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1

Define the difference between RMBS and CMBS.

RMBS are residential mortgage backed securities. The pool of loans in these securities come from residential mortgages.

CMBS are commercial mortgage backed securities. The pool of loans in CMBS come from commercial mortgages.

2

What is the role of the Special Purpose Vehicle in the debt securitisation process?

The Special Purpose Vehicle (SPV) issues securities to investors, the securities are backed by the pool of loans that are securitised into a mortgage backed security. Investors receive returns back by the repayment of the loan and interest payments.

The SPV is set up as a trust and is ‘bankruptcy remote’ in two ways.

First, if the SPV cannot pay entitlements to all the investors, the mortgage originator is not responsible for the losses.

Second, the securities are independent of the mortgage originator. The SPV generally splits the income from the loans into different classes of securities, known as tranches.

3

The income from a mortgage backed security is sometimes split into different classes of security, known as tranches. Define the role tranches in a mortgage backed security.

Tranches are different credit levels of securities that can be issued through the debt securitisation process. They have different entitlements and priorities. Tranches stratify the default risk of the loans. Tranches levels can range from one to even four, depending on the size of the pool of loans and their value. For example, a MBS with 2 tranches can be split into senior and subordinate levels. The senior tranches earn a lower rate of return, but are paid before the subordinate holders. In the case of default by some of the loans, subordinate holders have a higher probability of not receiving payments, however, to compensate them for this higher risk they will be offered a higher rate of return

4

What is the purpose of credit enhancement in the debt securitisation process? List two ways credit enhancement can be done

Credit enhancement is designed to minimise the consequences of default. Credit enhancement can be done via:
a) Loan insurance taken out by individual borrowers (i.e. mortgage insurance) or on all of the loans within a tranche
b) Credit ratings provided by credit agencies such as Standard & Poor’s.
c) Credit default swaps which are a financial instrument that provide a form of insurance to cover losses from loan defaults. The originator pays a premium for these swaps

5

Describe the two groups of lenders that issue Residential Mortgage Back Securities.

First group are called Mortgage Managers. They are independent mortgage providers (e.g. RAMS).
The second group are banks and other traditional lenders (e.g. ANZ).

6

What is the major advantage for retail banks to use Residential Mortgage Back Securities

The securitisation of loans by retail banks removes the loan liabilities from the bank’s balance sheets. Once the loans are ‘off the books’ they have less impact on their "capital adequacy requirements".
This results in the bank being able to grant more loans.

7

Identify and describe the four main types of Mortgage Funds

Pooled Mortgage Funds:
Managed investment schemes that hold portfolios of mortgages in unit trusts. Unit holders receive their portion of mortgage interest & capital repayments. They are mortgage pass-through funds, unit holders are entitled to amounts received proportionate to the number of units they own.

Contributory Mortgage Schemes:
These funds let investors choose one or more mortgages from a number that have been sourced by the fund manager. Investors contribute capital to the selected mortgages and receive their proportion of the loan payments. They are also mortgage pass-through securities. Mortgage pool typically interest only loans for shorter periods (1 to 3 years).

Mezzanine Mortgage Funds:
Mezzanine refers to subordinate (junior) debt or second mortgages. Holders of these securities receive loan interest and repayment of capital after all the entitlements of senior debt holders (fist mortgages) have been paid. They are akin to the lower tranches of RMBS & CMBS. Because they are higher risk they offer higher rates of return. These funds raise capital to lend as second mortgages, predominantly property development.

Property-Based Debentures and Notes:
Debentures are debt securities issued by companies to raise capital or issued to financial institutions for them to lend to other businesses. They range from relatively safe loans to finance companies (e.g. Esanda) through to unsecured loans to unlisted companies for property development. Due to the variability of their risk profile, the returns offered vary greatly. Debentures & notes differ from pass-through mortgage funds in that they offer a fixed rate until maturity

8

explain pooled mortgage funds

Managed investment schemes that hold portfolios of mortgages in unit trusts. Unit holders receive their portion of mortgage interest & capital repayments. They are mortgage pass-through funds, unit holders are entitled to amounts received proportionate to the number of units they own.

9

explain contributitoutionary mortgage schemes

These funds let investors choose one or more mortgages from a number that have been sourced by the fund manager. Investors contribute capital to the selected mortgages and receive their proportion of the loan payments. They are also mortgage pass-through securities. Mortgage pool typically interest only loans for shorter periods (1 to 3 years).

10

explain mezzainine mortgage funds (junior)

Mezzanine refers to subordinate (junior) debt or second mortgages. Holders of these securities receive loan interest and repayment of capital after all the entitlements of senior debt holders (fist mortgages) have been paid. They are akin to the lower tranches of RMBS & CMBS. Because they are higher risk they offer higher rates of return. These funds raise capital to lend as second mortgages, predominantly property development.

11

explain Property-Based Debentures and Notes

Debentures are debt securities issued by companies to raise capital or issued to financial institutions for them to lend to other businesses. They range from relatively safe loans to finance companies (e.g. Esanda) through to unsecured loans to unlisted companies for property development. Due to the variability of their risk profile, the returns offered vary greatly. Debentures & notes differ from pass-through mortgage funds in that they offer a fixed rate until maturity.

12

Why would an investor be concerned about the saleability of the properties within a pool of properties that have been securitised?

In the case of default an investor wants to be confident that the properties within the pool can be sold quickly and at the prevailing market value. Difficulties in achieving a sale can increase the investor’s possible losses. For example, unusual properties are generally harder and slower to sell, particularly is a depressed market.

13

For non-traded debt securities how, in theory, would we estimate the value of the security?

In theory the value of any asset/security should be the present value of the future cash flows, discounted at a rate that reflects the risks of the security.

14

define par value

The amount the issuer will pay the holder at maturity.

15

define maturity date

The date at which the issuer re-pays the par value. The amount of time remaining until the maturity date is called the term to maturity.

16

define coupon interest rate

The rate of interest to be paid annually on a debt security as a percentage of the par value

17

a) Assume a property trust bond has 5 years until maturity with a par value of $100,000. The coupon interest rate is fixed at 6% per annum paid annually. If the current market interest rates are 5%, what is the bonds current market value?

This is a fixed coupon bond, thus we can use the fixed coupon rate formula:
BV=PMT((1-〖(1+r⁄m)〗^(-nm))/(r⁄m))+PAR/〖(1+r⁄m)〗^nm
Part a) Identifying the variables:
PMT = $100,000 x 6% (coupon rate) = $6,000
PAR = $100,000
r = 5% (question tells us current market interest rates are 5%), as a decimal 0.05
n = 5 years (term to maturity)
m = 1 (coupons are paid annually)
Inputting the variables into the formula:
BV=6,000((1-〖(1.05)〗^(-5))/0.05)+100,000/〖(1.05)〗^5
BV=6,000((1-(0.7835))/0.05)+100,000/((1.2763))=6,000(4.3295)+78,351.49=$104,328.49

more calcs on week 8 answers - asasin analz

18

What does the yield to maturity (YTM) represent in relation to property backed bonds (debentures)?

The YTM is the internal rate of return of the cash flows with the bond price being the initial outlay.

19

What is a pass through security?

Mortgage pass-through issues are mainly pooled mortgage funds (retail) and contributory mortgage schemes. Payments in each period to investors is determined by the payments collected from the borrowers (less fees & expenses). The expected cash-flows are determined by the characteristics of the loans (not coupon rate like on bonds).

20

When assessing the risk of default, what two issues does the lender (and investors) consider to be very important?

The risk of default by borrower(s) is a major factor influencing the value of MBS
The lender (& consequently investors) will consider:
1) How likely default is at different times in the loan, and
2) How much of the outstanding would be recovered.

21

Define the term ‘yield degradation’. How is yield degradation used to assess the risk of a debt security?

Yield degradation is the decline in the yield to maturity that could result from default.

Yield degradation assesses the probability of default and how much of the yield would be lost. If yield degradation is large, investors may be discouraged from purchasing or increase their required rate of return. Investors can use the expected return and yield degradation as a notional measure of default risk.

22

What is prepayment risk? How is prepayment risk minimised?
SOLUTIONS:

Prepayment risk is when borrowers are able to repay loans early without significant penalty. The risk to MBS holders is that the security may be repaid in full or partly before maturity.
Prepayment penalties are designed to discouraging prepayment, these penalties can be substantial for borrowers and are designed to compensate the lender (& security holder) for the loss of interest payments.

23

Which security has more prepayment risk, a fixed interest rate security or a variable interest rate security?

Prepayment risk is more of a concern for fixed interest rate securities. Because fixed interest borrowers will look to repay their loans when interest rates fall and then try to refinance at a lower rate of interest.
The MBS holders will therefore miss out on earning the higher (compared to current market rates) rates of return.

24

The aspects of securitised debt issues that determine their suitability for an investor can categorised into four sections:

The loans and any other assets
The properties
The issue
The management

25

explain investigating loans and other assets

The terms of the loans are critical to the risks of the issue, questions investors should ask:

What proportion of the loans are registered first mortgages?
What are the LVRs?
For loans other than mortgages, are they secured and against which assets?
Are all or some of the loans insured?
If the pool of mortgages has been formed a while ago, what is the arrears level?
What proportion of loans have fixed and variable rates?
7. Are there prepayment and/or late payment fees?
8. What are the characteristics of the borrowers?
9. What is the loan approval process?

26

explain 'properties' considerations

What properties are in the pool and where are they?
What purposes are the properties used for?
For income-producing properties, does the current net rental income cover loan payments?
Would the properties be readily saleable in the case of default?
How well diversified are the properties?

27

explain the issue consideration

What is the life of the issue or fund?
How liquid is the issue or fund?
Has the issue or fund been rated?

28

explain management consideration

Does the manager have the capacity and skills to effectively administer the loans and the issue or fund?
What fees are paid to the managers and how are the fees structured?
How well are arrears managed

29

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