P2.T6. Credit Risk Measurement & Management Ashcroft & Schuermann, Understanding the Securitization of Subprime Mortgage Credit Bionic Turtle FRM Study Notes Reading 48 By David Harper, CFA FRM CIPM www.bionicturtle.com
ASHCROFT: UNDERSTANDING THE SECURITIZATION OF SUBPRIME MORTGAGE CREDIT... 3 EXPLAIN THE SUBPRIME MORTGAGE CREDIT SECURITIZATION PROCESS IN THE UNITED STATES.... 4 2
Ashcroft: 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 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. 3
Explain the subprime mortgage credit securitization process in the United States. Subprime securitization: view from 10,000 feet 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 some general. The special-purpose vehicle (SPV, middle 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 issues notes to investors (right-hand side below). If the securitization is a pass-through, there is only one tranche of investors. However, in this case study, there were about 17 tranches (although only 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. 4
Subprime securitization: step-by-step Borrower applies for a mortgage. The mortgagor (borrower) applies for a mortgage in order to purchase a property or to refinance an existing mortgage Originator underwrites loan. The originator, possibly through a broker (yet another intermediary in this process), underwrites and initially funds and services the mortgage loans. 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 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. Securities 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. 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. 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. 5
Subprime securitization: the case study (the motivating example ) The Ashcraft paper is a case study of a specific subprime securitization. The originator was New Century Financial (once the 2 nd largest subprime lender, but went bankrupt in 2007) The arranger was Goldman Sachs, who was also a swap counterparty The subprime loans were initially purchased by a subsidiary of Goldman Sachs, who in turn sold the loans to a bankruptcy-remote special purpose vehicle (SPE) The special purpose entity (SPE) was a trust called GSAMP Trust 2006- NC2 The trust funded the purchase of these loans through the issue of assetbacked securities, which required the filing of a prospectus with the SEC detailing the transaction. New Century serviced the loans initially, but upon creation of the trust, the servicing business was transferred to Ocwen Loan Servicing, LLC in August 2006 As the servicer, Ocwen received a fee of 50 basis points (or $4.4 million) per year on a monthly basis. The master servicer and securities administrator was Wells Fargo, who receives a fee of 1 basis point (or $881K) per year on a monthly basis. The prospectus includes a list of 26 reps and warranties made by the originator. Some of the items include: the absence of any delinquencies or defaults in the pool; compliance of the mortgages with federal, state, and local laws; the presence of title and hazard 6