LO 36.3: Describe the characteristics o f the subprime mortgage market, including

LO 36.3: Describe the characteristics o f the subprime mortgage market, including the creditworthiness o f the typical borrower and the features and performance o f a subprim e loan.
Subprime borrowers have a history of either default or strong indicators of possible future default. Past incidents include 30- or 60-day delinquencies, judgments, foreclosures, repossessions, charge-offs, or bankruptcy filings. Low FICO scores (660 or below) or a high debt service ratio of 30% or more are likely indicators of future default.
The vast majority of subprime loans are adjustable rate mortgages. The loan offers a teaser rate for a short period of time, and then adjusts each year relative to a floating rate index (usually LIBOR). The 2- and 3-year teaser rates are called 2/28 and 3/27 hybrid arms denoting the fixed and floating terms, respectively (e.g., fixed term is 2 years, floating term is 28 years). Since the majority of the term of the mortgage is floating, the borrower is bearing the interest rate risk in contrast to a traditional fixed rate mortgage where the lender bears the interest rate risk.
The performance of subprime pools indicates defaults and foreclosures way above historical levels. As a point of reference, the authors of the assigned reading analyze a New Century pool originating in May 2006 and estimate a 23% cumulative default rate through August 2007.
Securitized pools incorporate structures to provide protection to investors from losses in the collateral including subordination, excess spread, shifting interest, performance triggers, and interest rate swaps.
Subordination involves creating tranches of differing priority levels. Losses are applied first to the most subordinated tranche, the equity tranche. The equity tranche is usually created from overcollateralization (i.e., assets in excess of face value). If the losses exceed the size of this tranche then losses will reach the next highest subordinated level called the mezzanine. Credit ratings on mezzanine debt typically vary from AA to B. In this fashion, the most senior tranche is protected by all the junior tranches and offers the lowest return.
Mortgages pools are typically constructed so that the weighted average coupon (less servicing, hedging, and other expenses) exceeds the weighted average payout. The difference is called the excess spread which is paid to equity tranche investors when available. Thus, the excess spread protects all tranches.
Under shifting interest, the senior investors receive all principal in the pool while the mezzanine investors receive only interest. The senior holders may receive the principal for a set period of time (lockout period) or until a cutoff ratio is reached.
Performance triggers denote the release of overcollateralizion which is applied from the bottom of the capital structure up.
Since the first few years of the pool are fixed, the pool faces interest rate risk. As protection, interest rate swaps are used where the pool will pay a fixed rate and receive a floating rate.
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Topic 36 Cross Reference to GARP Assigned Reading – Ashcroft & Schuermann
T h e C r e d i t R a t i n g s P r o c e s s

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