P2.T6. Credit Risk Measurement & Management. Ashcraft & Schuermann, Understanding the Securitization of Subprime Mortgage Credit

Transcription

1 P2.T6. Credit Risk Measurement & Management Ashcraft & Schuermann, Understanding the Securitization of Subprime Mortgage Credit Bionic Turtle FRM Study Notes Sample By David Harper, CFA FRM CIPM and Deepa Raju

2 Ashcraft: Understanding the Securitization of Subprime Mortgage Credit EXPLAIN THE SUBPRIME MORTGAGE CREDIT SECURITIZATION PROCESS IN THE UNITED STATES

3 Ashcraft: Understanding the Securitization of Subprime Mortgage Credit Explain the subprime mortgage credit securitization process in the United States. Identify and describe key frictions in subprime mortgage securitization, and assess the relative contribution of each factor to the subprime mortgage problems. Describe the characteristics of the subprime mortgage market, including the creditworthiness of the typical borrower and the features and performance of a subprime loan. Describe the credit ratings process with respect to subprime mortgage backed securities. Explain the implications of credit ratings on the emergence of subprime related mortgage backed securities. Describe the relationship between the credit ratings cycle and the housing cycle. Explain the implications of the subprime mortgage meltdown on portfolio management. Compare predatory lending and borrowing. Explain the subprime mortgage credit securitization process in the United States. This reading uses the motivating example of an early, prominent failure of a subprime securitization in order to highlight frictions in the chain. The case study revolves around GSAMP Trust 2006-NC2, the special purpose vehicle (SPV) arranged by Goldman Sachs and originated by New Century Financial (who was the second-largest subprime mortgage lender, at the time, in 2007) While this was a specific case study, it reflects certain general features of the subprime mortgage credit securitization process: The essence of securitization is diversification via pooling and credit risk transfer. While the subprime (and credit) crisis exposed key weaknesses (frictions) in the securitization chain, benefits do exist. In this reading, the credit-sensitive assets happen to be subprime loans, but the components of securitization are somewhat general. The special-purpose vehicle (SPV, as shown in the diagram below) purchases the credit-sensitive assets (e.g., mortgage loans), which are pooled and therefore benefit (to various degrees depending on the structure) from diversification. Even in a pool of subprime loans, the majority will not default. The SPV purchases the loans with cash generated by issuing notes to investors. If the securitization is a pass-through, there is only one investor tranche. But in this case study there were about 17 tranches (with four major divisions: senior, mezzanine, class B, and equity). Tranches expose different investors to different risk/return profiles: senior tranches will be safer but yield less than lower tranches. 3

4 Subprime securitization: step-by-step The borrower (not pictured) applies for a mortgage. The mortgagor (borrower) applies for a mortgage in order to purchase a property or to refinance an existing mortgage The originator underwrites the loan. The originator, possibly through a broker (yet another intermediary in this process), underwrites and initially funds and services the mortgage loans. The arranger buys pool of mortgage loans and probably arranges funding from a third-party lender. The pool of mortgage loans is typically purchased from the originator by an institution known as the arranger or issuer. Arranger sells mortgage loan pool to bankruptcy-remote trust. The arranger is responsible for funding the mortgage loans until all of the details of the securitization deal can be finalized. When the arranger is a depository institution, this can be done easily with internal funds. However, mono-line arrangers typically require funding from a third-party lender for loans kept in the warehouse until they can be sold. (Since the lender is uncertain about the value of the mortgage loans, it must take steps to protect itself against overvaluing their worth as collateral. This is accomplished through due diligence by the lender, haircuts to the value of collateral, and credit spreads. The use of haircuts to the value of collateral imply that the bank loan is over-collateralized). The pool of mortgage loans is sold by the arranger to a bankruptcy-remote trust, which is a special-purpose vehicle that issues debt to investors. This trust is an essential component of credit risk transfer, as it protects investors from bankruptcy of the originator or arranger. The trust employs a servicer who is responsible for collection and remittance of loan payments, making advances of unpaid interest by borrowers to the trust, accounting for principal and interest, customer service to the mortgagors, holding escrow or impounding funds related to payment of taxes and insurance, contacting delinquent borrowers, and supervising foreclosures and property dispositions. 4

5 Securities are sold to asset manager (agent for investors). Securities are collateralized by mortgage loans. The arranger underwrites the sale of securities secured by the pool of subprime mortgage loans to an asset manager, who is an agent for the ultimate investor. Investors provide the funds for the purchase of the mortgage-backed security. As the investor is typically financially unsophisticated, an agent is employed to formulate an investment strategy, conduct due diligence on potential investments, and find the best price for trades. Key features of this stylized mortgage-backed securitization include: Mortgage loans are pooled into the reference portfolio. This should create at least some diversification benefit; however, in retrospect, shared exposure to common factors was underestimated. Credit risk is transferred to investors but in various risk/reward profiles according to the tranche of the (credit-linked) notes that are issued Tranches of RMBS were often further pooled into CDOs; i.e., the assets of RMBS were mortgages, but the assets referenced by a CDO were RMBS tranches. The illusion of super-safety was enabled by modelling assumptions. 5