile with a substitution period and/or a cash accumulation account would allow the creation of bullet securities, although at the time of writing this has not been done for a European issuer. This is not the only way to create notes that expect to have a bullet redemption profile. In the Delphinus 2002-11 transaction, the substitution period extended up to the step-and-call date, so the notes are likely to be redeemed on that date. However, if for any reason the issuer is not able or willing to call the notes, they will redeem as in a standard pass-through transaction, and so the legal maturity is dependent on the term of the underlying mortgages. 

Mortgage master trusts require the seller to maintain a certain minimum interest in the collateral pool held by the master trust. In credit card transactions this is used to absorb the monthly fluctuations in the balance outstanding on the credit cards and ensure there is always sufficient collateral to support the notes. In RMBS transactions the minimum seller s interest tends to be smaller as the mortgages have a more stable repayment profile, and this is primarily available to cover set-off risk in the event of originator insolvency. In existing transactions it is the minimum trust size rather than the minimum seller s share that has been the key constraint. 

The calculation of credit enhancement for notes in a master trust transaction seems more complicated than in a traditional pass-through transaction because subordinated notes from an earlier series are expected to be redeemed before the senior notes of later series. However, if the mortgages were to perform poorly, the trigger events ensure that all outstanding junior notes would only be repaid after all the senior notes. So the credit enhancement can be calculated as the aggregate balance of subordinate notes as a proportion of the total notes outstanding. 

Excess spread is available to build up the reserve fund to its required level and cover any principal deficiencies. For example, in the Holmes Financing transactions there is a mechanism whereby, if the yield on the mortgages falls below a certain specified level, excess spread will be trapped in a second reserve fund to provide additional credit enhancement as compensation for the reduction in excess spread. 

Arrears rates provide an early indication of potential future losses and so are the single most closely followed performance statistic for RMBS transactions. Whether arrears actually result in losses will depend on the property value in relation to the size of the loan, and whether these borrowers are able to recover, or at least make sufficient mortgage payments to allow the lender not to foreclose on the loan. 

In the remainder of this section we discuss the performance of the UK nonconforming mortgage sector. Many of these transactions are backed by collateral that has been originated within a relatively short period of time. These transactions do not have a revolving period, which allows us... 

Exhibit 11.19 shows the average proportion of the collateral that are more than three months behind with their payments, measured against the average age of the mortgages in the pool. As expected, arrears tend to increase during the early stages of a transaction and then stabilise after approximately two years, typically in the 12-14% range. However, there has been considerable variation between issuers. 

Prepayments have been more consistent across different MBS transactions than either arrears or losses (see Exhibit 11.21). Traditionally, UK nonconforming MBS transactions have been priced nsing the assumption that the prepayment speed would be at a CPR of 25%. Exhibit 11.21 shows that prepayments have generally started at a mnch slower rate but then have accelerated np to a CPR of 35% by the time the mortgages are approximately 18 months old. As a result, a 25% CPR assumption is likely to underestimate the average life of a fast-pay security but probably overestimate the average life of a longer-life security. 

Commercial mortgage-backed securities (CMBS) represent an important and growing sector of the European securitisation market. However, in many cases there are significant differences between transactions, even those backed by collateral from the same originator, and it is these differences, in both collateral types and structural features, that make European CMBS such an interesting asset class. This chapter focuses on some of the more important aspects that investors should consider when analysing the collateral supporting these transactions and briefly looks at the key features of the common transaction structures. 

Large multiborrower deals, where numerous commercial property loans, originated to numerous borrowers and secured on a variety of properties are grouped together into one transaction, in a similar way to a traditional residential mortgage deal. Such a deal may be either a traditional true sale transaction or a synthetic credit-linked structure. 

Double credit risk is a particular feature of such synthetic transaction structures. Not only are investors exposed to the performance of the reference pool of commercial mortgages, but also to the performance of the collateral the issuer is holding. If this includes notes issued by the originator itself then this will also include exposure to the credit rating of the originator. 

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