FIIG ESSENTIALS GUIDE. Residential Mortgage Backed Securities

Transcription

1 FIIG ESSENTIALS GUIDE Residential Mortgage Backed Securities

2

3 Introduction Residential Mortgage Backed Securities (RMBS) are debt securities that are secured by a pool of home loans. RMBS are a subset of a larger group of Asset Backed Securities (ABS) which can be built around many types of cash flow receivables including (but not limited to) residential mortgages, commercial mortgages, credit card payments and vehicle loans. Typically, home loans are illiquid and private in nature, however by combining them into a large and diversified pool and then breaking the combined pool into smaller marketable classes, the RMBS become attractive to investors who would otherwise be unable to take exposure to the underlying sector. The concept of breaking the pool into varying classes of securities allows investors with specific risk appetites to target the appropriate class and thus the investment returns they are after. In this way, the classes act not unlike a normal company capital structure, where investors with the lowest risk appetite target the senior bonds (or in the case of RMBS, the highest classes) and those with a higher risk appetite target the lower ranked capital, like hybrids or equity (or in the case of RMBS, the lowest ranking classes). RMBS have come about due to the need of lenders to source funding for their home lending activities in addition to customer deposits and corporate borrowings. Virtually all Australian Prudential Regulation Authority (APRA) regulated lenders (such as banks) use RMBS as a source of funding. Investors in RMBS include super funds, insurance companies, high net wealth investors and, more recently, the Commonwealth Government. Prior to the financial crisis around 25% of housing credit was funded through RMBS; and while this level has decreased, RMBS still represent around 10% of housing credit funding in the Australian market FIIG Securities Limited The Essentials Guide - RMBS 1

4 RMBS Structure There are a number of key players as well as minor players in an RMBS transaction. An understanding of the key players and their roles forms part of the analysis of any RMBS investment. Loan Originator Loan Overcollateralisation RMBS Trust Proceeds Senior Class RMBS Source: FIIG Securities Limited Junior Class RMBS Who are the key players in an RMBS transaction? Originator - the originator is the organisation that originates the home loan. Examples of originators are banks, credit unions and specialised home loan providers. The quality of the loans within an RMBS is partially determined by the quality of the lending procedures of the originator. Loan quality is taken into account in the determination of credit ratings of the RMBS. Trustee - the trustee is the issuer of the RMBS. 2 The Essentials Guide - RMBS 2012 FIIG Securities Limited

5 Servicer - is either the originator or a third party provider. The servicer provides the IT infrastructure to administer the home loan pool and calculates interest, fees and loan balances. The servicer remits loan statements to the home loan borrowers. Special Servicer - usually the originator. The special servicer contacts borrowers who may want to redraw against their home loan and more importantly who may be late in payment of their home loans. For those borrowers who can t or won t pay, the special servicer administers legal proceedings to enforce the home loans. Trust Manager - usually the originator. The trust manager is the controller of the cash flows flowing to and from the RMBS transaction. The trust manager reconciles interest, fees and principal being received from home loan borrowers and directs the Trustee, as issuer of the RMBS, to make principal and interest payments to RMBS investors consistent with the RMBS transaction. Banker - provides banking services to the trust. This may include providing liquidity facilities and interest rate swaps, as well as normal banking services. Rating Agencies - the rating agencies play a key role in RMBS and in its analysis. Rating agencies get full access to the details of the underlying loans which form the asset pool and undertake detailed analysis of the individual loans. As part of its review, the rating agency will consider the quality and history of the key players in the structure such as the originator, service providers and counterparties, as well as the underlying structures of the cash flow waterfall, and liquidity provisions FIIG Securities Limited The Essentials Guide - RMBS 3

6 There are separate and distinct cash flow waterfalls for principal and interest within the RMBS structure. A cash flow waterfall lays out the order in which receipts from borrowers are applied to the RMBS securities, with the highest ranked securities paid first. 4 The Essentials Guide - RMBS 2012 FIIG Securities Limited

7 Principal and interest waterfalls Tax Trust expenses Source: FIIG Securities Limited Senior Note class interest Junior Note class interest Charge offs Excess spread Reflecting the nature of the underlying collateral (that is home loans), RMBS are structured so as to separate receipts of principal and receipts of interest. Principal and interest receipts from the home loans are allocated in rank order to the RMBS classes making up the RMBS transaction. The principal waterfall is quite basic, with principal receivables simply applied in rank order to the various classes of RMBS. The interest waterfall is slightly more complicated in that it is required to cover the expenses of the trust prior to making interest payments to investors. These expenses include both tax (given first priority) and trust management expenses. Once these expenses are covered, interest is paid in rank order similar to the principal waterfall. Interest payments received in excess of what is required to be paid to the RMBS investors are used firstly to cover any losses from selling an enforced property then any prior shortfalls which may have occurred and then finally, excess spread is paid as a form of equity return to the originator FIIG Securities Limited The Essentials Guide - RMBS 5

8 What are the key protections for investors? There are a number of protections for investors in RMBS, some of which are covered in the calculation of credit enhancement for the various securities classes (which is discussed below) and others which are the result of the fundamentals of the underlying assets and the structure of the security. Overcollateralisation - A key protection for investors is the built-in overcollateralisation of the RMBS. This is expressed in the loan-to-value ratio (LVR). The lower the LVR, the lower the risk to the lender, for the following reasons: The difference between the amount lent and the value of the property represents the equity the owner has in the property. The more equity the owner has, the more they have to lose if they default on the loan. A borrower capable of building up equity value in the property displays the ability to service the mortgage. Should the borrower default, the proceeds from the sale of the property need only cover the value of the loan to achieve full recovery for investors. The lower the LVR, the lower the sale price required to achieve this. Bankruptcy remoteness - The RMBS structures are not affected by the performance of the originator of the loans. This is because RMBS are held in bankruptcy remote vehicles. Should the originating financial institution fall into financial difficulty, the RMBS would not be exposed to the risk of the originator. 6 The Essentials Guide - RMBS 2012 FIIG Securities Limited

9 There is a significant pool of historic evidence of loan performance upon which the rating agencies base their analysis of and adjustments to the loan pool. Importantly, these adjustments are not static, with the rating agencies reviewing the level of adjustment on an ongoing basis. For example, at the time of writing, international ratings agency Standard & Poor s is reviewing the loan adjustment levels applied to Australian RMBS given the high prices currently being experienced in the Australian property market. There are also several underlying property protections which are required before a loan is accepted into an Australian RMBS. In the case of mortgages, this would include general insurance over the property and in the case of Prime Residential Mortgage Backed Securities, this generally includes mortgage insurance FIIG Securities Limited The Essentials Guide - RMBS 7

10 Subordination - Notwithstanding the other investor protections discussed earlier, the key protection in all asset backed securities is the inbuilt subordination contained in the structure. When rating RMBS, rating agencies determine the relative sizes of each note class. The proportion of second ranking junior notes will determine the credit ranking of senior notes. To determine the relative proportions for RMBS transactions, rating agencies calculate the Weighted Average Loss Severity (WALS) and Weighted Average Foreclosure Frequency (WAFF). Subordination required to a prescribed rating levels is calculated by multiplying WALS by the WAFF Subordination = WALS x WAFF Given the cash flow waterfalls covered on page 7, the securities higher up in the RMBS structure enjoy enhancements provided by lower ranked securities, which offer a buffer in the same way that equity and subordinated debt provide a buffer to senior bond investors in company or bank bonds. Rating agencies calculate a specific level of required subordination for each unique RMBS structure and each security within that structure. The calculation of the required subordination results in probabilistic equality between RMBS ratings and corporate ratings. That is, the chance of investor loss from a AAA rated RMBS should be equal to the chance of investor loss from a AAA rated corporate bond. 8 The Essentials Guide - RMBS 2012 FIIG Securities Limited

11 Lenders Mortgage Insurance (LMI) Loans with an LVR greater than 80% are typically insured by the lender with an LMI insurer. The dominant providers of LMI are Genworth Financial and QBE LM, who are both rated AA- by Standard and Poor s. These APRA regulated entities insure the lender against loss on the sale of the properties that secure a home loan. In RMBS transactions, investors enjoy the benefit of LMI as LMI has the effect of reducing WALS. Over 90% of Australian RMBS transactions have LMI as a key component of their credit structure FIIG Securities Limited The Essentials Guide - RMBS 9

12 The relationship between foreclosure frequency and loss severity The concept of subordination in RMBS is predicated on the WALS and the WAFF. WALS is the level of loss expected as a percentage of the loan amount if a default occurs. From an analysis standpoint, the quoted WALS for a security is a proxy for the investor s view on the strength of the housing market. Essentially, an investor in a security with a WALS of 30% has an expectation that the property market is not going to fall by more than 30%. If the market falls by more than 30%, the investor s principal may be at risk. As an example, assume an RMBS comprises of just one loan, rather than hundreds. If a home owner takes out a $400,000 mortgage on a house valued at $500,000 and the borrower defaults on the loan, the servicer of the RMBS will foreclose on the property and sell at an auction. If the auction achieves a price of less than $400,000, the trust will take a loss on the loan. In that instance, the loss severity would be 20%. 10 The Essentials Guide - RMBS 2012 FIIG Securities Limited

13 2012 FIIG Securities Limited The Essentials Guide - RMBS 11

14 An investor in an RMBS with a WAFF of 20% is comfortable with the expectation that no more than 20% of borrowers will be unable to meet their commitments. The WAFF represents the likelihood a borrower will default on a loan. From an analysis standpoint, the WAFF is a proxy for the quality of lending practices and the overall state of the economy. In the context of RMBS and in the real world, the WALS and WAFF are closely related. In the above examples, an investor would need to be comfortable that no more than 20% of mortgagees would default AND that residential prices would not drop by more than 30%. If house values drop by 50% but no-one defaults, the principal will be repaid. There is however a correlation in the economy between defaults and house prices. In a weak economy, you would expect to see defaults increase and residential property prices decrease at the same time. 12 The Essentials Guide - RMBS 2012 FIIG Securities Limited

15 Where to from here? This Essentials Guide to RMBS is intended to provide only a basic overview of Residential Mortgage Backed Securities and there is more detail on the topic available from our website You can also call your FIIG dealer for more detail on RMBS and specific RMBS offers. Please call on or contact us by at info@fiig.com.au 2012 FIIG Securities Limited The Essentials Guide - RMBS 13

16 Definitions Charge off a reduction in the principal value of an RMBS resultant from losses on the sale of the underlying properties. CPR the Constant Prepayment Rate is the rate at which mortgagors are repaying the principal of their mortgages. Excess spread the interest income which is in excess of the cash required to meet tax and management charges, interest payments to RMBS holders and to replenish any previously recorded losses. Excess spread may then be returned to the originator. LVR loan-to-value is the ratio of the total loan to the value of the property securing the loan. If you are lending $400,000 to acquire a property valued at $500,000, your LVR would be 80%. The lower the LVR, the lower the risk to the lender. MVD the Market Value Decline is simply the decline in market value in the underlying property. Non conforming mortgages loans to borrowers who do not meet the normal requirements of prime mortgages. Non conforming RMBS will generally provide a higher return. Prime mortgages in Australia, prime mortgage RMBS would typically have an average loan-tovalue ratio (LVR) of around 70%. To be provided a loan, borrowers would have to prove their income and the loan would be fully documented. Low doc and non conforming loans are also funded through the RMBS process. These are loans that are made to borrowers wishing to state their income, such as the self employed, or to borrowers who do not qualify for loans supported by mortgage insurance. 14 The Essentials Guide - RMBS 2012 FIIG Securities Limited

17 Seasoning the number of months since the loans have been originated. All loans in RMBS have been seasoned after one month (i.e. have received one payment) to avoid including any fraudulent applications. All things being equal, securities which are more seasoned have lower risk as issues with repayment may have already arisen. Subordinated some securities in RMBS will be subordinated to the more senior securities. These subordinated securities offer a higher return for higher risk, while also providing protection for more senior investors. Tenor the remaining length of time of the security usually expressed in years. WAFF the Weighted Average Foreclosure Frequency represents the likelihood a borrower will default on a loan. WALS the Weighted Average Loss Severity is the level of loss expected as a percentage of the loan amount, if a default occurs FIIG Securities Limited The Essentials Guide - RMBS 15

18 Disclaimer FIIG Securities Limited ( FIIG ) provides general financial product advice only. As a result, this document, and any information or advice, has been provided by FIIG without taking account of your objectives, financial situation and needs. Because of this, you should, before acting on any advice from FIIG, consider the appropriateness of the advice, having regard to your objectives, financial situation and needs. If this document, or any advice, relates to the acquisition, or possible acquisition, of a particular financial product, you should obtain a product disclosure statement relating to the product and consider the statement before making any decision about whether to acquire the product. Neither FIIG, nor any of its directors, authorised representatives, employees, or agents, makes any representation or warranty as to the reliability, accuracy, or completeness, of this document or any advice. Nor do they accept any liability or responsibility arising in any way (including negligence) for errors in, or omissions from, this document or advice. Any reference to credit ratings of companies, entities or financial products must only be relied upon by a wholesale client as that term is defined in section 761G of the Corporations Act 2001 (Cth). FIIG strongly recommends that you seek independent accounting, financial, taxation, and legal advice, tailored to your specific objectives, financial situation or needs, prior to making any investment decision. FIIG does not make a market in the securities or products that may be referred to in this document. 16 The Essentials Guide - RMBS 2012 FIIG Securities Limited

19 2011 FIIG Securities Limited Sydney Melbourne Brisbane Perth

20 2012 FIIG Securities Limited ABN AFS Licence No