There are a number of protections in RMBS that provide comfort to investors including the structure of the securities, as well as various protections for individual loans
1. The tranches
Residential mortgage backed securities groups of a range of mortgages, then split into tranches as shown by the Bank of Queensland Reds 2017 – 1 table below.
Source: Bank of Queensland
|S&P credit rating
|Weighted average life
|Margin to swap
|1m BBSW + 1.13%
|1m BBSW + 1.70%
|1m BBSW + 2.05%
|1m BBSW + 2.50%
|1m BBSW + 3.45%
|1m BBSW + 6.00%
Dependent on the class of security invested in, more deeply subordinated classes of security provide protection to higher ranking classes. Generally, the lower the ranking of the security class, the higher the risk as these securities are ranked lower in the payment priority waterfall and are the first to incur capital losses.
2. Principal and interest waterfalls
Cashflow waterfalls are essentially a set of rules laid out in the contract documents which define the order cashflows are applied. At a basic level, it follows the concept of credit seniority.
In RMBS, these waterfalls are separated into principal and interest reflecting the underlying nature of the collateral (loans). The structure then pays the principal and interest receipts from the home loans, to the principal and interest balances of RMBS investors, with the principal typically being repaid over the life of the security.
The ‘cashflow waterfalls’ for principal and interest within the RMBS structure contractually ensure the highest ranking class of securities receive payment ahead of lower ranking classes of securities.
a. Principal waterfall
The principal waterfall is quite basic, with principal receivables simply applied in rank order to the various classes of RMBS – the highest ranking class being paid first and thus having the lowest risk.
b. Interest waterfall
The interest waterfall is slightly more complicated in that it is required to cover the expenses of the trust prior to making interest payments to investors. These expenses include both tax (given first priority) and trust management expenses. Once these expenses are covered, interest is paid in rank order similar to the principal waterfall.
Once the RMBS investors’ interest is paid, excess interest payments received from borrowers are applied to cover firstly any previous short fall in interest in what is called a charge off, and finally, once any previous losses have been cleared, excess spread is paid as an equity return to the originator. No equity return can be made while carried forward losses are present.
Interest payment priority in an RMBS structure
Source: FIIG Securities Limited
Provisions are also made in the structure for borrowers who pay principal ahead of schedule and for borrowers who utilise redraw facilities.
3. The originator
The RMBS structures are not affected by the performance of the originator of the loans that is the bank or the non bank that agrees to make the loan in the first place. This is because RMBS are held in ‘bankruptcy remote’ vehicles. Should the originating financial institution fall into financial difficulty, the RMBS would not be exposed to the risk of the originator. Note, the originator of the loan is often the servicer and while the RMBS vehicle is bankruptcy remote, if the originator got into financial difficulty there may be negative implications in the administration of the trust. ‘Standby servicers’ can step in and take over administration.
Protections built into the loans
Investing in RMBS provides multi property and geographical diversification. If we use the Bank of Queensland Reds 2017 – 1 RMBS above as an example, the pool has 4,031 loans – 27.6% in the Brisbane Metro area, 21.5% in Queensland, non-metro, 20.6% in NSW, 15.2% in WA and 11.6% in Victoria.
Another key protection for investors is the built in overcollateralisation of the RMBS.
This overcapitalisation is expressed in the Loan to Valuation Ratio (LVR). That is the percentage value of the loan compared to the value of the property. The lower the LVR, the lower the risk to the lender due to:
- Greater ownership of the home by the borrowers, meaning less chance of ultimate loss if the borrowers get into financial difficulty. The difference between the amount lent, and the value of the property represents the equity the owner has in the property. The greater the equity, the greater the buffer against loss if they default on the loan.
- A borrower capable of building up equity value of the property displays the ability to service the mortgage.
- Should the borrower default, the proceeds from the sale of the property need only cover the value of the loan to achieve full recovery for investors. The lower the LVR, the lower the sale price required to recover the outstanding loan.
There are also several underlying property protections which are required before a loan is accepted into an Australian RMBS, in the case of mortgages this would include general insurance over the property and in the case of Prime RMBS, this would generally include mortgage insurance – to cover losses incurred by the lender not the borrower.
Credit ratings add comfort
There is a significant pool of historic evidence of loan performance upon which the credit rating agencies base their analysis of and adjustments to the loan pool. Importantly, these adjustments are not static, with the rating agencies reviewing the level of adjustment on an ongoing basis.
Next week in part three we will look at the final key concepts for investors in RMBS; credit enhancement, weighted average foreclosure frequency, and weighted average loss severity. We will look at how they relate to each other, and how investors can use them to form a risk/reward judgement on an investment.