1. Mortgage-Backed Sector of the Bond market

2. Overview of Mortgage-Backed Securities
Securities backed by a pool of loans or receivables.
Residential mortgage-backed securities, commercial mortgage-backed securities, asset-backed securities
Agency mortgage-backed securities, nonagency mortgage-backed securities.

3. Overview of Mortgage-Backed Securities (Continued)
MBS: securities backed by residential mortgage loans
MBS include
(1) mortgage passthrough securities
(2) collateralized mortgage obligations (CMO)
(3) stripped mortgage-backed securities
In the United States, the MBSs are divided into two sectors:
(1) those issued by federal agencies (agency MBS)
(2) those issued by private entities (nonagency MBS)
CMBS: securities backed by commercial loans
ABS: securities backed by loans other than traditional residential mortgage loans, or commercial mortgage loans and backed by receivables

4. Agency vs. Nonagency
In the United States, the three major types of passthrough securities are guaranteed by agencies. (Ginnie Mae, Freddie Mac, and Fannie Mae)
Credit risk does not exist for agency mortgage-backed securities issued by a federally related institution. (Ginnie Mae)
Credit risk is viewed as minimal for securities issued by government sponsored enterprises. (Freddie Mac and Fannie Mae)
In order for a loan to be included in a pool of loans backing an agency security, it must meet specified underwriting standards, and is called a conforming mortgage.

5. Nonagency
Jumbo Prime: Loans carrying agency credit and meeting all other agency credit criteria except size are referred to as jumbo prime loans. (Often they are referred to as either “jumbo” or “prime”).
A subprime: Subprime loans are a type of loan granted to individuals with poor credit histories (often below 600), who, as a result of their deficient credit ratings,would not be able to qualify for conventional mortgages.
An Alt-A: The short for Alternative A-paper, is a type of U.S. mortgage that, for various reasons, is considered riskier than "prime", and less risky than “subprime“.

6. Outstanding Mortgage Securities
Year
1-4 Mtg Outstanding
Agency
Nonagency
%Agency
%Nonagency
MBS as % of 1-4 Mtg
2000
5,126,531
2,625,453
385,501 87 13 59
2001
5,677,996
2,974,531
463,217 61
2002
6,436,575
3,312,600
544,055 86 14 60
2003
7,226,763
3,394,021
664,005 84 16 56
2004
8,284,980
3,467,453
1,049,767 77 23 55
2005
9,323,217
3,607,949
1,536,627 70 30
2006
10,359,047
3,904,911
1,991,459 66 34 57
2007-Q2
10,749,703
4,148,691
2,120,175 58

7. Out of the 34% Nonagency
Alt-A
13%
Jumbo Prime 8%
Subprime

8. The Different Characteristics between Agency and Nonagency
loan size
average FICO score
average LTV and CLTV
occupancy (owner versus investor)
documentation (full versus nonfull)
loan purpose (purchase, cash-out refi, or rate refi)
the percent in adjustable rate mortgages
the IO percent
debt-to-income (DTI) ratio.

9. Loan Characteristics loan size
- Smaller loans are less prepayment-sensitive than loans with larger balances.
- Smaller loans also tend to have higher losses than larger loans, reflecting the higher fixed costs of liquidation.
average FICO score
- FICO scores are tabulated by an independent credit bureaus, using a model created by Fair Isaac Corporation (FISO).
- These scores range from 350 to 900, with higher scores denoting lower risk.
average LTV and CLTV
- The loan-to-value (LTV) ration refers to the loan amount divided by the value of a home. The CLTV ration is the sum of the first and second mortgages divided by the home’s value.
- Loans with higher CLTV ratios have higher delinquencies and higher loss severities.

10. Loan Characteristics Occupancy
- Loans with a higher percentage of investor properties tend to default more often, and they also experience higher loss severities when they default.
- Investor properties also tend to have somewhat more stable prepayment profiles.
- It is widely believed that many investors stated that their properties were owner-occupied, when in fact they were not, causing an underestimate of investor share.
Documentation
- Full documentation generally involves the verification of income and assets.
- With limited documentation, either income or assets are not verified.
- Limited documentation loans tend to have higher default rates than full documentation loans.
- However, from , documentation standards were relaxed considerably, without requiring any type of compensating factors.

11. Loan Characteristics loan purpose
- Historically, loan purpose has not been that important in determining either default or prepayment behavior.
- However, in the period, purchase loans had much more risk layering than did either refi or cash-out refis.
the percent in adjustable rate mortgages
- The standard adjustable rate mortgage (ARM) is fixed for a period of time, and floats thereafter.
- Borrowers taking out ARMs are generally looking to lower their monthly payment.
- ARM borrowers generally have more risk layering than their fixed rate counterparts, and hence have higher defaults.
- ARM borrowers have historically prepaid faster than their fixed rate counterparts.

12. Loan Characteristics the IO percent.
the IO percent
- Interest-only mortgages are mortgages in which the borrower does not pay principal for a period of time.
- Borrowers taking out interest-only mortgages or 40-year mortgages tend to have higher defaults than those who use conventional 30-year mortgages.
- Prepayment behavior on interest-only mortgages tends to be fairly similar to that on amortizing mortgages.
debt-to-income (DTI) ratio.
- DTI is used as a measure of their ability to repay it.

13. Roots of the 2007 – 2009 subprime crisis
The decline in agency issuance during 2004 – 2006, mirrored by a rise in subprime and Alt-A issuance, reflected the drop in housing affordability during this period. In order to maintain market share, originators began to relax origination standards. Combined loan-to-value (CLTVs) rose, the interest-only share rose, and documentation dropped.
- A rise in interest rates from mid through 2006.
- The large run-up in home price appreciation during 2003 – 2005.
- As a result, housing affordability dropped sharply.
The relaxation in origination standards was fine as long home prices were appreciating. When a borrower ran into difficulty, selling the home at a profit was a much better option than defaulting. However, in mid-2006 housing began to weaken. Existing home sales fell; home prices were stagnant and then began to decline.

14. Loan and Borrower Characteristics by Product Type
Agency
Jumbo Prime
Alt-A
Subprime
Lien
1st
Loan Limit
<= Agency
> Agency
None
Average Loan Sice
221,301
509,013
293,719
185,451
Credit A
A/A-
A-/C
Average FICO
725
739
712
628
Average LTV 71 69 74 81
Average CLTV - 75 86
Occupancy 9owner)
96%
99%
85%
95%
Full documentation
50%
23%
60%
Loan purpose
Purchase
39%
46%
40%
Cash out
59%
36%
53%
Rate refi
30%
18% 7% IO 9%
45%
43%
20%
ARMs
12%
52%
63%
73%
DTI
33%
41%

15. Characteristics of Residential Mortgages
A fixed-rate, level-payment, fully amortized mortgage.
The mortgage rate is fixed.
The dollar amount of each monthly payments is the same for the life of the mortgage loan.
When the last scheduled monthly mortgage payment is made the remaining mortgage balance is zero.

16. An Example of fixed-rate, level-payment, fully amortized mortgage
Mortgage loan: $100,000
Monthly payment: $742.50
Mortgage rate: 8.125%
Term of loans: 30 years (360 months)

17. Month
Balance
(Beginning )
Mortgage Payment
Interest
Scheduled Repayment
Balance (End) 1
$100,000.00
742.50
677.08
65.41
$99,934.59 2
99,934.59
676.64
65.86 3
676.19
66.30
99,802.43 4
675.73
66.75
99,735.68 …
358
2,197.66
14.88
727.62
1,470.05
359
9.95
732.54
737.50
360
737.70
4.99
0.00

18. The Process of Securitization

19. Cash Flow Characteristics of Passthrough
The cash flow of a mortgage pasthrough security depends on the cash flow of the underlying pool of mortgages.
Payments are made to security holders each month.
The monthly cash flow for a passthrough is less than the monthly cash flow of the underlying pool of mortgages by the amount equal to servicing and other fees.
A passthrough is described by a weighted average coupon rate (WAC) and a weighted average maturity (WAM).

20. An Example of WAC and WAM
Loan
Outstanding Mortgage Balance
Weight in Pool
Mortgage Rate
Months Remaining 1
$125,000
22.12%
7.50%
275 2
$85,000
15.04%
7.20%
260 3
$175,000
30.97%
7.00%
290 4
$110,000
19.47%
7.80%
285 5
$70,000
12.39%
6.90%
270
Total
$565,000
100.00%
7.28%
279

21. WAC and WAM
WAC:
* 7.5% * 7.20% * 7.00% * 7.80% * 6.90% = 7.28%
WAM
* * * * * 270 = 279 months

22. Prepayment Risk
A payment made in excess of the monthly mortgage payment is called a prepayment.
Most of residential mortgages have no prepayment penalty.
The effect of prepayments is that the amount and timing of the cash flow from a mortgage loan are not known with certainty.
There are ways to redistribute prepayment risk among the different bond classes created.

23. Measuring the Prepayment Rate
Single Monthly Mortality Rate (SMM)
Given the prepayment for a month for a mortgage pool, an investor can calculate the SMM .
Conditional Prepayment Rate
Given an assumed SMM, an investor will use it to project the prepayment for a month. The prepayment for a month will then be used to determine the cash flow of a mortgage pool for the month.
PSA Prepayment Benchmark

24. Single Monthly Mortality Rate (SMM)
= Prepayment in month t / (Beginning mortgage balance for month t – Scheduled principal payment in month t )
Assume the following:
Beginning mortgage balance in month 33 = $358,326,766
Scheduled principal payment in month 33 = $297,835
Prepayment in month 33 = $1,841,347
= $1,841,347 / ($358,326,766 - $297,835) = %
It is interpreted as follows: In month 33, % of the outstanding mortgage available to prepay in month 33 prepaid.

25. Conditional Prepayment Rate
Market participants prefer to talk about prepayment rates on an annual basis rather than a monthly basis.
Given the SMM for a given month, the CPR can be calculated to be
Given a CPR, the corresponding SMM can be computed as follows:

26. PSA Prepayment Benchmark
The model is designed by the Public Securities Association (PSA), later renamed the Bond Market Association, in early 1980s.
The PSA benchmark assumes that prepayment rates are low for newly originated mortgages and then will speed up as the mortgages become seasoned.
“100% PSA” or simply “100 PSA” can be expressed as follows:
if t < 30 then CPR = 6%*(t/30)
if t >= 30 then CPR = 6%
Slower or faster speeds are then referred to as some percentage of PSA. For example, “50 PSA”, “200 PSA”.

27. An Example of PSA Benchmark--- the SMMs for month 5
Assuming 100 PSA
CPR = 6% * (5/30) = 1%
Assuming 165 PSA
CPR = 1%,
165 PSA = 1.65 * 1% =

28. An Example of PSA Benchmark--- the SMMs for month 31
Assuming 100 PSA
CPR = 6%
Assuming 165 PSA
CPR = 6%,
165 PSA = 1.65 * 6% = 9.9%

29. Example: Monthly Cash Flow with Prepayments
Assume
- $400 million Passthrough with
- 7.5% passthrough rate
- A WAC of 8.125%
- A WAM of 357 months (the loans are seasoned an average of months)
- 100 PSA

30. Outstanding-Balance (3) SMM (4) Mortgage Payment(5) Net Interest (6)
Months from Now (1)
Months Seasoned (2)
Outstanding-Balance (3)
SMM (4)
Mortgage Payment(5)
Net Interest (6)
Scheduled Principal (7)
Prepayment (8)
Cash Flow (9) 1 4
$400,000,000
$2,975,868
$2,500,000
$267,535
$267,470
3,035,005 2 5
399,464,995
2,973,877
2,496,656
269,166
334,198
3,100,020 3 6
398,861,631
2,971,387
2,492,688
270,762
400,800
3,164,447
---
356
359
1,004,191
507,201
6,276
500,401
2,591
509,269
357
360
501,199
504,592
3,132
504,331

31. Illustration (cash flow in month 1)
Column 4: SMM
CPR = 6% (4/30) = 0.8%, SMM =
Column 5: the total monthly mortgage payment, which is declining as prepayments reduce the balance outstanding.
Column 6: the net monthly interest
outstanding balance (beginning) * passthrough rate * (1/12)
= $400,000,000 * 7.5% * (1/12) = $2,500,000
Column 7: the scheduled principal repayment
total monthly mortgage – outstanding balance (beginning) * 8.125% * (1/12) = $2,975,868 - $400,000,000 * 8.125% * *1/12) = $267,535
Column 8: the prepayment for the month
[outstanding balance (beginning) – scheduled principal repayment] * SMM = ($400,000,000 - $267,535) * = $267,470
Column 9: the projected monthly cash flow
monthly interest + scheduled principal repayment + prepayment
= $2,500,000 + $267,535 + $256,470
= $3,035,005

32. Cash Flow Yield
The cash flow yield is the discount rate which equates the sum of the present values of expected cash flows to the market price.
: the expected cash flow at time t
y: the cash flow yield

33. Average Life Average life =
The average life of a passthrough depends on the prepayment assumption.
The higher (lower) the speed, the shorter (longer) the average life.

34. Factors Affecting Prepayment Behavior
Prevailing mortgage rate
- The spread between the prevailing mortgage rate in the market and the rate paid by the homeowner affects the incentive to refinance.
- The path of mortgage rates also affect prepayments.
Housing turnover
- Without interest rate changes, there is a normal amount of housing turnover.
- The housing turnover is higher (lower) in a growing (weak) economy.
Characteristics of the underlying residential mortgage loans
- the amount of seasoning
- the geographical location

35. Contraction Risk and Extension Risk
Prepayment risk encompasses contraction risk and extension risk.
Contraction risk: (when mortgage rates decline)
- Prepayment will speed up.
- The reinvestment risk becomes higher.
- The price is compressed. (The price will increase less than the option-free bonds.)
- There is a decline in the average life (shortening).
Extension risk: (when mortgage rates increase)
- Prepayment will slow down.
- Less cash flows than expected to reinvest at the higher interest rates.
- The price will decrease more than the option-free bonds.
- There is an increase in the average life (lengthening).

36. Collateralized Mortgage Obligations
There is prepayment risk associated with investing in a mortgage passthrough security.
Some institutional investors are concerned with extension risk and others with contraction risk.
This problem can be mitigated by redirecting the cash flows of mortgage-related products to different bond classes, called tranches.
When the cash flows of mortgage-related products are redistributed to different bond classes, the resulting securities are called collateralized mortgage obligations (CMO).
There is a wide range of CMO structures.

37. Sequential-Pay Tranches F01
Payment rules:
For payment of monthly coupon interest
Disburse monthly coupon interest to each tranche on the basis of the amount of principal outstanding for each tranche at the beginning of the month.
For disbursement of principal payments
Disburse principal payments to tranche A until it is complete paid off. After tranche A is completely paid off, disburse principal payments to tranche B, and so on.

38. A Hypothetical 4-Tranches Sequential-Pay Structures F01
Par Amount ($)
Coupon Rate (%) A
194,500,000
7.5 B
36,000,000 C
96,500,000 D
73,000,000
Total
400,000,000

39. Average Life for F01 Average Life for Speed (SPA) Collateral Tranche A
Tranche B
Tranche C
Tranche D 50
15.11
7.48
15.98
21.02
27.24
100
11.66
4.90
10.86
15.78
24.58
200
7.68
3.05
6.42
9.60
18.11
400
4.44
1.94
3.70
5.31
10.34
600
3.16
1.51
2.74
3.75
6.96

40. Prepayment Risk for F01 Tranche A exposes to contraction risk.
Tranche D exposes to extension risk.

41. Sequential-Pay with an Accrual Tranches F02
Payment rules:
For payment of monthly coupon interest
Disburse monthly coupon interest to tranche A,B,and C on the basis of the amount of principal outstanding for each tranche at the beginning of the month. For tranche Z, accrue the interest based on the principal plus accured interest in the previous month.
The interest for tranche Z is to be paid to the earlier tranches as a principal paydown.
For disbursement of principal payments
Disburse principal payments to tranche A until it is complete paid off. After tranche A is completely paid off, disburse principal payments to tranche B, and then disburse trahcne C. After trnache C is completely paid off, disburse principal payments to tranche Z.

42. A Hypothetical 4-Tranches Sequential-Pay with an Accrual Structures F02
Par Amount ($)
Coupon Rate (%) A
194,500,000
7.5 B
36,000,000 C
96,500,000
Z (Accrual)
73,000,000
Total
400,000,000

43. Average Life for F91 and F02 at 165 PSA
Structure
Tranche A
Tranche B
Tranche C
F02
2.90
5.80
7.87
F01
3.48
7.49
11.19

44. 5-Tranche Sequential-Pay Structure with Floater, Inverse Floater, and Accrual Bond Tranches F03
Payment rules:
For payment of monthly coupon interest
Disburse monthly coupon interest to tranche A,B, FL and IFL on the basis of the amount of principal outstanding for each tranche at the beginning of the month. For tranche Z, accrue the interest based on the principal plus accured interest in the previous month. The interest for tranche Z is to be paid to the earlier tranches as a principal paydown.
The maximum coupon rate for FL is 10%; the minimum coupon rate for IFL is 0%.
For disbursement of principal payments
Disburse principal payments to tranche A until it is complete paid off. After tranche A is completely paid off, disburse principal payments to tranche B, and then disburse trahcnes FL and IFL . After trnache I FL and IFL are completely paid off, disburse principal payments to tranche Z.

45. 5-Tranche Sequential-Pay Structure with Floater, Inverse Floater, and Accrual Bond Tranches F03
Par Amount ($)
Coupon Rate (%) A
194,500,000
7.5 B
36,000,000 FL
72,375,000
1-mon LIBOR +0.5
IFL
24,125,000
28.5 – 3 * (1-mon LIBOR)
Z (Accrual)
73,000,000
Total
400,000,000

46. FL and IFL Trahcne C: 96,500,000 (coupon rate 7.5%)
IFL cannot be negative. Thus the minimum rate for IFL is 0%.
K – L * (1-mon LIBOR) = 0%
- 1-mon LIBOR = K/L=28.5/3 = 9.5%
- the maximum of FL is 9.5% +0.5% = 10%
The maximum rate for IFL is K = 28.5%, when 1-mon LIBOR = 0%. The minimum rate for FL is therefore 0.5%.

47. A 5-Tranche Sequential Pay with an Accrual , an Interest-Only, and a Residual Class F04
CMO structures can be created so that a tranche receives only interest.
Interest only (IO) tranches in a CMO ctructure are referred to as structured IOs.
It is the excess interest that is used to create one or more structured IOs.
Excess interest = Collateral tranche’s coupon rate – Tranche coupon rate
For example, for tranche A:
Excess interest = 7.5% - 6% = 1.5%
Tranche’s par value = $194,500,000
Notional amount for 7.5% IO = (Original tranche’s par value * Excess interest) / = ($194,500,000 * 0.015) / = $38,900,000

48. A 5-Tranche Sequential Pay with an Accrual , an Interest-Only, and a Residual Class F04
Payment rules:
For payment of monthly coupon interest
Disburse monthly coupon interest to tranche A,B, and C on the basis of the amount of principal outstanding for each tranche at the beginning of the month. For tranche Z, accrue the interest based on the principal plus accured interest in the previous month. The interest for tranche Z is to be paid to the earlier tranches as a principal paydown. Disburse periodic interest to the IO tranche based on the notional amount for all tranches at the beginning of the month.
The maximum coupon rate for FL is 10%; the minimum coupon rate for IFL is 0%.
For disbursement of principal payments
Disburse principal payments to tranche A until it is complete paid off. After tranche A is completely paid off, disburse principal payments to tranche B, and then disburse trahcnes C . After trnache C are completely paid off, disburse principal payments to tranche Z.
3. No principal is to be paid to the IO tranche.

49. A 5-Tranche Sequential Pay with an Accrual , an Interest-Only, and a Residual Class F04
Par Amount ($)
Coupon Rate (%) A
194,500,000
6.00 B
36,000,000
6.50 C
96,500,000
7.00 Z
73,000,000
7.25 IO
52,566,667 (Notional)
7.50
Total
400,000,000

50. Creating a Notional IO Tranche
Par Amount
Excess Interest (%)
Notional Amount for a 7.5% IO A
194,500,000
1.50
$38,900,000 B
36,000,000
1.00
4,800,000 C
96,500,000
0.50
6,433,333 Z
73,000,000
0.25
2,433,333
Notional amount for 7.5% IO = $52,566,667

51. Planned Amortization Class Tranches (PAC)
If the prepayment speed is within a specified band over the collateral’s life, the cash flow pattern is known.
The greater certainty of the cash flow for the PAC bonds comes at the expense of the non-PAC tranches, called the support tranches or companion tranches.
PAC tranches have protection against both extension risk and contraction risk, they are said to provide two-sided prepayment protection.

52. CMO Structure with One PAC Tranche and one Support Trance F05
Payment rules:
For payment of monthly coupon interest
Disburse monthly coupon interest to each tranche.
2. For disbursement of principal payments
- Disburse principal payments to tranche P.
- Any excess principal payments in a month over the amount necessary to ssatisfy the schedule for tranche P are paid to tranche S.
- When tranche S is completely paid off, all principal payments are to be made to tranche P regardless of the schedule.

53. CMO Structure with One PAC Tranche and one Support Trance F05
Par Amount
Coupon Rate
P (PAC)
243,800,000
7.5
S (Support)
156,200,000
Total
400,000,000

54. PAC Assuming 90 PSA and 300 PSA
Month
At 90 PSA
At 300 PSA
Minimum Principal Payment Available to PAC 1
508,169
1,073,931 2
569,843
1,279,412 3
631,377
1,482,194
---
211
949,482
213,309
212
946,933
209,409

55. Average Life for PAC F05 Prepayment Rate (PSA) PAC Bond Support Bond
15.97
27.26 50
9.44
24.00 90
7.26
20.06
100
18.56
200
8.38
250
5.37
300
3.13
350
6.56
2.51
400
5.92
2.17
500
4.93
1.77

56. Stripped Mortgage-Backed Securities
There are only two bond classes, one bond class receives all of the principal and one bond class receives all of the interest.
The bond class that receives all of the principal is called the principal-only class or PO class.
The bond class that receives all of the interest is called the interest-only class or IO class.

57. Principal-Only Strips
The PO security is purchased at a substantial discount from par value.
The yield an investor will realize depends on the speed at which prepayments are made.
The faster the prepayments, the higher the yield the investor will realize.
The price of a PO will increase when mortgage rates decline. (Cash flows improve and are discounted at a lower interest rate.)

58. Interest-Only Strips When an IO is purchased there is no par vale.
The IO suffers from a fast prepayment.
If mortgage rates decline below the coupon rate, prepayments are expected to accelerate, which leads to a deterioration of the expected cash flow for an IO. However, the cash flow will be discounted at a lower rate.
The net effect may be either a rise or a fall for the IO.

59. Commercial Mortgage-Backed Securities (CMBSs)
Commercial mortgage-backed securities are backed by a pool of commercial mortgage loans on income-producing property.
These properties include: multifamily properties, office buildings, industrial properties, shopping centers, hotels, health care facilities etc.

60. Credit Risk of CMBSs
Unlike residential mortgage loans, commercial mortgage loans are non-recourse loans.
“Non-recourse loans” means that the lender can only look to the income-producing property backing the loan for interest and principal repayment, and has no recourse to the borrower for any unpaid balance.
Two indicators of potential credit performance are the debt-to-service coverage ratio and the loan-to-value ratio.
The debt-to-service coverage ratio is the ratio of a property’s net operating income divided by the debt service.
Credit analysis be performed on a loan-by-loan basis not only at the time of issuance, but monitored on an ongoing basis.

61. Basic CMBS Structure
A rating agency will determine the necessary level of credit enhancement to achieve a desired rating level.
The rating agencies will require that the CMBS transaction be retired sequentially, with the highest-rated bonds paying off first.
Losses arising from loan defaults will be charged against the principal balance of the lowest-rated CMBS.

62. Call Protection
A critical investment feature that distinguishes residential MBS and commercial MBS is the call protection afforded an investor.
An investor in a residential MBS is exposed to considerable prepayment risk because the borrower has the right to prepay a loan without any penalty.
With CMBS, there considerable call protection afforded investors. This protection makes CMBS trading in the market more like corporate bonds than residential MBS.
Call protection comes in two forms : (1) call protection at the loan level and (2) call protection at the structure level.

63. Protection at the Loan Level
At the commercial loan level, call protection can take the following forms:
1. prepayment lockout
2. defeasance
The borrow provides sufficient funds for the servicer to invest in a portfolio of Treasury securities that replicates the cash flows that would exist in the absence of prepayments.
3. prepayment penalty points
4. yield maintenance charges
It is designed to make it uneconomical to refinance solely to get a lower mortgage rate.

64. Structural Protection
Because the CMBS bond structures are sequential-pay (by rating), the AA-rated tranche cannot pay down until the AAA is completely retired, and the AA-rated bonds must be paid off before the A-rated bonds, and so on.

65. Balloon Maturity Provisions
Many commercial loans backing CMBS transactions are balloon loans that require substantial principal payment at the end of the term of the loan.
If the borrower fails to make the balloon payment, the lender may extend the loan, and in so doing may modify the original loan terms. This is called balloon risk.
The balloon risk is a type of “extension risk.”