About 10 per cent of the loans in a standard prime RMBS mortgage pool are low-doc loans.
the average life of an RMBS is substantially shorter than its final legal maturity, which is usually set to occur after the
longest dated loan in the underlying portfolio is due to be repaid in full, and is typically around 30 years.
The expected life at issue of most RMBS is typically two to five years.
The most common form of enhancement comes from splitting the asset-
by the loan originator or another bank.
Asset Securitisation in Australia
http://www.rba.gov.au/publications/fsr/2004/sep/pdf/0904-1.pdf
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The loans can be financed initially on or off the originator’s balance sheet. Banks and other deposit-taking institutions generally opt for the former and periodically sell a pool of loans to an SPV to be securitised. Mortgage originators tend to do the latter, finding interim funding for the loans from financial institutions or from commercial paper issued by an SPV.
In most cases, borrowers will not be aware that their loans have been securitised because the originator will continue to service the loans following their securitisation (collecting loan repayments, providing customer service and enforcing delinquent loans). The cash flow from the loan repayments is passed from the originator to the SPV and is used to meet the debt-servicing obligations (both interest and principal) on the bonds and any other on-going costs such as trustee and management fees.
Two main types of SPV are used in the Australian market: individual trusts, which are established to securitise a specific pool of loans and wound up once the loans are fully repaid; and conduits, which are used to securitise a
revolving pool of loans. The vast majority of individual trusts’ assets are residential mortgages, and they fund themselves by issuing bonds secured against those loans either in Australia or offshore. Conduits are generally sponsored by banks and are used to securitise assets from either a bank’s own balance sheet or from those of
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its corporate clients. They hold a much broader range of assets (including individual loans and both asset-backed and non-asset-backed bonds) than individual trusts and fund themselves by issuing asset-backed commercial paper. Various liquidity and hedging facilities are put in place to ensure that the SPV can fulfil its debt-servicing obligations.
These services may be provided by the loan originator or another bank.
Credit Quality of RMBS and Underlying Mortgages
There are two main types of RMBS issued by Australian entities: prime RMBS and non-conforming RMBS. Prime mortgage loans are those made by mainstream mortgage lenders (banks and other deposit-taking institutions and mortgage originators). Non-conforming mortgage loans are those made to borrowers who do not meet the normal eligibility requirements of the mainstream lenders.
Prime RMBS account for most of the RMBS issuance by Australian entities, with $145 billion having been issued
since 2000. A typical prime residential mortgage would be one with a loan-to-valuation ratio of less than 80 per cent, to a borrower with a sound credit history and a full set of documentation.
However, within the pool of loans backing a prime RMBS there can be substantial variation between individual loans
in regard to: loan size; the amount of time that has elapsed since the loan was originated (older loans tend to have
lower probabilities of default than more recently originated loans); loan-to-valuation ratio; the amount of documentation provided; and borrower demographics.
Prime RMBS mortgage pools will often contain some low-documentation (‘low-doc’) loans.
Low-doc loans are loans where the borrower is not required to provide documentary proof of their income or saving history; they are particularly popular with self-employed people. They are perceived to be more risky than ‘full-doc’ loans and so are generally required to have a lower loan-to-valuation ratio.
Partial data since 2003 suggest that, on average,about 10 per cent of the loans in a standard prime RMBS mortgage
pool are low-doc loans.
However, in recent months, there has been a trend towards issuing prime RMBS backed by mortgage pools
comprising solely low-doc loans.
Anecdotal evidence suggests that this reflects investors’ demand for the higher yield of low-doc portfolios. It may also reflect a desire to identify and manage more proactively the credit risk associated with low-doc loans.
Second, almost all RMBS benefit from some form of credit enhancement, which is used to raise the credit rating of some or all of the securities above that of the underlying loans.
The most common form of enhancement comes
from splitting the asset-backed security into senior and subordinated tranches.
The subordinated securities provide protection for the senior tranche by absorbing the first round of defaults in the pool of assets. So long as the value of losses does not exceed the combined amount of the subordinated tranche and any external credit enhancement, the senior securities will be repaid in full. Although tranching generally allows the senior securities to be assigned an AAA-rating, the subordinated tranches will have lower credit ratings than they otherwise would.6
Another common tool is lenders’ mortgage insurance, while a recent innovation has been the provision by the
monoline insurers of additional protection for the senior tranches over and above that provided by mortgage
insurance. These external guarantees usually lift the rating on the securities to at least that of the insurer.
Third, the principal of the RMBS is amortised over the life of the security rather than being repaid as a bullet payment when the security matures, reflecting the payment profile of the underlying loans. If early repayments of principal are received, these are generally paid through to investors rather than being held with the SPV. The
amortising principal and ability to repay the loan early means that the average life of an RMBS is substantially
shorter than its final legal maturity, which is usually set to occur after the longest dated loan in the underlying
portfolio is due to be repaid in full, and is typically around 30 years.
To ensure that the RMBS can be redeemed before it becomes uneconomic for the SPV to service the loans and to protect investors from being left with a small, illiquid rump of stock once the bulk of loans have been repaid, most RMBS include an option for the originator to buy back the loans and redeem the RMBS after a certain date or when the aggregate principal outstanding on the mortgage pool falls below a stated threshold (say 10 per cent) of its original face value. The option also facilitates the return of any profits from the SPV to the mortgage originator. If the option is not called, a higher interest rate may become payable on the securities.
The expected life at issue of most RMBS is typically two to five years.
5 SPVs generally have to pass on to investors any excess repayments as soon as they are received, which means they cannot build a sizeable buffer against the possibility that occasionally fewer repayments will be received than were expected. Such a situation could occur if, for example, borrowers make net underpayments in one month after a period of overpayments.
6 For further discussion see Davies, M and L Dixon Smith (2004), ‘Credit Quality in the Australian Non-government Bond Market’, Reserve Bank of Australia Financial Stability Review, March 2004, pp 46-51.
Other internal credit enhancement techniques include: over-collateralisation, where the face value of the loans is
higher than the value of the securities they back; reserve funds created by or equity tranches held by the issuer; and the excess spread (yield differential) between the interest rate received from the underlying loans and that paid on the securities.