Mortgage Securitization Basics Karin Good, CFA President kmg consulting Karin@kmg-consulting.com 917-992-559

Class discussion Securitization Structures and Mechanics Mortgage Cashflows for securitizations Securitization waterfalls Losses and how they impact securitization cashflows Conflict of Interest or Something else?

Types of Securitizations- Two Segments of the market GSE eligible, Fannie Mae, Freddie Mac and Ginnie Mae eligible loans. Eligibility based on loan size and underwriting guidelines Securitization had Implicit guaranty by the government for Fannie Mae and Freddie Mac. Government guarantee for Ginnie Mae (FHA and VA loans). AAA rating Guidelines expanded significantly during the early 2000’s as initiatives for home ownership became popular. Private Label or Non – Agency loans Loan sizes larger and / or loans that had underwriting guidelines wider than the GSE’s. Securitizations were structured and rated by the rating agencies. No guarantee, ratings of bonds obtained by structure. When GSE’s expanded guidelines, some loans were eligible for both private label and GSE executions. Decision made by best price obtained.

Types of Structures Participation Agreements - 144A Passthrough – GSE fixed security CMO (Collateral Mortgage Obligation) WAC (weighted average coupon) Pass through – hybrids, arms Fixed coupon with supporting bonds – fixed rate loans Both structures have supporting bonds that create a AAA security CMO private label securities are done with a Special Purpose Vehicle (SPV). This is a special off balance sheet structure that is arms length to the issuer.

Types of collateral Loans were separated into collateral types and put on separate shelf’s. These are shelf registrations with the SEC for a specificate amounts. Each shelf had it’s own name so investors could identify what kind of loans were in the pool Jumbo A (CHASE-2005-6)- Best credit quality, higher loan amounts Fixed rate loans Hybrids Alt A (CFLEX -2004-7)expanded criteria and reduced docs Fixed Subprime (JPMAC 2006-3) Lower fico scores and credits All pools were derived from data files provided by the originator Rating Agency models to determine subordination levels could be run by the issuer prior to rating agency review

CMO Structure AAA Bond fixed pass-through 95% IO (interest only )- the interest above the fixed coupon PO (Principal only) – the principal below the fixed coupon Subordinate bonds 5% AA, A, BBB above investment grade BB, B, UR are the below investment grade Residual account with is excess interest in alternative structure, mostly for subprime deals.

Pricing of CMO - Assume a 4.125 WAC Bond Percentage coupon Price AAA bonds 95% 4.0 104.0 IO ( 4.0 multiple) .125 0.5 Total AAA 104.5 Subordinate bonds(AA,A,BBB,BB,B,UR) 5% 65.0 Total Proceeds from bonds 102.55

Implications of Pricing The example above is how mortgage companies would price a loan to the loan officers 102.55 less margins = par rate Increasing demand for AAA bonds reduced the rate offered to consumers The Subordinated bond demand also helps the price. However the lower the % of subordinated bonds needed to support the AAA bonds, the better the economics. Most investors required 2 rating agencies to rate the bonds. There were 3 prominent rating agencies Moody’s, S&P, and fitch. Issuers and dealers would decide on the 2 agencies that they would use to rate the bonds. The Issuer / dealers pay the rating agency fees.

Securitization Waterfall AAA bonds Pro rata portion of the principal paydown 100% prepayments go to the AAA bonds 0% of the defaults go to the AAA bonds Subordinate Bonds 100% of the loan defaults go the subordinates starting with the UR, then B,BB,BBB,A,AA 0% of the prepayments go to the subordinate bonds Shifting Interest After 5 years or overcollateralization triggers, shifting interest starts to take place. 20% of prepays will shift to the subordinate bonds each year for 5 years 20% of the defaults will shift to the AAA for 5 years. After 5 years or the trigger, the bonds become pro rata pay for all cashflows. Clean up call at 10% or 5% depending on the shelf

How Investors Got Paid- HPA Increasing, prepayments high Issuance AAA- 95% $ px 104.5 Subordinates 5% $ px 65 Prepayments- reducing AAA AAA – 90% Px stable or increase due to more subordination – proceeds to reinvest 10% Px increase up to 100

How Investors Got Paid- HPA declining and loans defaulting Issuance AAA- 95% $ px 104.5 Subordinates 5% $ px 65 Credit losses decreasing subordinate bonds AAA – 100% Px declines quickly and rating falls so liquidity drops 0% Px declines to 0

Issues occurring with the financial Meltdown HPA went down for the entire country. The theory of rating agencies, etc. was that any changing in housing value would be regional. Portfolio theory. Reps and warrants in the securitization documents stated issuers and underwriters can only buy back loans that had a breach. This was typically an underwriting of the loan that was flawed of inaccurate data. Due diligence review was negotiated down to about 10% of deal. Issuers, rating agencies and investors relied on data in a file! Reduced documentation and high LTV loans, where originators expanded guidelines were the worst performing loans.

Parties Involved- conflict of interest or something else? Investors – Used leverage to increase returns increasing demand AAA – banks, insurance companies and other portfolios Subordinates AA, A,BBB (investment grade tranches) – CDO’s BB, B and UR – Specialty finance firms Originators to consumer- Improved pricing from investors and demand expanding underwriting guidelines. Issuers / Underwriters – Driving and fulfilling demand created unprecedented profits. Rating Agencies – competition for deals made them more aggressive GSE’s – initiative for home ownership and entering some of the private label space reduced g-fees and expanded guidelines. Fair Value Accounting – Must see a trade to mark loans in pipeline. Lack of liquidity and tiering of shelf names in the market made this very difficult.

State of the Non Agency Market today Private label securities are back for Jumbo A fixed loans only. No liquidity vs the past. Most issuers are REITs or specialty finance companies or dealers with origination businesses Rating agency levels are not as predictable and much higher Most non agency loans go into bank portfolios, that by far still has the best pricing There are QM (Qualified Mortgage ) vs Non QM mortgages. Non QM have rep and warrant restrictions and are not currently securitizable By far, the largest part of the securitization market today are the GSEs