In addition to the investor protections discussed in Part 2, another key protection in RMBS is the inbuilt credit enhancement contained in the structure
Reflecting the cashflow waterfalls covered last week, the securities higher up in the RMBS structure enjoy enhancement provided by lower ranked securities which offer a buffer against loss in the same way that equity and subordinated debt provide a buffer to senior bond investors in a typical corporate capital structure.
Credit ratings agencies calculate a specific level of required credit enhancement for each unique RMBS structure and each security within that structure.
The calculation of the required credit enhancement aims to result in probabilistic equality between RMBS ratings and corporate ratings, i.e. the chances of investor loss from an ‘AAA’ rated ABS should be equal to the chance of investor loss from a ‘AAA’ rated corporate bond.
Types of credit enhancement available include:
- Lender’s mortgage insurance
- Excess spread
- Borrower’s equity
The relationship between foreclosure frequency and loss severity
The concept of Credit Enhancement in RMBS is predicated on two elements - the Weighted Average Loss Severity and Weighted Average Foreclosure Frequency.
The Weighted Average Loss Severity (WALS) is the level of loss expected as a percentage of the loan amount, given a default occurs. From an analysis standpoint, the WALS for a security is proxy of the investor’s view of the strength of the housing market.
An investor in a security with a WALS of 30% has an expectation that the property market is not going to fall by 30%. If the market falls by more than 30%, the investor’s principal may be at risk.
As an example, assume an RMBS comprises 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. The amount of the loss reflects the loss severity.
The Weighted Average Foreclosure Frequency (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.
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.
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 not more than 20% of mortgagees would default AND that residential prices will not drop by more than 30%. If house prices 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 prices decrease at the same time.
What adjustments are made to the pool in assessing its rating?
In determining the level of credit enhancement required to achieve a particular rating for a class of RMBS, the rating agencies make adjustments to each individual loan in the structure to reflect particular loan characteristics based on repayment histories observed in the market.
For example, the rating agencies take the view that PAYG employees, in general, maintain more stable cash inflows through salaries (which in turn are able to be applied to regular interest and principal payments) than the self employed who may have more volatile incomes.
The rating agencies also take the view the loans on investment property are more risky than owner occupier property due the likelihood of increased total household leverage and lower emotional attachment to divesting a property.
Loans with higher risk profiles will require more credit enhancement within the structure.
The number of ‘adjustments’ made to a loan pool is significant and detailed. Beyond the example above, these adjustments would include, but are not limited to:
- High value homes
- Households with high levels of debt to income
- Level of seasoning of the loans, that is how long the borrowers have been repaying the loan
- Borrowers in arrears
- Borrowers with defaults in their credit history
- Borrowers who have refinanced
- Borrowers with lines of credit loans
- Borrowers with interest only loans
- Location of the property (state/ regional/ metropolitan)
- Classification of the property (apartment vs house)
When assessing the quality of the loans contained in the RMBS, the rating agencies come up with levels of credit enhancement appropriate and reflective of the rating of the individual securities. For example, for the Bank of Queensland Reds 2017-1 trust notes have the following characteristics and enhancements.
Next week in our fourth and final in the education series on RMBS, we will define some of the key terms specific to RMBS which may be new to investors.