An Introduction to the Non-Agency CMO Market

Transcription

1 Fixed Income Research An Introduction to the Non-Agency CMO Market June 27, 2002 Brian Hargrave Marianna Fassinotti Steve Bergantino EXECUTIVE SUMMARY The non-agency (private-label) MBS market has been in existence for over a decade. As of mid-may 2002, the total outstanding amount of securities in the nonagency market was approximately $424 billion. Over time, the securitized product mix has evolved with the separation into the jumbo and alt-a sectors and, more recently, with the introduction of hybrid ARMs. While each sector has its defining features, the basic structure of non-agency CMOs, as well as the analysis of credit and prepayment risk, is analogous. In this piece, we present a broad overview of the credit and prepayment considerations of the non-agency market.

2 MARKET OVERVIEW The non-agency securitized market first grew significantly with the issuance of jumbo securitizations in the late 1980s and early 1990s. As shown in Figure 1, by 1993 issuance totaled approximately $150 billion in jumbo transactions, equivalent to about 50% of agency CMO issuance. Not surprisingly, securitized issuance has historically peaked during market rallies notably , , and most recently in 2001 when refinancing activity surged. By the mid-1990s, a separate alt-a market was formed when loans with slightly weaker credit characteristics than those of jumbos (but considerably better than subprime loans) were securitized. By 1998, alt-a issuance reached $23 billion. (For a detailed look at the formation of the alt-a market, refer to our publication, The Alt-A Market: Evolution and Outlook, January 9, 2002.) The non-agency investor base has expanded over time and today includes banks, money managers, insurance companies, and hedge funds. Most recently, regulatory changes have piqued the interest of banks, which already having a strong presence in the agency MBS market are trying to capture the higher yields offered in the non-agency market. The recent revisions to risk-based capital guidelines reduced the capital charge assessed on AAA non-agency MBS from 4.0% to 1.6% and have, therefore, made the securities more attractive from a return-on-regulatory-capital perspective. On the heels of this development, many banks have reevaluated their investment guidelines and allocated additional funds to privatelabel securities. The objective of this piece is to introduce the non-agency CMO market by describing the basic loan types and the collateral characteristics across different products. Figure 1. Issuance Trends in Non-Agency CMOs $ Billion 350, , ,000 Alt-A Jumbo Agency CMO 200, , ,000 50, June 27, Lehman Brothers

3 We also present a typical deal structure, explaining the important features used to create credit enhancement. Next, we examine credit performance and prepayment characteristics of non-agency collateral, before concluding with a brief discussion of relative value. COLLATERAL Non-agency CMOs are tranched cash flows whose collateral consists of loans not guaranteed by FNMA or FHLMC (Government Sponsored Enterprises). The GSEs follow specific guidelines for the loans they guarantee, the most important being loan size and credit quality; loans that meet these criteria are called conforming loans. The conforming loan size limit is set according to the yearly average home price as reported by the FHFB (Federal Housing Finance Board), and currently stands at $300,700. Agency MBS collateral guaranteed by FN/ FH is generally referred to as conventional. While strong credit and a nonconforming loan size are the two major characteristics of jumbo loans, an alt- A loan may or may not qualify in terms of the agency loan size requirement, but fail to meet the underwriting standards of the agencies or the jumbo market. Generally, these loans are of high quality but contain some credit blemishes such as reduced documentation. The alt-a market was created as a result of the market s increased emphasis on the pricing of collateral characteristics and investors desire for more homogeneous collateral backing individual nonagency securitizations. Lastly, while outside the scope of this piece, subprime loans also fail to meet the underwriting standards of the GSEs. As the name suggests, subprime loans have significantly weaker credit characteristics than jumbos or alt-as. Below, we summarize the main collateral characteristics that affect the prepayment and credit performance of non-agency mortgages, focusing on the relative differences between jumbos and alt-as. These collateral characteristics include loan size, FICO score, loan-to-value ratio, investment properties, documentation type, and spread at origination. Figure 2 outlines our conclusions. (We do not provide a comparison of non-agency collateral attributes to conventional collateral, except with respect to loan size, as the agencies do not publish this information.) Figure 2. Average Loan Characteristics: 2001 Originations Loan Limited/ Spread at Size Avg. FICO Avg. LTV Non-Owner Reduced Origination (000s) FICO <650 LTV >80 Occupied Doc (SATO) Jumbo % 71% 7% 3% 24% 24 bp Alt-A June 27, Lehman Brothers

4 Loan Size: Due to the GSEs loan-size limit, the average loan size of jumbos is considerably higher than conventional mortgage pools. The average loan size of 2001 jumbos is $407,000, while the average loan size of a conventional mortgage is $148,000. The current loan size limit for single family homes is $300,700. FICO Score: A frequently used measure of borrower credit quality, this incorporates a borrower s payment history (including outstanding debt, length of credit history, and the types of credit in use). Jumbos have higher average FICOs than alt-as, indicating stronger borrower characteristics. The proportion of borrowers with FICO scores less than 650 (a rough cutoff for prime ) in jumbo pools is 5%, whereas in alt-a pools the proportion stands at 15%. LTV: The loan-to-value ratio, which is inversely related to the borrower s equity in the property, also differs between jumbos and alt-as: jumbos have an average LTV of 71%, and alt-as have an average LTV of 77%. The proportion of LTVs exceeding 80% in jumbo pools is 7%, while alt-a pools have almost four times that amount. Investment properties: Jumbo pools have considerably fewer non-owneroccupied properties than alt-a pools. In the 2001 vintage, jumbo pools contain only 3% non-owner-occupied properties, while 11% of alt-a pools consist of non-owner-occupied properties. Reduced Documentation: While reduced documentation (e.g., employment status, property appraisal, etc.) can be present in agency and jumbo pools, it is most prevalent in alt-a pools. The average percentage of reduced documentation in jumbo pools is 24% in the 2001 vintage and 71% in alt-a pools. As these statistics suggest, reduced or limited documentation is a defining feature of alt-a loans. Spread at Origination (SATO): This refers to the difference between the gross WAC of a given loan and the average conforming mortgage rate in the month the loan was originated. In general, SATO is a valuable tool capturing how poorer borrower characteristics affect the mortgage rate. Thus, a higher SATO implies weaker credit characteristics. In 2001, jumbos paid on average a 24 bp premium over the conforming mortgage rate, while alt-as paid a 94 bp spread. Geographic Distribution: Non-conforming loan size pools tend to be more heavily concentrated in metropolitan areas with high-cost housing. As a result, the California market is particularly important in non-agency pools. Jumbos and alt-as have similar California concentrations of about 40%-45% for a given pool. June 27, Lehman Brothers

5 SENIOR-SUBORDINATE STRUCTURE Due to their non-conforming status, CMOs backed by non-agency collateral hold no agency credit guarantee, and, therefore, credit enhancement must be structured. Non-agency CMOs are commonly created in a senior-subordinate structure. As the name suggests, this type of credit enhancement structure is composed of two main classes. The senior tranche, for which a AAA rating is sought, holds top priority over payments of principal and interest, while one or more subordinate tranches follow in the structure. The subordinated tranches are rated at lower investment grades or non-investment-grade ratings, and the juniormost tranche (usually the first-loss piece) may remain unrated. Similar to the agency CMO market, AAA securities are typically further tranched to redistribute prepayment and interest rate risk. For example, the AAA tranche is often carved up to create other cash flow structures such as sequentials or PACs, also common in the agency market. The generic senior-subordinate structure simply seeks to redistribute credit risk through credit-tranching. An example illustrates this point. We assume a $250 million deal, in which the senior tranche comprises 96% of the deal and the remaining 4% is divided among 6 subordinate tranches (Figure 3). These statistics are representative of new issue jumbo transactions. The subordinate classes will absorb all losses up to $10 million (or 4% of original balance). If losses exceed $10 million, the senior tranche would experience a loss amount equal to the difference between the total loss and $10 million. Not surprisingly, the subordinate tranches are compensated for their greater default risk exposure with additional yield spread. Shifting Interest & Delevering Typically, a generic non-agency senior-subordinate structure incorporates shifting interest, through which both credit and prepayment risk are re-allocated by redirecting principal payments to the senior tranche according to a specified schedule. The objective of a shifting interest structure is to increase subordination to the senior tranche. Specifically, to build credit enhancement for the senior tranche, the pro rata share of prepayments attributed to the subordinate class is Figure 3. Hypothetical Plain Non-Agency CMO Bond Credit Rating Amount ($ mn) % of Deal Senior Tranche AAA Sub. 1 AA Sub. 2 A Sub. 3 BBB Sub. 4 BB Sub. 5 B Sub. 6 Not Rated June 27, Lehman Brothers

6 allocated to the senior class according to the shifting interest schedule. Scheduled principal payments are distributed between the two classes pro rata. As shown in Figure 4, during the first five years, the AAA bonds receive 100% of the prepayments, effectively locking out the subordinates. After five years, the AAA bonds continue to receive a decreasing proportion of the subordinates pro rata share of prepayments, while still receiving their pro rata share. At the tenth year, the seniors will only receive their pro rata prepayment amount. The initial five-year lockout of the subordinates results in greater average life stability for the subordinates. Since all prepayments are diverted to the senior class at the outset of the deal, the AAA bonds effectively have a higher prepayment rate. As a result of the shifting interest structure, non-agency bonds typically delever over time. Delevering refers to the increase in subordination levels due to the effect of prepayments in the shifting interest structure. As the balance of the subordinates becomes a larger percentage of the total deal balance, the subordination increases. Figure 5 shows the increase in subordination of a AAA bond at different constant prepayment scenarios. Figure 4. Class AAA Prepayment Allocation Distribution Period (Months) Class AAA Total Prepayment Percentage % of Total Prepayments % of Sub. Prepayments + Class Pro Rata Share % of Sub. Prepayments + Class Pro Rata Share % of Sub. Prepayments + Class Pro Rata Share % of Sub. Prepayments + Class Pro Rata Share 108-Forward Class Pro Rata Share Only Figure 5. AAA Subordination at Constant CPR AAA Subordination (%) 25% 20% 6% CPR 12% CPR 55% CPR 15% 10% 5% 0% WALA June 27, Lehman Brothers

7 Rating Agency Methodology Fitch, Moody s, and Standard and Poor s are the three agencies that rate nonagency securities. To assess the level of credit risk of non-agency securities, the rating agency methodology generally begins with a forecast of base case foreclosure rates and loss severity assumptions. When analyzing a large number of risk factors, the rating agencies focus on a few loan attributes in this forecast. These criteria include LTV ratios, FICO scores, loan size, purpose of the loan, and geographic location. With seasoning, LTV ratios tend to improve as the amount of equity in a property increases. Improvements in LTV are also caused by rapid home price appreciation, a phenomenon particularly prevalent in the past years. In both cases, the incentive of the borrower to continue timely payments increases and the likelihood of a default falls. The FICO score is a compiled measure that reflects a number of credit characteristics, namely the borrower s credit history. With respect to loan size, the agencies assume that larger loan sizes tend to be riskier due to their historical relationship to defaults. Essentially, a large loan is more likely to suffer a greater decline in market value during a recession. In response, borrowers are less inclined to repay, resulting in higher defaults. The purpose of the loan is categorized either as a rate/term refinancing, a cashout refinancing, or a purchase loan. Rate/term refinancing clearly holds a lower risk profile, as a borrower is attempting to lock in a lower mortgage rate. Cashout refinancing is generally a sign of economic distress, while purchases refer to loans for new home purchases. The geographic dispersion of a pool of loans is seminal in the determination of its appropriate rating. Loans amply dispersed throughout the country will not be unduly burdened by a recession in any one geographic region. Geographic dispersion also controls for the effects of price appreciation volatility, a crucial element in the California housing market. The three rating agencies each employ slightly different methodologies for estimating the appropriate level of credit enhancement. Fitch begins by determining default probabilities using estimates of foreclosure. Next, loss severities are estimated, incorporating changes in regional home price trends. Finally, Fitch determines the credit enhancement at each rating using historical data on regional default rates to forecast lifetime pool loss scenarios. Similarly, the Standard and Poor s rating methodology starts by measuring a base case foreclosure rate. Using an automated system, individual loans are placed into risk buckets according to measured default probabilities. Once ranked, groups of loans are further differentiated across credit categories. Common to all the rating agency methodologies is the use of stress multiples. The base case foreclosure rates are stressed with multiples which have been established using historical economic data. Using these stress multiples, the rating agencies can test the securities under the full spectrum of economic conditions. The rating agencies assign higher ratings to those bonds which withstand higher stresses. CREDIT CONSIDERATIONS Delinquencies and Losses To analyze non-agency credit, we show loss expectations relative to subordination levels for both the jumbo and alt-a sectors. Our objective is to measure the strength of the credit enhancement embedded in the senior bonds. Given the lack of consistent data across issuers, we avoid showing sector-wide historical losses and June 27, Lehman Brothers

8 instead show data provided by RFC. In addition to providing continuous data, RFC issues both jumbo and alt-a loans. By using RFC, then, we are able to remove servicer variability across sectors. Figure 6 shows cumulative losses for RFC jumbos and alt-as. The low losses highlight the extent to which AAA bonds are protected by the 4% subordination typical in jumbo deals and 6% subordination in alt-a deals. Even in 1993, when RFC jumbo losses approached 25 bp, the 4% subordination of the AAA provided a solid cushion. Recap of Historical Ratings Actions A second method to assess historical credit performance of non-agency CMOs is the examination of upgrade/downgrade activity by the rating agencies. The upgrade/downgrade ratio indicates the relative strength of the sector by comparing the aggregate number of upgrades to the aggregate number of downgrades. The years 2000 and 2001 are of particular strength with an upgrade/downgrade ratio of 19 and 24 respectively (Figure 7). These ratios stand in stark contrast to the credit Figure 6. RFC Cumulative Losses, as % of Original Balance a. RFC Jumbo Cumulative Losses b. RFC Alt-A Cumulative Losses WALA WALA Figure 7. Historical Credit Rating Perfomance, No. of Rating Actions Non-Agency Corporate Upgrade Downgrade Ratio Upgrade Downgrade Ratio Q Source: Moodys and S&P. June 27, Lehman Brothers

9 performance of corporate bonds, with a 2000 upgrade/downgrade ratio of 0.5 and a 2001 ratio of 0.3. The resilience of the non-agency sector can largely be attributed to solid collateral performance and structural delevering. In fact, according to Fitch and S& P, only three AAA classes have been downgraded since As mentioned earlier, typically the senior class of a non-agency CMO will receive the first incoming prepayments and is retired faster. During a refinancing wave, when prepayments surge, the senior class is retired sooner, creating a higher level of credit enhancement for all bonds. These higher support levels, in turn, have yielded upgrades from the rating agencies. PREPAYMENTS Given the robust credit enhancement of non-agency securities, the primary concern for AAA investors is prepayment risk. The main factors affecting non-agency prepayment risk are loan size, credit quality, loan age, and prepayment penalties. Loan Size The size of a loan is at the crux of non-agency prepayment considerations. Put simply, larger loans tend to prepay faster than smaller ones when mortgage rates rally due to the greater dollar savings. A major theme in the non-agency prepayment experience of 2001 has been the narrowing of jumbo-agency prepayment differences. Since 1998, the agency loan size limit has increased by approximately $50,000, which in turn has increased the relative callability of agencies. Figure 8 shows the jumbo-agency prepayment difference by rate incentive during two refinance waves. Strong home price appreciation during the decade drove increases in both the agency and jumbo loan balances. However, since increases in loan size affect prepayments most at lower balances, the increase in the agency loan balance Figure 8. Jumbo-Agency Prepayment Differences % CPR WARI (bp) June 27, Lehman Brothers

10 causes a greater increase in their callability. For every increase in loan size at a given rate incentive, the incremental increase in the prepayment rate narrows. (For a more in-depth discussion of loan size, refer to Loan Size and Jumbo-Agency Prepayment Differentials in our MBS & ABS Outlook, June 25, 2001.) For example, the 2000 origination jumbos in Figure 9, which had significantly larger loans sizes than similar WAC FNMAs, prepaid at about 66% CPR versus 55% CPR for the FNMAs. Similarly, 2000 origination jumbo alt-as prepaid faster at 11% CPR higher than comparable WAC conforming alt-as, 54% CPR versus 43% CPR, respectively. Credit Quality In general, weaker credit translates into lower callability in unseasoned collateral. As Figure 9 shows, alt-a prepayment rates for 2000 originations are about 10-20% CPR lower versus jumbos or agencies. However, time and home price appreciation both help cure alt-a credit, significantly reducing prepayment differences on seasoned vintages of alt-as versus jumbos and FNMAs. Credit curing refers to a borrower s ability to improve credit characteristics and refinance into a conforming or jumbo loan at a lower rate. In addition, high coupon jumbos and FNMAs will burn out after seasoning through refinancing waves. 1 Observing 1997 originations in Figure 9, the prepayment rates of a conforming alt-a and a FNMA are very similar, 32% and 35% CPR, respectively. Similarly, the difference in prepayment rates between jumbos and jumbo alt-as is much narrower than 2000 originations. Prepayment Penalties Prepayment penalties have become more common in the alt-a market. The majority of penalties is for six months interest on 80% of the outstanding balance of a 1 Burnout refers to a scenario where refinancings do not surge in response to a fall in rates. Figure 9. January-December 2001 Prepayments 2000 Origination 1997 Origination WAC Size SATO 1-Yr WAC Size SATO 1-Yr Cut WAC ($K) (bp) CPR Cut WAC ($K) (bp) CPR Jumbo FNMA Jumbo Alt-A Conf. Alt-A Jumbo Alt-A PP Conf Alt-A PP FNMA 8.5% WAC refers to an 8.0% coupon. Lag-weighted average value of Lehman Brothers secondary market, conforming 30-year mortgage rate for January-December 2001 was 7.03%. PP refers to prepayment penalty loans. June 27, Lehman Brothers

11 refinanced loan. As one would expect, loans with penalties prepay slower than nonpenalty loans. In fact, prepayment penalties increase refinancing costs, reducing the callability of new issue prepayment penalty loans. In Figure 9, new issue jumbo alt-as with prepayment penalties prepaid 30% CPR lower than non-penalty jumbo alt-as (24% CPR versus 54% CPR) and even prepaid lower than non-penalty alt- As with conforming balances. RELATIVE VALUE FRAMEWORK Price movements in the whole loan market are typically quoted for the entire AAA class of a securitization versus the same coupon agency MBS passthrough. This is a reasonably fair comparison, as both securities are credit enhanced (the agency MBS by guarantee and whole loan by subordination) and represent a straight passthrough of the underlying mortgage cash flows. Historically, whole loan passthroughs have traded at a price drop to agency MBS of similar coupon (Figure 10). The primary reasons for this are twofold. First, whole loan collateral, in particular jumbo collateral, exhibits more callability, and, therefore, investors will pay a lower price for a security compared with the agency MBS market, all else being equal. Second, the agency MBS market is a more standardized market that fosters the liquidity and financability of securities. Within the whole loan sector, alt-as have historically traded at a premium to jumbos (or less of a price drop in Figure 10), due to the better convexity characteristics of the underlying collateral. Consistent with pricing themes at the passthrough level, whole loan CMOs will generally trade at wider nominal spreads (lower prices) than agency CMOs of similar coupon and structure. The comparison of a short agency sequential and a short non-agency sequential is a case in point. As shown in Figure 11, historically, the 3-year agency sequential consistently trades at a tighter nominal Treasury spread than the comparable non-agency sequential. This nominal Figure 10. Historical Jumbo and Alt-A Price Drop 32nds Jumbo Price Drop Alt-A Price Drop /97 1/98 5/98 9/98 1/99 5/99 9/99 1/00 5/00 9/00 1/01 5/01 9/01 1/02 5/02 June 27, Lehman Brothers

12 spread difference primarily reflects the greater convexity cost in the non-agency sequential, due to the greater refinancability of the jumbo loan collateral. To assess the effectiveness of wider nominal spreads to compensate investors for increased convexity costs, we use option adjusted spread (OAS) analysis. The OAS methodology takes into account how cash flows may change when interest rates change. In other words, it acknowledges a borrower s prepayment option and how this option affects prepayments under different interest rate movements. Mathematically, the OAS is the difference between the zero-volatility spread and the option cost. In Figure 12, we show OAS valuations of a 3-year agency sequential and a 3-year non-agency sequential. As expected, the non-agency sequential trades at a wider spread than the agency. The higher option cost of the non-agency sequential reflects the greater callability of non-agency collateral, while the difference in zero-volatility spread reflects the difference in nominal spreads between the two securities. The higher ZV of the non-agency sequential more than compensates for its higher option cost, resulting in a 3 bp pickup in OAS. Figure 11. Historical 3-Year Sequential Nominal Treasury Spreads bp Year Agency Seq 3-Year Non-Agency Seq /20/00 10/28/00 2/5/01 5/16/01 8/24/01 12/2/01 3/12/02 Figure 12. OAS Analysis of Current Coupon Non-Agency 3-Year Sequential Nominal Avg. Life ZV Option Price Spread** (Static) Yield Spread Cost LOAS 3-Year Agency Seq /C 2.86 Yr Year Non-Agency Seq /C Difference * 6.5% Current Coupon, GWAC 6.96%. ** Nominal spreads are quoted to the interpolated Treasury curve. ZV spreads are calculated using Lehman Brothers Prepayment model projections along the zero volatility path. June 27, Lehman Brothers

13 CONCLUSION In sum, the non-agency CMO market offers an attractive alternative for agency CMO investors. Structured credit enhancement provides a robust level of protection given historical loss experience. As a result, the risk in AAA non-agency CMOs is largely concentrated in prepayments, similar to that of agency CMOs. While, in the case of jumbo collateral, callability is greater than that of agency MBS collateral, wider nominal spreads generally more than compensate investors for the increased risk. In the case of alt-a collateral, slight credit blemishes reduce overall prepayment risk by muting prepayments in a rallying rate environment. With recent changes to bank regulatory capital requirements, what has been a long-term migration of investors into non-agency CMOs is likely to increase in pace. June 27, Lehman Brothers

14

15

16 Publications: L. Pindyck, A. DiTizio, B. Davenport, W. Lee, D. Kramer, J. Threadgill, R. Madison, A. Acevedo, K. Kim, C. Rial, J. Batstone This material has been prepared and/or issued by Lehman Brothers Inc., member SIPC, and/or one of its affiliates ("Lehman Brothers") and has been approved by Lehman Brothers International (Europe), regulated by the Financial Services Authority, in connection with its distribution in the European Economic Area. This material is distributed in Japan by Lehman Brothers Japan Inc., and in Hong Kong by Lehman Brothers Asia. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy the securities or other instruments mentioned in it. No part of this document may be reproduced in any manner without the written permission of Lehman Brothers. We do not represent that this information is accurate or complete and it should not be relied upon as such. It is provided with the understanding that Lehman Brothers is not acting in a fiduciary capacity. Opinions expressed herein are subject to change without notice. The products mentioned in this document may not be eligible for sale in some states or countries, and they may not be suitable for all types of investors. If an investor has any doubts about product suitability, he should consult his Lehman Brothers' representative. The value and the income produced by products may fluctuate, so that an investor may get back less than he invested. Value and income may also be adversely affected by exchange rates, interest rates, or other factors. Past performance is not necessarily indicative of future results. When an investment is denominated in a foreign currency, fluctuations in exchange rates may have an adverse effect on the value, price of, or income derived from the investment. If a product is income producing, part of the capital invested may be used to pay that income. Lehman Brothers may make a market or deal as principal in the securities mentioned in this document or in options, futures, or other derivatives based thereon. In addition, Lehman Brothers, its shareholders, directors, officers and/or employees, may from time to time have long or short positions in such securities or in options, futures, or other derivative instruments based thereon. One or more directors, officers, and/or employees of Lehman Brothers may be a director of the issuer of the securities mentioned in this document. Lehman Brothers may have managed or co-managed a public offering of securities for any issuer mentioned in this document within the last three years, or may, from time to time perform investment banking or other services for, or solicit investment banking or other business from any company mentioned in this document. Unless otherwise permitted by law, you must contact a Lehman Brothers entity in your home jurisdiction if you want to use our services in effecting a transaction in any security mentioned in this document Lehman Brothers. All rights reserved.