Credit Crisis, Academics and Analysis - 2

This blog is a continuation of the previous blog ‘Credit Crisis, Academics and Analysis -1’. As mentioned there, I will try to build up an understanding for ‘Securitized Loans’, which held the biggest share in US Credit Markets up until the Credit Crunch.

Securitized Loans have been one of the greatest innovations in the recent history of Financial Markets. This Asset Class can broadly be put under 2 categories, categorized by their underlying Assets.

• Mortgage Backed Securities (MBS) – with underlying asset as Home Mortgage Loans.

- Pass Thru Securities
- Collateralized Mortgage Obligations (CMOs)

• Asset Backed Securities (ABS) – with underlying assets such as Corporate Receivables, Credit Card Receivables, Auto Loans, Student Loans, Home Equity Loans etc.

This blog, I will discuss MBS and leave ABS for next blogs.

Understanding MBS Structure

• Home Buyers are the borrowers, borrowing loans against their purchased homes.
• Banks and Financial Institutions provide them with those mortgage loans.
• Subsequently, these individual home loans are pooled together (there need to be a minimum of 300 individual loans to form one such pool) and an MBS issuer will issue securities against that pool. Once Securities have been issued and subscribed, Banks’ (Loan Issuers’) Capital is freed and they are ready to issue more loans.
• MBS issuers in the US are agencies like Ginnie Mae, Fannie Mae and Freddie Mac. These agencies also act as guarantors for their issued securities. Out of the three, Ginnie Mae is a Govt. Agency and its creditworthiness is backed by full faith of the US Govt. While, Fannie Mae and Freddie Mac are Private Agencies and their creditworthiness is rated by Credit Rating Agencies like S&P and Moody’s.
• These securities are then bought by Individual and Institutional Investors. They are similar to other coupon paying Fixed Income Securities, but could be prepaid early, and will not have any embedded options.

For Pass Thru Securities, Security Investors would get periodic Interest and any Prepaid Principal, in direct proportion to their Investment in that Mortgage Pool.

For, CMOs (Collateralized Mortgage Obligations), there are defined Tranches. That is, any prepaid Principal in the pool will first go to investors in the uppermost Tranche, till that tranche is exhausted. Investors opt for investing in specific Tranches, based on their Investment Requirements. That is, relative short term investors may prefer investing in upper tranches, whereas, long term investors like Pension Funds, Insurance Companies etc, could invest in lower tranches. Interest Payments are proportional payments to investors in all tranches, which is same as that for Pass Thru Securities.

Risk Analysis for MBS

Credit Risk

There are 2 parts to Credit Risk here.

1. Credit Risk to Investors: Credit Risk to Investors is creditworthiness of its Security Guarantor. Investors will include a premium to their asking rate, based on Credit Ratings of their Security Guarantor/Issuer. Also, understand that Credit Ratings of Guarantor may get downgraded in future. If that happens, as an investor, price of your securities will go down in secondary market.
2. Credit Risk to Guarantor: This risk to guarantor is from borrowers defaulting on their monthly payments. Since, the underlying pool is a big pool of loans (at least more than 300), cost of premium for this risk is lowered, as the risk is considered distributed over a big pool.

Prepayment Risk

For Pass Thru Security Investors, Prepayment risk will always be there, especially when Interest Rates are going down. Now, why Prepayment is considered a Risk? Because, when Interest Rates go down any prepaid amount would have to be re-invested by Investor at lower rates, thus reducing overall yield on his Security Investment.

For CMOs, however, Prepayment Risk is lower for deeper Tranches and higher for Investors in upper Tranches. For upper tranches, Prepayment Risk is higher and Credit Risk is lower. Whereas, in lower tranches, Prepayment Risk is lower at the cost of higher Credit Risk. As there is a tradeoff available between Prepayment and Credit Risk here, and there are matching requirements (demand) available among investors, combined premium for both Risks together is lowered for the Pool as a whole.

To summarize MBS:

• Home loans are financed by a wider base of investors, including individual investors. Thus more Capital is available for lending. In a conventional scenario, where a Bank lends home loan to a borrower, bank’s lending capacity is limited by Fed controlled RRR (Required Reserve Ratio).
• Financing is much more liquid, as these securities can be traded in Secondary Markets.
• Overall cost of borrowing is reduced, as risk perception is lowered for the pool as a whole.

In subsequent blogs, I will discuss ABS and analyze the crisis.