Showing posts with label securitization. Show all posts
Showing posts with label securitization. Show all posts

Friday, May 27, 2016

Monte Carlo Mortgages

In his book Mortgage Wars, former CFO of Fannie Mae, Timothy Howard explains how Fannie's realization that mortgages behave like bonds with embedded call options revolutionized its ability to value its portfolio and manage risk. Prior to this change in thinking, Fannie Mae's methods for reserving capital were consistently shown to be inadequate. Today, the valuation of mortgages and mortgage-related securities as bonds with embedded calls is nothing new.

A call option is a type of derivative, which conveys the right (but not the obligation) to purchase another financial instrument (the underlying asset) for a specified price (the strike price) at a specified time (the expiration date). Purchasing a call option offers the right to purchase the underlying asset and selling a call options impose the obligation of delivering the underlying asset at the strike price on the execution date.

Mortgages are freely refinanceable at any point. In this way, they function as bonds in which the payments from the homeowner serve as the coupon payment and the ability to refinance serves as a call option sold to the homeowner by the mortgage holder. Typically the refinance rates increase as interest rates decrease. Although mortgage prepayment penalties are included in mortgages to discourage refinancing, a large enough drop in interest rates can make refinancing worthwhile to a property owner in spite of the prepayment penalty. For mortgage and MBS investors, prepayments are undesirable. Given that most mortgage investors look to invest anywhere between 5 and 30 years, an early decline in interest rates can leave many investors with cash from prepayments that must be invested in a market offering lower interests rates. This undesirable situation is the double-edged sword of prepayment risk for mortgages.

Sunday, October 4, 2015

Mortgage Backed Securities and Personal Bankruptcy

At long last, the end of the series!

Personal bankruptcy is usually filed by an individual for very different reasons than corporate bankruptcies. Whereas the primary motivation behind filing a business bankruptcy may be protection of the business or satisfaction of debts, personal bankruptcies are frequently filed for asset protection, in addition to satisfaction of debts.

The two sections of the bankruptcy code that apply to personal bankruptcies are chapter 7 and chapter 13. As with business bankruptcies, chapter 7 for personal bankruptcies is a process of liquidation and seeks include all non-exempt assets of the petitioner in the bankruptcy estate in order to liquidate them to pay off debts. Chapter 13, on the other hand, seeks to reorganize the debt of a petitioner pursuant to a payment plan, which typically last from 3 to 5 years.

Tuesday, March 3, 2015

Special Purpose Entity Bankruptcy Concerns for Mortgage-Backed Securities

Let us continue the bankruptcy theme begun in my last post and discuss the effects of Special Purpose Entity (SPE) bankruptcies and their effect on mortgage-backed securities. Obviously, most bond covenants designate the bankruptcy of a SPE an event of default and restrict the likelihood of its happening. In the unlikely event that such a bankruptcy does happen however, here is an overview of the process.

As a quick review, I would like to restate that mortgage-backed securities are the result of a process of securitization that takes place when a real estate lender sells a package of its loans to an entity, called and SPE. The SPE receives the money to purchase the loans from the sale of either securities, beneficial interests in the entity or trust certificates from a trust set-up to hold the loans. If securities or trust certificates are sold, they are called mortgage-backed securities (MBS). Through the securitization process, real estate lenders are provided with cash to originate more loans and investors are able to purchase MBS and invest in the real estate market without having to hold real property. If you question why one would want to invest in the real estate market at all, please see my earlier post, “Why I Choose Real Estate.”

Tuesday, February 24, 2015

Lender Bankruptcy and Mortgage-Backed Securitization

Mortgage-backed securitization is an essential part of the mortgage secondary market, as it provides both liquidity and expanded sources of funding for real estate lender. Securitization also allows for more widespread participation in the real estate market, since MBS bonds are an asset class that can be held by classes of investors that are restricted by law from retaining extended ownership in real property. More participation in the real estate secondary market, of course, translates to a more robust market with more available real estate funding and more real estate activity.

Despite its role in the market down-turn of 2007/2008, securitization of real estate assets has been and continues to be an important part of the U.S. real estate finance market. Securitization, however, heavily depends on a bankruptcy remote structure.

Friday, August 5, 2011

Residential Mortgage Backed Securities: How They're Supposed To Work

Residential Mortgage Backed Securities (RMBS) are the fuel that powers our country's mortgage market. Their role in mortgage lending is not complicated, despite the fact that accurately pricing them requires in-depth knowledge of stochastic processes, matrix math, as well as a solid understanding of partial differential equations. I recently found a great article on-line by American University's Peter Chinloy that explains the how RMBS functions and the many of the assumptions that undergird them.
The long and short of it is that RMBS expands the lending capacity of financial institutions by allowing them to sell the home loans that they originate to purchasers on the secondary market to other institutions, exchanging the cash flow from the loans for cash for their balance sheets. The purchasers of these loans then package them and create investment vehicles or conduits. Investors are then offered an opportunity to participate in the cash flows that comes from the payment of these loans through the purchase of bonds issued on behalf of a conduit. These bonds are categorized as RMBS. They offer the investor exposure to the returns and activity of the housing market without the idiosyncrasies of property ownership or the capital  and labor requirements of lending. Moreover, a great deal of investment grade RMBS is guaranteed and can be insured. Add in the historically low home loan default rates with the lower capital reserve requirements of for insurance companies holding RMBS and it seems like a solid investment.
By now, the story of RMBS and its function has been told in many different places since the beginning of the economic downturn, so I harbor no delusion that what I have written thus far is not already widely understood. Chinloy's article, though written 16 years ago, offers a refreshing explanation of the purpose of each component of the mortgage lending system. It also illustrates the mathematical assumptions of lending behavior, important variables and basic RMBS pricing that can be easily used in Excel.
Chinloy describes the differences in private and agency RMBS that were once key to residential loan securitization. Originally, GNMA or agency RMBS was the outlet for borrowers that had less capital or lower credit scores than was required of conventional loans. Loans that fell under the purview of GNMA, known as FHA, VA or FmHA loans, were not only insured by FHA, VA or FmHA, but they also had default premiums priced into the mortgage payment. GNMA assumed  that the lower access to credit and/or capital typical of the borrowers of these loans would sever to lessen the frequency of prepayment through early payoff or refinance. Prepayment is generally undesirable to the bond holders of RMBS products, because it lowers the interest rate carry of each prepaid mortgage, reducing the amount of cash flow from that note and thus reducing the cash flow to the bond holder. The insurance premiums built into the loans covered prepayment due to default and the entire system was guaranteed with government credit. The added risk of the borrowers of an agency loan was therefore offset by the government's guarantee and the bond holder was generally assured that loan prepayment would be low.
Conventional mortgages, on the other hand required higher down-payments and were typically given by borrowers that had more access to capital (let's remember the borrowers give mortgages and banks give loans). Prepayment risk is generally higher via early payoffs or refinances, especially as interest rates tended downward. Fannie Mae and Freddie Mac, the largest purchasers of conventional mortgages, insured all mortgage collateral and the payments on their RMBS issues, in order to reduce this risk. The money from this insurance was both built into the price of the RMBS, but was also guaranteed by both organizations' access to a $2.5 billion credit line from the government. Principal Mortgage Insurance (PMI) was also employed in cases where the borrower's loan-to-value, LTV, exceeded 80%, making the loan more of a risk for default. PMI, however, only covered the difference between market value and mortgage value.
One of the most ironic aspects of the article is its discussion of private RMBS securitization, which it describes as a highly risky and generally below investment grade for a number of reasons. We know that this view of private securitization was largely ignored during the real estate bubble and that not only did private RMBS overtake the RMBS market, but also the resultant demand for mortgage notes led to the replacement of PMI. This practice traded insurance for increased exposure to risk from the same asset. Understanding the function of PMI, default rates and down payment requirements from the perspective of RMBS issuances, allows one to see why the once widespread practice of "piggyback loans" and "no money down" financing was a recipe for disaster. Not only did such lending practices dilute the relationship of the borrower to the property, making default much more likely, but they also eroded many of the insurance fail-safes of the private home mortgage lending system that insured the private RMBS payments to the investors in case of default. Additionally, piggyback loans, created two instances of default for a property instead of one, doubling the effect of default of each similarly financed property on the secondary market and on the related securities markets.
I could write a book about my reaction to Chinloy's article. I particularly like his analysis of mortgage payments and defaults as options, which lends borrowing behavior to derivative analysis. I also appreciate his in-depth explanation of forward and backward solving models for pricing RMBS. I am not sure which one I prefer, but I must say that I am somewhat partial to the type of analysis that the backward solving model employs. Though both types of models are useful tools, forward solving models are inherently more optimistic.  There is also a key point made on page 19 of the article regarding Fannie Mae's finding that properties with more than 10% negative equity have a high likelihood of default. Chinloy's mention of the lack of accounting for borrower liquidity in most RMBS pricing models is also noteworthy.
I do want to point out that some of the references in this article are dated. Due to mortgage acceleration clauses, new FHA, VA and FmHA mortgages are no longer assumable, therefore all of the sections about the assumablity of mortgages and selling the mortgage with the house are no longer relevant. It is also clear that Chinloy had no indication of the explosion of private and conventional loan and RMBS origination that would begin to take place just 3 or 4 years after the writing of his article and thus some of his predictions seem disconnected with what actually transpired in the real estate and securities markets. Chinloy, however, offers a cogent overview of the system of RMBS issuance that existed up until the late 1990's. It is clear that had this system been more clearly understood and followed by lenders, investment banks, investors and RMBS originators much of the calamity that recently befell our financial system could have either been predicted or avoided.

Friday, July 22, 2011

Commercial Notes and Properties

Commercial mortgage note valuations are distinguished from residential note valuations in that commercial notes, and by extension their related CMBS bonds and derivatives are based on the performance of the underwritten property, whereas residential notes and their related securities rely heavily on the financial behavior of the borrower. Many commercial mortgages are non-recourse to the borrower and often the borrower of a commercial mortgage is an entity, which can be dissolved and disappear upon insolvency or bankruptcy. It is also not unheard of to find commercial lenders and servicers managing properties obtained through foreclosure for a number of years to collect the cash flow from the property until it is sold. Bank-owned residential properties, however, are generally seen as liabilities to be sold at the highest price, as quickly as possible.

Given the non-recourse nature of most commercial financing and the strong consideration of the performance of the property, many commercial note valuation financial models are very similar to commercial asset acquisition models, with a number of lending considerations, such as debt yield, added. The closely related nature of commercial note and commercial property valuations has led me to title this post "Commercial Mortgage Notes and Properties." There are a number of elements that are essential components of both types of models. First, an asset description worksheet detailing the asset and its financing is key. This worksheet should be flexible enough to run a number of quick scenarios or "stress tests" and should have some basic information that it is being fed from other worksheets in the model.

The next essential component of a good commercial mortgage and property model is a rent role worksheet. This worksheet can be separate from combined with a lease expiration table. A clear presentation of such information will allow one to quickly evaluate the condition of the property's rent role in order to understand the flexibility of the asset and how it will perform over the life of the acquisition or note. The next component is a valuation table that should compare a number of different methods of valuing the worth of the property. Area cap rate, replacement costs, and appraised value are some of the many ways to find the value of an asset.  Another important component is an expense and profit escalation table. This table will allow one to project the possible value of the asset over the life of the deal. These projections will be essential to obtaining the asset's net present value (NPV) and for obtaining a rate for the internal rate of return (IRR). I also like to add a worksheet that attempts to predict how this asset as a note will behave if it were securitized with similar assets, worse assets or better assets. Access to the rating agencies' projected returns for each asset class can be very helpful in building and using such a worksheet.

Having discussed the relative de-emphasis of the credit worthiness of the borrower of a commercial mortgage, I must clarify that the borrower credit history is still important to commercial mortgage underwriting and note valuation. Unworthy borrowers lower the value of commercial note, as any foreclosure process, even a "springing-lock box" mortgage, deed of trust or bank foreclosure mortgage (the three least expensive mortgages to foreclose) can be costly in terms of lost cash flow and lost time. Management costs will also accrue after the foreclosure process is complete. No lender wishes to underwrite a deal that will lead to foreclosure, as it would be cheaper for the lender to simply purchase the property, therefore borrower risk must be evaluated and priced through an appropriate interest rate. Borrower credit-worthiness, therefore, should not be absent from your commercial mortgage note model.

Having posted this cursory overview of Commercial Mortgage Note and Asset modeling, I welcome your comments on this or any other post on this blog.