IV. The Design and Complexity of Subprime RMBS Bonds The next link in the chain concerns how the subprime mortgages were financed. This too will require a unique security design, quite different from traditional securitizations.29 The originators of subprime mortgages were largely new entrants into mortgage lending, including many of the names that later became well-known, such as Countrywide Financial, New Century, Option One and Ameriquest. The main financing method for subprime originators was securitization. This will be important not only because the risk will be spread but also because the structure of the securitization will have special features reflecting the design of the subprime mortgages. This latter point means that there will be additional complexity.

 IV.A. Financing Subprime Mortgages via Securitization The table below shows the extent to which lenders relied on securitization for the financing of the mortgages.

The above table provides a snapshot of the quantitative importance of subprime securitizations. The table shows that subprime mortgage origination in 2005 and 2006 was about $1.2 trillion of which 80 percent was securitized. IV.B. The Design of Subprime Residential Mortgage-Backed Securities (Subprime RMBS) Subprime RMBS bonds are quite different from other securitizations because of the unique features that differentiate subprime mortgages from other mortgages. Like other securitizations, subprime RMBS bonds of a given transaction differ by seniority, but unlike other securitizations, the amounts of credit enhancement for each tranche and the size of each tranche depend on the cash flow coming into the deal in a very significant way. The cash flow comes largely from prepayment of the underlying mortgages through refinancing. What happens to the cash coming into the deal depends on triggers which measure (prepayment and default) performance of the underlying pools of subprime mortgages. The triggers can potentially divert cash flows within the structure. In some cases, this can lead to a leakage of protection for higher rated tranches. Time tranching in subprime transactions is contingent on these triggers. The structure makes the degree credit enhancement dynamic and dependent on the cash flows coming into the deal. In this section, I briefly explain the structural features of subprime bonds. The credit risk of the underlying mortgages is one important factor to understand in assessing the relative value of a particular subprime RMBS. Later, I will focus on the characteristics of the mortgages themselves, but here I focus on the securitization structure. However, the credit risk of the borrowers is intimately linked to the structure of the bond and, indeed, the structure of the particular transaction to which the bond is a part. The figure below shows the basic structure of a subprime RMBS transaction.

Overwhelmingly asset-backed securities (ABS) and mortgage-backed securities (MBS) use one or both of the following structures:  A senior/subordinate shifting of interest structure (―senior/sub‖), sometimes called the ―6-pack‖ structure (because there are 3 mezzanine bonds and 3 subordinate bonds junior to the AAA bonds), or An excess spread/overcollateralization (―XS/OC‖) structure. Over-collateralization means that the collateral balance exceeds the bond balance, that is, deal assets exceed deal liabilities. Because credit risk is the primary risk factor, subprime RMBS bonds have a senior/sub structure, like prime RMBS, but also have an additional layer of support that comes from the excess spread, i.e., the interest paid into the deal from the underlying mortgages minus the spread paid out on the RMBS bonds issued by the deal.31 Another important feature is overcollateralization, that is, there are initially more assets (collateral) than liabilities (bonds). (The overcollateralization reverts to an equity claim if it remains at the end of the transaction.)

In a prime deal with a senior/sub structure, basically the total amount of credit enhancement that will ever be present is in place at the start of the deal. The tranche sizes are fixed. In this setting, assuming that defaults and losses are bunched near the start of the deal is conservative, as this erodes the credit enhancement early on, and it cannot be replaced. Because of sequential amortization, senior tranches are being paid down over time in this structure. Subprime transactions are different because the XS/OC feature results in a build-up of credit enhancement from the collateral itself, during the life of the transaction. The allocation of the credit enhancement over time depends on triggers that reflect the credit condition of the underlying portfolio. Excess spread is built up over time to reach a target level of credit enhancement. Once the OC target is reached, excess spread can be paid out of the transaction (to the residual holder), and is no longer available to cover losses. Later, I discuss the triggers in more detail. There are several key features of RMBS structures to be mentioned. First, there is a lockout period. Mezzanine and subordinate bonds are locked out of receiving prepayments for a period of time after deal settlement. In other words, during the lockout period, amortization is sequential. The period of time of the lockout, and other details, differ depending on the type of collateral in the deal. Second, there may be cross-collateralization. That is, some transactions contain multiple loan groups. After interest payments are made on bonds in one group, available remaining funds can be used to pay interest to bonds in another group.32 The figure below displays the two types of transaction structures: senior/sub structure and the OC structure.

These transactions are quite complicated, so as a prelude to discussing XS/OC structures, I will very briefly start with the typical Prime and Alt-A deal structure. I emphasize that what follows is a brief overview only.

IV.C. Prime and Alt-A deals Most prime jumbo and Alt-A transactions use a 6-pack structure and most subprime, and a few Alt-A deals, use the XS/OC structure. Choice of structure is mostly a function of the amount of excess spread in the deal. Excess spread is the difference between the weighted average coupon on the collateral and the weighted average bond coupons. In an XS/OC structure the excess spread is typically between 300-400 basis points. There is no over-collateralization in a 6-pack structure. In a 6-pack deal, the mortgage collateral is tranched into a senior (AAA) tranche, mezzanine tranches (AA, A, BBB), subordinated tranches (BB, B,and unrated). The most junior bond, essentially equity, is unrated because it is the ―first loss‖ piece, meaning that it will absorb the first dollar of loss on the underlying pool of mortgages. In a senior/sub, or 6-pack, structure, the mezzanine (―mezz‖) bonds and subordinate bonds are tranched to be thick enough to absorb collateral losses to ensure that the senior bonds have a probability of loss sufficiently low to justify a triple-A rating. This is accomplished by reversing the order of the priority of cash flow payments and losses in the transaction. In the early years of the transaction, prepaid principal is allocated from top down (―sequential amortization‖), that is, only the senior bonds are paid, while the mezz bonds and sub bonds are ―locked out‖ from receiving prepaid principal. Losses are allocated from the bottom up, that is, the lowest-rated class outstanding at the time will absorb any principal losses. By using sequential amortization, the senior bonds are paid down first, and there is an increase in the percentage of the remaining collateral that is covered by the mezz and sub bonds. This continues during the lock-out period, which may be the first five years, in a fixed rate transaction, or for as long as 10 years in a prime ARM transaction. In ARM deals there may be triggers that allow for a reduction in the length of the lock-out period if certain performance metrics are satisfied. The two most common metrics in prime ARM senior/sub structures are (1) a Step-down Test and (2) the Double-down Test. A Step-down Test refers to when prepaid principal switches from sequential pay to pro rata amortization. Typically, prepaid principal switches from sequential pay to pro rata for all outstanding classes if: (a) the senior credit enhancement (―CE‖) is twice the original percentage; and (b) the average 60+ day delinquency percentage for the prior six months is less than 50% of the current balance; and (c) cumulative losses are under a specified percentage of the original balance. The Double-down Test means that prior to the initial three-year period, 50 percent of prepaid principal can be allocated to the mezz and sub bonds if the above three criteria (a) – (c) are satisfied.