APPENDIX B
Synthetic Securitization: Case of Mortgage-Backed Securities
The securitization technique described in Chapters 4 and 5 has been applied widely in capital markets worldwide since its introduction in the U.S. residential mortgage market in the 1970s. In those two chapters, we discussed cash flow securitizations. In Chapter 7, we discussed synthetic collateralized debt obligations (CDOs). Here we look at synthetic mortgage-backed securitization, both commercial and residential. We will see that the transaction is based on exactly the same principles as CDOs and that deals are originated for roughly similar reasons as balance sheet static synthetic CDOs.1
TRANSACTION DESCRIPTION
As has been observed in the synthetic CDO market, the European and U.S. commercial mortgage-backed securities (CMBS) and residential mortgage-backed securities (RMBS) markets have witnessed a range of different synthetic deal structures. The first deal was issued in 1998. As with synthetic CDOs, synthetic mortgage-backed securities (MBS) deal structures involve the removal of the credit risk associated a pool of mortgages by means of credit derivatives, rather than by recourse to a true sale to a special purpose vehicle (SPV). The originator, typically a mortgage bank, is the credit protection buyer and retains ownership, as well as the economic benefit, of the assets. The credit risk is transferred to the investors, who are the protection sellers.
The main market for synthetic MBS to date has been Germany, although deals have also been seen from U.K., Swedish, Italian, and Dutch originators.
DEAL STRUCTURES
As with synthetic CDOs, there exist funded and unfunded synthetic MBS deals, as well as partially funded deals. The type of structure adopted by the originator will depend on the legal jurisdiction, the regulatory environment, capital requirements, and also the preferences of investors.
Unfunded Synthetic MBS
An unfunded synthetic MBS deal uses CDS to transfer the credit risk of a pool of mortgages from the originator to a swap counterparty. There is no note issuance and frequently no SPV involved. The investor receives the CDS premium during the life of the transaction. In return for which, he agrees to pay out on any losses incurred by the originator on the pool of assets. The CDS references the pool of mortgages, which remain on the originator's balance sheet.
The CDS protection seller will pay out on occurrence of a credit event. The precise definition and range of credit events differs by transaction and jurisdiction, but generally there are fewer credit events associated with a synthetic MBS compared to a synthetic CDO deal. This reflects the nature of the reference assets. Credit events are defined in the deal documentation and their occurrence will trigger a payment from the protection seller. The common credit events described in a synthetic MBS are “Failure to Pay” and “Bankruptcy.”
As with vanilla CDS, in an unfunded synthetic MBS the investor is exposed to a counterparty risk if the originator is unable to continue paying its premium. To overcome this, some shorter-maturity deals are arranged with a one-off premium aid at the start of the deal, which covers the credit protection for the life of the deal. Conversely, the risk for the protection buyer is if the protection seller becomes bankrupt, in which case the former will no longer receive any credit protection.
As there is no SPV involved, unfunded deals can be brought to market relatively quickly, and this is a key advantage over funded deals. Because the credit default swap (CDS) counterparty needs to be equivalent rated to an OECD bank, the investor base is narrower than for funded deals.
Funded Synthetic MBS
In a funded synthetic MBS structure, an SPV is set up that issues a tranched series of credit-linked notes (CLNs), which are discussed in Chapter 9. These CLNs are referenced to the credit performance and risk exposure of a portfolio of reference assets, which may be residential mortgages, real-estate loans, or commercial mortgages. The proceeds of the CLNs are either:
- invested in eligible collateral, such as a guaranteed investment contract (GIC) account2 or AAA rated government securities; or
- passed to the originator or a third party.
If the note issue proceeds are invested in collateral, this is known as a collateralized funded synthetic MBS, otherwise the deal is uncollateralized.
Although fully funded synthetic MBS deals have been observed in the market, it is more common to see partially funded transactions, in which a portion of the reference pool credit risk is transferred via a CDS. This achieves credit risk transfer from the SPV to investors without any funding issues.
Exhibit B.1 shows a typical funded synthetic MBS structure. Exhibit B.2 shows a simplified structure for a synthetic CMBS where the originator is transferring credit risk on assets spread across more than one legal jurisdiction.
The structure is usually brought to market first by the originator entering into a credit protection agreement with the SPV, which requires it to pay the protection premium (or interest on par value) to the SPV, and second by the SPV (“issuer”) transferring this risk exposure to investors by means of the note issue. These investors ultimately pay out upon occurrence of a triggering event. The credit risk of the CLNs is in effect linked to the aggregated credit performance for the relevant tranche of risk of the reference pool. It is also linked to the risk profile of the collateral assets, but this should not be significant because only very high-quality investments are eligible for the collateral pool.
If the CLN(s) is (are) to be collateralized, the cash raised from the issue is used to purchase eligible securities or placed in a reserve cash account. The note collateral is used to back the coupon payments on the CLNs. It is also a reserve fund that can be used to cover losses in the reference asset pool and to pay expenses associated with the vehicle. If the losses suffered by the reference assets are greater than any reserve account, or the nominal value of the junior note, the note collateral is available to cover the originator for the loss. This is the loss borne by the investors who purchased the CLNs. This arrangement, because it is funded, eliminates the counterparty risk (for the protection buyer) associated with unfunded structures. This reason is that investors have covered the credit risk exposure with an up-front payment. If the CLNs are not to be collateralized, the note proceeds are passed to the originator directly or to a third-party agent. The originator or third party is of course obliged to repay principal on the CLNs upon maturity, but only if no triggering events have occurred.
EXHIBIT B.1 Synthetic MBS Generic Structure
EXHIBIT B.2 Pan-European Synthetic CMBS Generic Structure
Upon occurrence of losses in the reference pool, the allocation of those losses follows established synthetic deal procedures. Each loss is applied only to the most junior CLN (or CDS in an unfunded or partially funded deal) outstanding. More senior noteholders should not see their cashflows affected until the note below them is fully absorbed by continuing losses.
Partially Funded Synthetic MBS
In a partially funded deal, the issue of CLNs is combined with a CDS that transfers part of the credit risk but on an unfunded basis. Frequently this will be a basket or portfolio CDS that is ranked above the CLNs, so it becomes a super-senior CDS.
INVESTOR CONSIDERATIONS3
Traditional cash MBS and synthetic MBS deals have several features in common, and both aim to achieve several common objectives. The main objective is the transfer of the credit risk associated with a pool of mortgage assets away from the originating bank, usually via an SPV. Key to the attraction of a synthetic deal is the fact that it can be customized to investors' requirements more closely. In a synthetic deal, the credit risk exposure that is transferred is (in theory) defined precisely, compared to a cash deal where any and all risks associated with the assets are transferred. Thus a synthetic deal can be structured and documented to transfer precisely the risk exposures that the investors are looking for.
Below we highlight three areas of difference between the two products:
Originator Issues
As a synthetic MBS does not involve a true sale of assets, investors' fortunes are still connected with those of the originator. Therefore, if the originator becomes insolvent, the deal can be expected to terminate. Should this happen, an estimated loss is calculated, which is then applied starting with the most junior note in the structure.4 The collateral assets are then realized and the proceeds used to pay off the outstanding CLNs.
In a traditional cash MBS, there may be occasion when a shortfall in cash in the vehicle may lead to disruption of cash receipts by investors. Typically, cash MBS deals are structured with a liquidity provider or liquidity facility to cover such temporary shortfalls, which may be the arranging bank for the deal. With such an arrangement, the credit rating of the deal will be linked to some extent to that of the liquidity provider. With a synthetic MBS, this does not apply. Losses in the reference pool are applied to the note structure in priority order not when a credit event has been verified, but when the loss has been realized. In these circumstances, investors should continue to receive cash flows during the time interval up to the loss realization. Consequently, a liquidity provider is not required.
Cash Flow Liquidity Risk
In a customized structure aimed at transferring credit risk, the probability of default is an important factor but not the sole factor. The severity of loss is also significant, and the impact of this will differ according to whether it is a cash or synthetic deal. Under a cash structure, if an event occurs that results in potential loss to investors, any outstanding principal, together with accrued interest and recovery costs, will need to be recovered from the securities. So the performance of a cash deal is dependent on the recovery time and costs incurred during the process (such as legal costs of administration).
Loss Severity
With a synthetic deal, the originator may customize the type and level of risk protection for which it pays. So it may, if it wishes, purchase protection for one or a combination of the following: (1) principal outstanding, (2) interest costs (capped or uncapped), and/or (recovery costs).
1 A quantitative model for issuers in evaluating cash and synthetic securitizations is provide in Ian Barbour and Katie Hostalier, “A Framework for Evaluating a Cash (‘True Sale’) versus Synthetic Securitisation,” Chapter 6 in Frank J. Fabozzi and Moorad Choudhry (eds.), The Handbook of European Structured Financial Products (Hoboken, NJ: John Wiley & Sons, 2004).
2 We refer here to the European market definition of a GIC, which is a bank account with a fixed spread to LIBOR.
3 For a comprehensive discussion of synthetic MBS transactions, see Ian Barbour, Katie Hostalier, and Jennifer Thym, “True Sale versus Synthetics for MBS Transactions: The Investor Perspective,” Chapter 5 in The Handbook of European Structured Financial Products.
4 Under this approach, an expected loss is calculated on nonperforming loans, although the actual credit event may or may not have occurred.