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P2.T5.102. Residential mortgage-backed securities (RMBS) by Pietro

David Harper CFA FRM

David Harper CFA FRM
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I resume with some fresh, original questions to address new readings, starting in Part 2 with Pietro Veronesi's fabulous Fixed Income Securities. If you expected this reading, along with the new Fabozzi readings on mortgage-backed securities (MBS), to be located in T6 (credit risk) rather than here in T5 (market risk), you are not alone! In fact, the better theoretical introduction to securitization is Culp's chapter (Securitization); Culp helps us understand that Veronesi implicitly refers to a "cash securitization" (i.e., a true sale of assets, off the originator's balance sheet, to the bankruptcy-remote SPV) as opposed to a "synthetic securitization." (i.e., the assets are not sold but credit risk is transferred via credit default swaps). Nevertheless, the location of these MBS readings in market risk rather than credit risk, while I don't necessarily agree, highlights the total return perspective that cannot really, totally parse market risk (pricing in the mark-to-market context) from credit risk. Elsewhere, in fact, we have observed this "line blurring" as the very definition of securitization. That is, securitization, among other benefits and for good/bad, transforms credit risk into market risk.

AIMs: Summarize the securitization process of residential mortgage backed securities (RMBS). Differentiate between agency and non-agency MBS and describe the major participants in the residential MBS market.

Questions:

102.1. Each of the following is true about the securitization of residential mortgage backed securities (RMBS) EXCEPT for:

a. The originator(s) pools mortgage loans and sells them an issuer or special purpose vehicles (SPVs), which issues securities to investors
b. Key benefits of securitization, including RMBS, include but are not limited to (i) transfer of credit risk to investor and (ii) diversification via pooling of credit-sensitive assets
c. By selling mortgage loans to issuers in a securitization, originators raise cash to underwrite new, additional loans
d. The mortgage servicer ensures that the SPV delivers on its contractual obligations

102.2. In regard to agency mortgage-backed securities (MBS), each of the following is true EXCEPT:

a. Agency MBS include loans securitized through Ginnie Mae, Fannie Mae, or Fredie Mac (the major agency players)
b. An investor in an agency MBS is not directly exposed to credit risk because the agency insures the investor against default of individual mortgages
c. An investor in an agency MBS is not directly exposed to prepayment risk because the agency insures the investor against prepayment of individual mortgages
d. Like Fannie Mae, Ginnie Mae provides credit guarantees. Unlike Fannie Mae, Ginnie Mae does not originate or purchases mortgage loans; nor does it buy, sell or issue securities

102.3. In regard to residential mortgage-backed securities (RMBS) and the 2007-2009 credit crisis, according to Pietro, each of the following statements is true EXCEPT:

a. The market share of non-agency issuance (i.e., private-label MBS and CMO) increased dramatically from 1996 to 2006, at least in part, because agencies could only securitize conventional mortgages that could not exceed size limits and an 80% loan-to-value (LTV) ratio
b. The market share of non-agency issuance plummeted to less than 5% in 2008 because investors became wary of MBS not backed (explicitly or implicitly) by the full faith of the U.S. government.
c. The crisis showed that the agency securitization market has little or no impact on mortgage loan origination: agency securitization collapsed in 2008 and subsequently, but mortgage lending was not impacted
d. The credit crisis is (was) characterized by an unusually large number of homeowner defaults. Unlike investors in non-agency RMBS are exposed to default risk, investors in agency RMBS are (were) generally protected against default risk, but they nevertheless are (were) exposed to the early receipt of cash flows as agencies stepped in to repay the mortgages; i.e., prepayment risk.

Answers:
 
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