Subprime Mortgage Credit Derivatives

CHAPTER 4

Features of Excess Spread/Overcollateralization: The Principle Subprime Structure

As discussed in earlier chapters, credit and prepayments are the two principal risks inherent in agency and nonagency mortgage-backed securities (MBS). Agency MBS have minimal credit risk (although in certain stressful situations even Freddie Mac and Fannie Mae's credit can become an issue). Relative value for those securities, therefore, centers on prepayment risk. In the nonagency market prepayment risk is also present, but as you go down the credit spectrum from prime, to Alt-A, to subprime credit becomes the most important risk element.

In order to maximize the value of a securitized pool of nonagency loans, issuers need to address those credit concerns. They do this by separating the cash flow from a pool of loans into individual tranches (securities) with credit ratings that start at AAA and go down to B or unrated. One could structure a nonagency pool of loans as a security that looks like an agency pass-through, with a single tranche and a single rating. However, the greatest value for a given pool of nonagency loans is extracted when the deal is structured with a series of bonds with a range of credit ratings. This allows investors with a wide range of credit preferences to participate in the deal, from conservatively managed institutions that require AAA securities to hedge funds and private equity funds that are looking for high-yield returns.

In the nonagency market two principal ...