External credit enhancements come in the form of third-party guarantees that provide for first-loss protection against losses up to a specified amount. Historically, the most common forms of external credit enhancements have been (1) a letter of
The author is grateful to Bill Berliner and Jonathan Lieber of Countrywide Securities; Brian Grow, Ray Morel, and Weili Chen of Standard & Poor's; and Patrick Fitzsimonds of UBS for their helpful comments.
credit, (2) bond insurance, and (3) pool insurance. A structure with external credit support is subject to the credit risk of the third-party guarantor. Should the third-party guarantor be downgraded, the tranches of a transaction guaranteed by that entity could be subject to downgrade depending on the historical performance of the collateral. This is the chief disadvantage of third-party guarantees.
External credit enhancements do not materially alter the cash-flow characteristics of a structure except in the form of prepayment. In case of a default resulting in credit losses within the guarantee level, investors will receive the principal amount as if a prepayment has occurred. If the credit losses exceed the guarantee level, investors may realize a shortfall in the cash flow.
A bank letter of credit (LOC), one of the oldest forms of credit enhancement but one that has been used rarely in recent years, is a financial guarantee by the issuing bank. The financial guarantee specifies that the issuing bank is committed to reimburse credit losses up to a predetermined amount. In the case of nonagency MBS products, a top-rated international bank is used to provide coverage of credit losses on the underlying mortgage pool that is less than 100% of the pool but an amount sufficient to obtain a triple-A rating.
There are two reasons for the decline in the popularity of LOCs for credit enhancing nonagency MBS products. First, there are few banks that have retained triple-A ratings, and even for those that have, there is the risk that they will be downgraded in the future. As noted earlier, a downgrading may result in the downgrading of the affected tranches. Second, risk-based capital requirements have changed since this form of credit enhancement was first popular. These requirements made it more expensive for banks to issue a letter of credit, thereby increasing the cost to entities seeking to use it as a form of credit enhancement.
Bond insurance, also called a surety bond, is a financial guarantee from a monoline insurance company. The guarantee is for the timely payments of principal and interest if these payments cannot be satisfied from the cash flow from the underlying mortgage pool. The principal payments will be made without acceleration, except if the insurer elects to do so. The monoline insurers that are primary insurers are Ambac Assurance Corporation (Ambac), Financial Guaranty Insurance Corporation (FGIC), Financial Security Assurance (FSA), Municipal
1. For a more detailed discussion of bond insurance, see Mahesh K. Kotecha, "The Role of Financial Guarantees in Asset-Backed Securities," Chapter 6 in Frank J. Fabozzi (ed.), Issuer Perspectives on Securitization (Hoboken, NJ: Wiley, 1998).
Bond Insurance Corporation (MBIA), and BIAXLCA/XLFA, whereas the reinsurers are ACE Guaranty Re, AXA Re Finance, Enhance Re, and RAM Re.
Based on historical experience with financial guarantees by monoline insurers, capital market participants have a high degree of confidence in bond insurance because no investor in any bond-insured security failed to receive a single timely payment of principal or interest. Moreover, downgrade risk is viewed as minimal because no U.S. financial guarantee company has been downgraded. Investors realize another benefit from bond insurance. While rating agencies face reputational risk when assigning a rating to a security, monoline insurers are placing their own capital and credit rating at risk. Hence investors can correctly expect that the transaction structure is inherently safe and will remain so over the life of the securities guaranteed.
Bond insurance covers losses resulting from defaults and foreclosures. Policies typically are written for a dollar amount of coverage that continues in force throughout the life of the pool. Since only defaults and foreclosures are covered, additional insurance must be obtained to cover losses resulting from bankruptcy, fraud arising in the origination process, and special hazards. Each of these is discussed below.
When a borrower files for personal bankruptcy, there is a risk that a bankruptcy judge could reduce the borrower's mortgage debt. This debt reduction, called a cramdown, usually occurs only when the value of the borrower's home has fallen so that the mortgage loan balance exceeds the home's market value. If a cram-down is ordered, the loan's terms can be altered by reducing the unpaid principal balance or the loan's interest rate. A few cramdowns have occurred in recent years in settling Chapter 13 bankruptcy cases.2 However, the 1993 Supreme Court case of Nobelman versus American Savings ruled that a borrower filing under Chapter 13 cannot effectively reduce his or her mortgage debt.
Another potential risk that the cash flows will be impaired arises from borrower fraud or misrepresentation during the application process. This type of risk often is not covered by the originator/conduit/sellers' representations and warranties. The risk of losses owing to fraud is front-loaded. That is, borrowers who misrepresent their income, employment, or net worth generally will run into payment problems early in the loan's life. Therefore, fraud coverage is largest at issuance.
2. A mortgage borrower can file for personal bankruptcy under Chapter 7, Chapter 11, or Chapter 13. Chapter 13 allows for restructuring or forgiving debts while letting borrowers retain their assets. In a Chapter 7 bankruptcy filing, a type of bankruptcy that generally involves liquidation of assets to make payments to creditors, cramdowns also have been disallowed under a Supreme Court ruling. Cramdown filings under Chapter 11 are more rare than those under Chapter 7 or Chapter 13 because of their cost and complexity. Jumbo loan borrowers are more likely to file under Chapter 11 because this section can be used only when the debtor's secured debt exceeds $350,000.
Special-hazard losses result from properties damaged by earthquakes, mud slides, tidal waves, volcanoes, or floods. Such losses are excluded from coverage under homeowners' and private mortgage insurance policies. Subordinate tranches absorb special-hazard losses up to a predetermined capped amount that declines as the mortgage pool amortizes. This "capped" amount is determined by the rating agencies. Special-hazard losses in excess of this capped amount are distributed among the senior and subordinate classes pro rata. Historically, losses from special hazards are quite rare because special casualty insurance often is required on homes in high-risk areas (i.e., flood insurance in flood zones and earthquake insurance along known fault lines), and damage caused indirectly by an act of God, such as water damage or fire caused by an earthquake, can be covered under standard homeowners' policies.3
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