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AAA Senior
Subordinate Subordinate
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Quarters
1,000% PSA
0% PSA
1
Moodys also downgraded 62 structures, primarily because of declining collateral credit quality.
2
Higher incomes lead to lower loan-to-value ratios.
202 Nancy DeLiban and Brian P. Lancaster
Dominance of the Senior-Subordinate Structure
The market witnessed a relatively large increase in the cost of pool insurance in early
1992, primarily because of general loss experience in California and several other states.
Also in 1992, new Securities and Exchange Commission regulations allowing subordi-
nates rated BBB and above to be included as publicly traded securities contributed to
increased liquidity of the subordinates. As a result, the market began to further credit-
tranche the subordinates, and the percentage of senior-subordinate deals rose to 83 (see
table 2). The total subordinate tranche was typically divided into a small unrated bond,
followed by B-rated, BB-rated, BBB-rated, A-rated, and AA-rated securities.
These changes, along with reduced loss expectations in the higher rated subordinates and
better analyses, helped attract new buyers. This new acceptance of and confidence in the
evaluation of credit risk was most evident in the BBB-rated sector and above. Investor
participation in the nonagency mortgage sector was further spurred as the bull market
caused many investors to consider alternative investments to increase yield and provide
prepayment protection. Mortgage funds, hedge funds, and foreign investors began to join
insurance companies in buying the credit risk embedded in the subordinates. Confidence
was further increased in 1993 when Standard & Poors dramatically reduced the amount
of subordination necessary to achieve a AAA rating. Given the new investors, increased
volume, more extensive historical data, and lower interest rates, total execution on
subordinate tranches increased substantially (by about 10 percentage points for new-
origination current-coupon securities) from the levels achieved three years earlier.
Superior Convexity Characteristics of Subordinates
In a market plagued by rapid prepayments, the extra call protection offered by subordi-
nates in a shifting interest structure was also a key factor in their growth and their lower
overall transaction costs. As a result, AA-rated mezzanine tranches often traded tighter
than AAA-rated plain-vanilla tranches of equal average life, because the shifting interest
structure reduced their prepayment risk. Shifting interest structures work by directing
all collateral prepayments to the senior bonds without paying down a pro rata amount of
the subordinates for a time (typically 5 years for fixed-rate mortgages, 10 years for
adjustable-rate mortgages). This causes higher levels of subordination to build up over
time as senior bonds are paid off by prepayments while the subordinate tranches are not
(see figure 3).
The effect of the shifting interest structure on the subordinates principal cash flows is
shown in figure 4. Because prepayments are locked out and shifted away from the
subordinates for the first five years, the amount of principal paid out is fixed for the first
five years across a wide range of prepayment scenarios. Although the principal balance
outstanding after the lockout would be affected by changes in prepayment speed, the
lockout would greatly dampen the overall average life variability of the bond.
In marked contrast, the impact of changing prepayments on the seven-year senior class
with the same average life is shown in figure 5. Here, principal paydowns change at both
the beginning and the end of the principal payment window. In fact, average life
instability is magnified because of the transfer of all prepayment risk for a time.
Understanding Nonagency Mortgage Security Credit 203
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204 Nancy DeLiban and Brian P. Lancaster
Figure 4. Principal Paydowns of a Seven-Year Subordinate Tranche
Source: Bear, Stearns & Co., Inc.
The side effect of this credit enhancement technique, which is common to all subordinate
pieces, is to reduce significantly their negative convexity (the risk of the duration of a
bond changing when it is least desired) and average life variability. The average lives of
the two seven-year securities (the senior and the subordinate) are compared in table 3.
The average life of the subordinate tranche at a pricing speed of, for example, 275 percent
of the Public Securities Association Standard Prepayment Model (PSA) would be 7.84
years, about one month shorter than that of the senior tranche. However, in this example,
the average life of the subordinate tranche shortens by only about 0.5 year, as compared
with a shortening of 1.8 years for the senior tranche, if prepayments rose to 400 percent
PSA. Similar stability would hold at slower speeds. The subordinate tranche extends by
only about 0.5 year, as compared with an extension of 2 years for the senior tranche, if
prepayments slow to 200 percent PSA.
Another security resulting from a credit enhancement technique that incorporates both
insurance and a senior-subordinate structure is the credit certificate. A standard
noncredit tranched subordinate obtains an insurance policy from GEMICO similar to an
FSA wrap whereby the subordinate would collect for any credit losses (see figure 6). If
GEMICO or an alternative insurer is downgraded, only the subordinate is affected. The
senior bonds respond exactly like a senior tranche in a regular senior-subordinate
structure; that is, they have no additional protection.
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Pricing Speed
Understanding Nonagency Mortgage Security Credit 205
Figure 5. Principal Paydowns of a Seven-Year Senior Tranche
Source: Bear, Stearns & Co., Inc.
The investor should note when evaluating these bonds that the relatively small subordi-
nate (5 to 8 percent of the deal in a single-family, fixed-rate structure) collects for losses
on the entire pool. Because the subordinate collects shortfalls from the insurer, losses act
as prepayments, even during the lockout period. Thus, a 1 percent annual loss on
collateral with a 6.5 percent subordinate is equivalent to a 14.4 percent constant-
percentage prepayment to the subordinate. Making a speed adjustment for defaults is
very important when evaluating these bonds, even when they are in their lockout period.
Lower Credit Quality Mortgages
The success of selling higher risk collateral gave rise to selling nonconforming,
nonperforming, or delinquent collateral called A, B, C, and D paper. The A paper consists
of mortgages without delinquencies that would generally conform to agency standards
except that their loan balances are too large. B and C mortgages are made to borrowers
with some incriminating mark on their credit history, such as one or a few 30- to 60-day
delinquencies. C paper may have a few to several 30-day delinquencies or one 90-day
delinquency. Loans to borrowers who are habitually delinquent or have a default on their
record are classified as D paper.
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Pricing Speed
206 Nancy DeLiban and Brian P. Lancaster
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Understanding Nonagency Mortgage Security Credit 207
Figure 6. Structure of a Credit Certificate Security
GEMICO
Collateral
Credit
Certificates
Regular Senior
Default Collects
from Wrap
Insurance
Deal 1
Unrated
Subordinates
Unrated
Subordinates
Unrated
Subordinates
Unrated
Subordinates
Senior Senior Senior Senior
. . . Deal N Deal 3 Deal 2
Credit Tranche
for Resale
Unrated subordinates
pooled together
for seasoning, diversity,
and liquidity
A BBB BB B Unrated