In the second article of our WIRE series focusing on Residential Mortgage Backed Securities (RMBS), we delve into some of the finer details of what matters for a RMBS transaction. For background, RMBS transactions are designed to cope with the worst conditions
as envisaged, and yet the vast majority of the contractual provisions will never be used.
This approach is necessary to ensure that these transactions can be structured as bankruptcy remote from the originator of the mortgages, whereby all possible scenarios have hard wired steps that can be followed. This is diametrically opposite to a plain
vanilla corporate bond whereby an issuer will typically have complete freedom until an event of default occurs, at which time control will transfer to creditors.
Because of this necessary complexity to cover all potential outcomes, we review in this article what should be front of mind to existing and prospective investors in RMBS transactions.
1. Tranches & Subordination
RMBS transactions are designed to offer a range of risks and returns to suit a number of different investors. This will go from the most senior tranche that has priority over cash flows and the lowest overall risk to the most junior tranche, with equity-like
risks and rewards.
Below is the capital structure of the recently issued Pepper No. 36PP, sponsored by Pepper Money, a non-APRA regulated mortgage originator.
The structure above, while designed specifically for the Pepper No. 36PP transaction (including the characteristics of the underlying portfolio of loans) is nevertheless consistent with all other RMBS transactions, noting there could be more or less tranches
– for example, Macquarie Bank, through its PUMA RMBS programme, will only typically issue two tranches.
The key data points in the table above are the credit enhancement and weighted average life, or WAL (which we will cover later).
Credit enhancement is a direct measure of the protection afforded to investors in a given tranche and reflect the amount of notes that are more junior, as a percentage of the total transaction size.
For example, the Class D shows a credit enhancement of 3.27%, which is equal to the Class E, Class F and Class G notes (AUD22.10m) divided by the total transaction size (AUD675m). This means that investors for the Class D notes will only suffer a potential
loss if 3.27% of the total transaction has suffered a complete loss.
A simple rule of thumb when considering the credit enhancement is to first consider what a base case scenario might look like. This would include the general economy growing at a moderate pace, unemployment remaining reasonable and house prices experiencing
gradual growth. In such an environment, an RMBS transaction would be expected to pay down all its tranches as they fall due, with minimal losses to the equity tranche.
Then, the tranche rated in the B category would be able to sustain a moderate stress (modest recession, increase in unemployment,…) and the level of stress for every subsequent higher rated tranches would be a multiple of the first rated tranche.
A BB tranche would generally be able to sustain a stress that is twice as hard and that multiple would grow as the rating becomes higher. The most senior tranche, rated AAA, would generally be able to sustain a stress that is anywhere between five
to ten times harsher than the single B stress.
The assumed stress is always the same (for every transaction and every tranche), which is why different transactions will have different amounts of credit enhancement at the same rating, because the characteristics of the underlying loans are different.
2. Cash Waterfall
While the position of a given Class of the notes in the overall capital structure will determine the level of credit enhancement (i.e. protection), it will also determine the investors’ ranking in the payment priority (referred as to cash waterfall).
The most senior tranche (the Class A1 above) will be the first to receive any payment and the Class F investors will only receive any amount if investors in all other classes of notes have received all amounts expected to be paid.
In practice, a transaction would have two cash flow waterfalls: one for principal payments and one for interest payments (reflecting the payments from each underlying mortgage loan). Since the transaction will need to maintain a perfect balance between
assets and liabilities, principal payments received will only be used to repay the various tranches of notes issued. On the other hand, the interest payment will be used to pay not only the interest on the notes, but also all transaction expenses,
any potential losses and excess cash would typically be paid to the mortgage originator.
We note that the principal cash waterfall will typically change over time. In the early days of the transaction, all the principal payments will go to the most senior tranche (the Class A in the example above).
During that period, the credit enhancements of all tranches will improve since the dollar amount of more junior tranches will be unchanged but the transaction size will decrease. While this makes sense from the perspective of the Class A investors, it
is to the detriment of the overall structure, since the cheapest debt is being repaid ahead of all other (more expensive) classes of notes.
For this reason, after a period of time (typically two years) and provided the transaction performance meets certain pre-determined thresholds, the principal repayment will typically no longer go solely to the most senior tranche but instead be distributed
to all classes (except the most junior tranche) on a pro-rata basis. During that time, the credit enhancement for each tranche will remain constant given the pro-rata payment.
3. Weighted average life
For a typical corporate bond, the maturity date will be one of the key data points since it will determine the date at which the issuer is required to repay the bond. However, for an RMBS transaction, principal will be returned to investors every month,
starting with the most senior class of notes and then switching to all notes on a pro-rata basis.
While it is possible to determine the amount of principal repayments to be received in a given period, this doesn’t account for accelerated repayment, refinancing or non-payment. As such, it is only possible to forecast a potential repayment profile
rather than having a precise idea of each monthly payment to be received.
Because of this ongoing repayment as well as uncertainty, investors in RMBS notes will use the concept of weighted average life, which is a proxy for the amount of time it will take to receive the principal back. Imagine for example an investment of AUD10k,
with AUD5k repaid after six months and the remaining AUD5k 12 months after purchase. The weighted average life (or WAL) will be 0.75 years.
It is important to note that a WAL does not give an indication of when the final repayment will take place. In the example above, the final repayment is made 12 months after purchase. An AUD10k investment returning AUD9k after 6 months and AUD0.2k every
year for 5 years would also have a WAL of 0.75 year. Nevertheless, the WAL will provide investors an indication of the time period during which their investment is most at risk.
It is also important to note that the WAL will be influenced by a number of variables, including any assumption around refinancing / accelerated principal repayment, and if the transaction will be redeemed at its earliest opportunity. It also assumes
that the principal payment will switch from sequential (i.e. most senior tranche first) to pro-rata at the first opportunity.
The WAL for transactions from banks and other regulated entities will generally be a lot more sensitive to these assumptions because their call dates are tied to the transaction size dropping below a pre-determined level. For non-regulated entities, the
call will generally be a precise date, meaning the timing of the final principal repayment will generally be the same in all scenarios, meaning limited variability in the WAL.
4. Other terms you should know about
The three concepts above are probably the most important but you will no doubt hear about the following:
- CPR or Constant Prepayment Rate: this is a measure of how fast (or slow) the underlying mortgage loans are being repaid. A high CPR (typically above 25%) means a fast repayment, which will translate in a lower WAL. A low CPR (below 10%) will result
in a longer WAL. Prime RMBS (i.e. those with the highest quality loans) will typically have a low CPR because borrowers will have competitive terms. Non-conforming RMBS will have higher CPR because borrowers will constantly look to the best (i.e.
cheapest) option available and will therefore refinance on a more frequent basis.
- Arrears: this is a measure of the number of underlying mortgage loans that are behind on their payments. Only loans that are more than 30 days behind are considered and investors will generally look at 30-day, 60-day and 90-day arrears (i.e. loans
that are more than 30, 60 or 90 days late). Arrears will typically be a key data point used to determine if the principal repayment will switch from sequential to pro-rata.
- Excess spread: this is the excess income generated by the transaction, i.e. the difference between interest received from the underlying mortgage loans and all the expenses of the structure, including interest on all the notes but excluding all principal
repayments). Excess spread is one of the key protections for a RMBS structure, as it is effectively spare cash not otherwise allocated to an expense and therefore available to make losses good before being paid to the originator, akin to a dividend.
- Lenders Mortgage Insurance (LMI): typically found on prime or near prime mortgage loans when the loan-to-value (LVR) is above 80%. This is an additional protection available either to a whole structure or individual loans within a structure in the
event of a property being foreclosed on and sold for an amount lower than the amount outstanding under the loan. Key LMI providers in Australia are QBE and Genworth.
Conclusion
RMBS are a well-known, stable funding solution that have been in place in the bond markets for 40 years or more. In that time there has never been an unrecovered loss to any rated tranche of a public transaction.
Due to the complexity of the structures compared to vanilla corporate bonds, a similar tenor and rating for an RMBS bond has historically paid around 1% more than its more mainstream equivalent.
We are comfortable with RMBS as a sub-class of the wider bond market and believe they offer very strong relative value.