We define some of the key residential mortgage backed securities terms which may help you understand the securities. Links to Part 1-3 RMBS notes are provided at the end of this note
Definitions
Charge off – the process of repaying previously missed payments with excess spread.
Constant repayment rate (CPR) – the constant repayment rate is the rate of pay down, that is the rate at which the amount of principal outstanding is decreasing.
Credit enhancement – A method where the debt issuer tries to improve its debt or credit worthiness. RMBS examples include:
- Lender’s mortgage insurance
- Excess spread
- Borrower’s equity
Credit rating agencies – Engaged by RMBS issuers to assign credit ratings to tranches of RMBS.
Excess spread – is the interest income which is in excess of the cash required to meet tax and management charges, interest payments to RMBS holders and replenishing any previously recorded losses. Excess spread may then be returned as equity.
Lenders mortgage insurance (LMI) – lender’s mortgage insurance is an insurance policy on a mortgage loan, protecting the lender (the financial institution who initiated the loan) from any shortfall in the event of default and on realisation of the assets securing the loan. LMI is typically used when the loan is considered risky, for instance when the loan to valuation rate is high – above 80% or more. LMI protects the bank and not the home owner.
Low doc loan - A loan that requires less financial documentation compared to other loans. It is primarily for borrowers who do not meet the standard loan application criteria for example self employed and other borrowers whose income could not be readily verified.
Loan to value ratio (LVR) – 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.
Market value decline (MVD) – refers to the percentage by which credit rating agencies assume property valuations will decline at a particular stress level.
Non conforming mortgages – are loans to borrowers who do not meet the normal requirements of prime mortgages. Non conforming RMBS will generally provide a higher return than conforming RMBS. They are sometimes referred to as specialist or sub prime mortgages.
Overcollateralisation – A structure when the assets securing the mortgages are worth more than the amount being lent, that is if the borrower defaults, a loss won’t necessarily be realised, as the secured property can be sold at a surplus. Overcollateralisation is used as a form of credit enhancement in certain securitisations.
Prime mortgages – in Australian RMBS, typical prime mortgages would have:
- a LVR of less than 80%,
- a borrower with a sound credit history
- a full set of documentation and often include mortgage insurance.
Prime RMBS will often include some proportion of ‘low doc’ loans, however these usually support lower LVRs for the individual loans.
Principal - The face value of the debt security on which interest is calculated.
Repurchase agreement - A contract where a seller of a security agrees to buy the security back from a buyer at a later date for an agreed price. ‘Repo’s’ are often used by ADI’s to manage liquidity.
Residential mortgage backed securities (RMBS) - A pool of residential mortgages.
Seasoning – is the number of months since the loans or bonds were first issued. All loans in RMBS have been seasoned one month (ie. have received one payment) to avoid including any fraudulent applications. All things being equal, securities which are more seasoned show the borrower’s ongoing ability and willingness to service the debt. In the case of principal and interest loans, the debt will have reduced, reducing risk.
Special purpose vehicle (SPV) - Also referred to as a special purpose entity, it is an insolvency remote trust, usually a subsidiary company, created to carry out a specific purpose activity, or series of such transactions, and has no other purpose than to carry out those transactions it was created for.
Subordinated – some securities in RMBS will be subordinated to the more senior securities. These subordinated securities offer protection to senior investors while offering a higher return for higher risk.
Sub prime mortgages - A type of loan that fails to meet traditional lending criteria, i.e. the borrower has a poor credit history. The rate charged is usually higher, as these mortgages are higher risk. These are also known as non conforming mortgages
Tenor – is the remaining length of time of the security usually expressed in years.
Tranche - In investing, tranche is a term often used to describe a specific class of bonds within one offering, where each separate tranche offers different terms and conditions, ranks differently in the payment waterfall (see ‘Waterfall’), and as a result have varying degrees of risk to investors. Separate tranches can be denominated in different currencies, have different maturities and coupon types.
Waterfall - Also referred to as priority of payments for a residential mortgage backed security structure, a waterfall is a set of rules laid out in the contract documents and details the order (priority) for which cashflows are applied. In RMBS, these waterfalls are separated into principal and interest reflecting the underlying nature of collateral (loans). The waterfall ensures the highest ranking class (tranche) of securities receive payments ahead of lower ranking classes.
Weighted average foreclosure frequency (WAFF) – A term used for residential mortgage backed securities. WAFF represents the likelihood a borrower will default on a loan. From an analysis standpoint, WAFF is a proxy for the quality of lending practices and the overall state of economy. This term is closely connected with WALS (see below) and commonly used in RMBS and related structures’ transactions. An investor in RMBS with a WAFF of 20% has the expectation that no more than 20% of borrowers will be unable to meet their commitments.
Weighted average life (WAL) – WAL refers to an average term to maturity from the date of its issuance until each dollar of principal is repaid in full amount. WAL on RMBS and related structures is influenced by the rate at which principal is paid on the pool of mortgage loans underlying the security.
Weighted average loss severity (WALS) – A term used for residential mortgage backed securities. WALS is the level of loss expected as a percentage of the loan amount, given a default. From an analysis standpoint, the WALS for a security is a proxy for 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 RMBS can withstand deterioration in the property market of 30% of without incurring a loss. If the market falls by greater than 30%, the investor’s principal may be at risk.