Demystifying Residential Mortgage Backed Securities

Many investors approach fixed income markets with a sense of trepidation as the concepts underlying them appear somewhat arcane. Partly this is due to the nature of fixed income investments and the more formalised dynamics and relationships which drive their returns. To demystify the fixed income markets what follows is a series of primers outlining the key concepts behind fixed income dynamics and portfolio management. The fourth instalment of this series shall take a closer look at residential mortgage backed securities.

What is Asset Backed Lending?

Residential mortgage backed securities (‘RMBS’) are a subset of a broad class of loans referred to as asset backed lending (‘ABL’). ABL is where a loan is secured against tangible/financial assets owned by the borrower which act as collateral. This collateral can be taken by the lender to repay the loan in the event that the borrower is unable to service the loan. For the lender the risk associated with the loan is measured by (a) quality of the assets acting as collateral and (b) value of the loan compared to that of the collateral referred to as the loan to value ratio. ABLs can be contrasted to cash flow lending where a loan is backed by the borrowers expected cash flows; i.e. loan is supported by the general creditworthiness and operating income of a borrower.

Asset backed loans can be separated into direct and securitised lending based on how investors access the market. Direct lending simply refers to where the investor is associated with the origination and provision of a loan. Securitised lending by contrast involves the process of packaging loans into a security, referred to as securitisation, to be on-sold to investors post origination. There are a range of benefits arising from securitisaton; from the investor’s perspective the main ones are (a) diversification of risk across a larger pool of loans and (b) ability to tier risk via ‘tranching’. For investors it is important to note that there may also be disadvantages, most notably that the absolute returns earned may be lower. The lower returns from securitisation mainly arises from two reasons. Firstly, securitisation works best when applied to largely ‘standardised’ loans which are relatively small in size such as residential mortgages or vehicle leases. The result is that the ability, and desire, of the originator to tailor loans is more limited. Secondly, unlike direct lending, the ability of the ultimate lender to retain any upfront fees associated with the loan is limited; i.e. ‘upfronts’ are retained by the loan originator not the security investor. Accordingly, for many investors looking to earn higher returns there may be a preference for accessing the ABL market via direct lending rather than securitisation.

What is an RMBS?

RMBSs are simply securitised pools of underlying mortgages (‘collateral’) where the pool of mortgages is placed in a discrete trust/special purpose vehicle.

Against the cashflows generated from the pool of mortgage loans are issued a series of tiered securities. Tiering of the different tranches of securities is achieved through subordination that occurs in two ways. The first is during the unwind phase when the repayment of collateral principal flows down through the structure, like a waterfall, from the highest rated tranches (AAA) down to the lowest rated component (Unrated). The second is where any principal losses are incurred then the flow is reversed with losses “flowing up” the structure. Clearly, lower rated tranches involve more risk but also offer a correspondingly higher rate of return. Due to the flow of losses the lowest rated tranche in a RMBS structure is referred to as being in the ‘first loss’ position. This is the standard structure for all securitised vehicles with the differences largely being the types of loans/assets comprising the underlying security.

There are Two Main Types of RMBS

Though the structures for all securitised vehicles are similar the major difference lies in the nature of the assets in the underlying collateral pool. In terms of value outstanding the domestic RMBS market is dominated by Prime issuance. Prime mortgages are those which satisfy Authorised Deposit taking Institution (‘ADI’) standard lending criteria. Further most prime mortgages are fully mortgage insured under either a primary or pool mortgage insurance policy (referred to as lenders mortgage insurance or ‘LMI’). Mortgage insurance is where the LMI provider guarantees the lender against any losses arising from the sale of the underlying property and is only provided where mortgages meet specific criteria.

In contrast a non-conforming (‘N/C’), also referred to as non-prime, mortgage is one where the borrower has either an impaired credit history or is unable to supply full documentation when applying for a mortgage. As either of these conditions prevents the lender from taking out mortgage insurance on the loan the borrowers are viewed as being ‘non-prime’ or more commonly referred to as ‘non-conforming’. Though often compared to US subprime loans, non-conforming loans in Australia are quite different. Australia regulators require that lenders have a ‘duty of care’ to ensure that a borrower can meet loan repayments at not only current but also materially higher levels of interest rates. Accordingly, non-conforming borrowers in Australia, unlike their US counterparts, can still represent relative low risk borrowers.

This is not to say that there aren’t additional risks associated with lending to non-conforming borrowers. Several key characteristics which raise the overall risk profile of such mortgages are:

· Income streams for many borrowers may be more volatile and exhibit heightened sensitivity to economic downturns.

· Absence of full documentation can make assessing the borrower’s ability to meet mortgage repayments more problematic and potentially open to more optimistic mortgage serviceability assessments.

RMBS where the collateral comprises non-prime mortgages tend to place greater emphasis on the subordination of different tranches to support the quality of the senior tranches.

What Drives the Performance of an RMBS Issue?

Most RMBS in Australia are floating rate in nature and consequently do not directly expose the investor to interest rate risk. There are five main risks which can impact upon the return earned from an RMBS which investors should be aware of.

Pre-Payment Risk :

Mortgages are amortising loans with the valuation of the securities being based on an estimate of the Weighted Average Life (‘WAL’) of the pool of underlying mortgages. As these estimates are based on anticipated amortisation rates they can change as the market environment changes. Factors which can impact upon the rate of amortisation, and hence the WAL of the RMBS, tend to be cyclical in nature and include (a) level of workforce mobility, (b) overall turnover in housing stock and (c) the refinancing rate of the actual mortgages.

Pool Performance Risk :

The magnitude of this risk is driven by the level of arrears. Clearly the greater the magnitude of arrears within a pool of mortgages the less cashflow is available to be passed through to the holders of the securities.

Default Risk :

The gross loss risk arises where arrears become actual foreclosures. In the event of foreclosure, the gross loss risk is where the ultimate sale price of the property is less than the outstanding loan. The potential for investors to suffer from a gross loss is often measured by the Loan to Value Ratio (‘LVR’) where Value refers to that of the collateral. The lower the LVR the more protection the lender has against declines in the underlying value of the collateral. The default risk faced by investors in RMBS is driven by (a) quality of underlying pool of mortgages (often summarised by the LVR at origination), (b) current point in the housing cycle and (c) the length of time since the pool of underlying mortgages was originated (often referred to as the level of ‘seasoning’ in the pool which impacts on the current LVR).

Call Risk :

Call risk is where the effective life of the security is materially less than the average life of the underlying pool of mortgages due to the existence of a ‘date based’ call provision which can be utilised by the issuer. The risk is that if an RMBS is valued on the assumption that it will be called on the pre-specified date, i.e. ‘valued to call’, then investors may suffer from adverse returns in the event that the call is not exercised by the issuer. Such call risk is closely linked to refinancing risk and is particularly relevant for non-conforming RMBS.

It is worth distinguishing between a ‘date based’ and ‘percentage’ based call provision. With prime RMBS the main form of call provision is a ‘percentage based’ call provision. These are normally utilised once the pool has amortised down to only 10% of its initial value. Such ‘percentage based’ calls are simply clean-up provisions utilised to wind up pools which have amortised to a level where the ongoing management of the pool is no longer economically viable. ‘Percentage based’ calls associated with clean up provisions are unlikely to have a material impact on the value of an RMBS.

Refinancing Risk :

Refinancing risk is more of an issue for N/C RMBS and is linked not just to the structure of the RMBS but also the characteristics of the issuers. Turning first to the structure of the securities themselves, to provide greater certainty with respect to final maturity dates the originators of N/C RMBS will normally incorporate a call option within the structure. This call option allows the originator to repay the investors in the N/C RMBS at a pre-set date thereby providing investors with greater clarity as to the timing of cashflows. Providing greater certainty regarding the final repayment date aims to make the issues more attractive to investors. Yet the ability of the originator to exercise the shorter dated call option depends on their own characteristics and, more specifically, being able to refinance the underlying mortgages. Such refinancing risk tends not to be a material issue for large banks which maintain portfolios of mortgages on their balance sheets and have access to a range of funding sources.

Refinancing risk becomes more relevant as the N/C RMBS market, for a range of reasons, has seen a material increase in the participation by Non-Bank Financial Institutions (‘NBFIs’). Unlike banks, NBFIs are much more dependent on their ongoing ability to issue new N/C RMBS to fund the repayment of existing N/C RMBS at the predefined call dates. Such a reliance on refinancing increases the risk that any event which reduces investor demand for new N/C RMBS has the potential to reduce the value and liquidity of existing issues by preventing the originators from repaying the outstanding securities on the call date; i.e. effectively lengthening the WAL of existing issues. As NBFI’s tend to have fewer sources of funding this can materially increase the level of refinancing risk associated with a N/C RMBS securities. Aggravating the situation is that refinancing risk is likely to increase at a time that the underlying financial conditions for non-conforming borrowers making up the collateral pool are deteriorating.

RMBS are a core type of security utilised within many funds aiming to enhance returns over cash like benchmarks. Understanding the nature of RMBS and the factors which can impact on their performance is often a key aspect in understanding and managing the risk within a fixed income portfolio.