Senior-Sub is only one of many credit enhancement methods to achieve AA+ rating
Credit lined note (e.g. MODERNs)
1998 Freddie Mac, US$20B US RMs, use mortgage default recourse notes to insure first loss and mezzanine credit risk
US$20B US seasoned RM G-3 SPV Insurance Premium Default Claims Collateral ($520M) Issue Proceeds P&LIBOR rate Freddie Mac A, 60M, BBB, 1% B, 30M BBB-, 1.3% C, 50M, BB, 2.85% D, 46M, B, 6.5% E, 64M, NR, 20% * P&LIBOR+Spread Issue Proceeds * Only $57.3M of class E was actually issued.
CDO offers the cheapest capital to fund MBSs
The question should therefore be:
If CDO pulls out, how much additional cost (rate) will borrowers need to pay?
Higher spread required by alternative investors
Higher PMI insurance premium
Less favorable selling prices of MBB/PT
Higher funding cost by bank debt and capital
Less efficient hedge of credit risk via conforming loan CD swaps
The authors could try to quantify the impact by analyzing the execution cost of these alternatives
BBB Trache Is Riskier than BBB Bond Tranche A1 Tranche A2 Tranche BBB Tranche Residual Prepaid Principal Default Loss First Loss Default Loss Mezzanine Loss AAA Support Level Mortgage Pool Pass Through BBB Over Collateral Principal & Interest Default Loss First Loss
Tranche BBB And PT Gets Same Rating Tranche A1 Tranche A2 Tranche BBB Tranche Residual Mortgage Pool Pass Through BBB Over Collateral Loss
Cliff! Tranche A1 Tranche A2 Tranche BBB Tranche Residual Mortgage Pool Pass Through BBB Over Collateral Loss Return = -100% Return = -20%
CDO builds double Cliff! Even more concentrated default risk
What’s the impact?
Need to understand BBB tranche CDO is much riskier than BBB pass through (corporate bond)
Rating agency only measures the probability of not recoverprincipal
No LGD indicator, no interest income risk indication
Backward looking (rating change only after credit event)
Investors clearly understand it by the much higher spread they require for tranche
Need a forward looking credit score (similar to KMV or CreditMatrics)?
How Much to Disclose?
REMICs currently disclose
Pool level distribution of LTV, FICO, location, loan size, contract rate, and sometimes cross tabulation among variables
Some subprime REMICs even provide loan level disclose
Structure and payment sequences
Numerical examples of payment to individual sequences
Monthly prepayment, default, or even delinquency experience via Intex
Due diligence by major auditors
Need more financial disclosure? What specific information?
Who Should Government Protection?
The authors should clearly analyze who in the process should be protected by the government.
Typically only institutional investors purchases junior tranche CDOs
Pursue higher return by knowingly invest in high credit risk securities
Financial loss does not affect national economy or individual savers or households
Need to prevent pension funds, life insurance companies, and small individual investors from heavily invest in these high credit risk securities
Avoid hurting insurees, retirees, average savers
Risk Based Capital Regulation
IRB approach will accurately reflect the higher default risk into higher capital requirement
Standardized approach specifies different capital requirement for different structured tranches (B or NR tranche required 1250% risk weight, BB tranche requires 200% risk weight)
Pillar II government supervision allow closer scrutiny
Pillar III market discipline
What additional regulations are needed? On which party? By which agency? Why?
Mortgage Lending: Higher Risk Products
Extremely high total LTV
Historically low interest rate environment
IO or option ARM with teaser (income constraint)
Introduced payment shocks much higher than income growth
Borrower could roll over using teaser (if rate remains low and house price does not fall)
But prepayment penalty made roll over impossible
Lead to high default rates
Is a problem, with or without CDO
This issue is less relevant to government and conforming loans
High default rate is particular sever in private markets
Government needs to educate home buyers about the risk entering into these loans
Probability of Income Shortage Yang, Ling, and Cho, 2006, “Balancing Credit and Interest Rate Risks: Choice between Fixed- and Adjustable- Rate Mortgages”, presented at 2006 International AREUEA coference
Relative Default Risks
Encourage Home Ownership High Income Household Poor Household Homeless current renters young professionals moderate-income households seniors person with disabilities No Yes No Yes Wealth Constrained? Income Constrained?
Made good inventory check and established basic link of CDO and primary mortgage market
Possible contributions to make
More clearly describe the linkage between CDO and mortgage borrowers
Focus on the marginal impact of CDO on the MBS market
Be more specific about what the government has done; what additional regulations are needed from which agency; and on which group
The high default rate is caused by the aggressive underwriting and product design, with or without CDO
Any implication of the balance between affordable housing objective and financial stability
Housing Market Forecast Follain and Follain, “Searching for Clues About the Future of House Prices”, 2007 Cyberhomes.com