There are a number of key attributes that define the instruments in question that can be characterized by the following dimensions:

We discuss each below.

Lien Status

The lien status dictates the loan's seniority in the event of the forced liquidation of the property due to default by the obligor. A first lien implies that a creditor would have first call on the proceeds of the liquidation of the property if it were to be repossessed. Borrowers often utilize second lien or junior loans as a means of liquefying the value of a home for the purpose of expenditures such as medical bills or college tuition or investments such as home improvements.

Original Loan Term

The great majority of mortgages are originated with a 30-year original term. Loans with shorter stated terms are also utilized by those borrowers seeking to amortize their loans faster and build equity in their homes more quickly. The 15-year mortgage is the most common short-amortization instrument, although issuance of loans with 20- and 10-year terms has grown in recent years.

Credit Classification

The majority of loans originated are of high-credit quality, where the borrowers have strong employment and credit histories, income sufficient to pay the loans without compromising their creditworthiness, and substantial equity in the underlying property. These loans are broadly classified as prime loans, and have historically experienced low incidences of delinquency and default.

Loans of lower initial credit quality, which are more likely to experience significantly higher levels of default, are classified as subprime loans. Subprime loan underwriting often utilizes nontraditional measures to assess credit risk, as these borrowers often have lower income levels, fewer assets, and blemished credit histories. After issuance, these loans are typically serviced by special units designed to closely monitor the payments of subprime borrowers. In the event that subprime borrowers become delinquent, the servicers move immediately to either assist the borrowers in becoming current or mitigate the potential for losses resulting from loan defaults.

Between the prime and subprime sector is a somewhat nebulous category referenced as alternative-A loans or, more commonly, alt-A loans. These loans are considered to be prime loans (the "A" refers to the A grade assigned by underwriting systems), albeit with some attributes that either increase their perceived credit riskiness or cause them to be difficult to categorize and evaluate.

Mortgage credit analysis employs a number of different metrics, including the following.

Credit Scores Several firms collect data on the payment histories of individuals from lending institutions and use sophisticated models to evaluate and quantify individual creditworthiness. The process results in a credit score, which is essentially a numerical grade of the credit history of the borrower. There are three different credit-reporting firms that calculate credit scores: Experian (which uses the Fair Isaacs or FICO model), Transunion (which supports the Emperica model), and Equifax (whose model is known as Beacon). While each firm's credit scores are based on different data sets and scoring algorithms, the scores are generically referred to as FICO scores.

Loan-to-Value Ratios The loan-to-value ratio (LTV) is an indicator of borrower leverage at the point when the loan application is filed. The LTV calculation compares the face value of the desired loan to the market value of the property. By definition, the LTV of the loan in the purchase transaction is a function of both the down payment and the purchase price of the property. In a refinancing, the LTV is dependent on the requested amount of the new loan and the market value of the property as determined by an appraisal. If the new loan is larger than the original loan, the transaction is referred to as a cash-out refinancing, while a refinancing where the loan balance remains unchanged is described as a rate-and-term refinancing or no-cash refinancing.

The LTV is important for a number of reasons. First, it is an indicator of the amount that can be recovered from a loan in the event of a default, especially if the value of the property declines. The level of the LTV also has an impact on the expected payment performance of the obligor, as high LTVs indicate a greater likelihood of default on the loan. Another useful measure is the combined LTV (or CLTV), which accounts for the existence of second liens. A $100,000 property with an $80,000 first lien and a $10,000 second lien will have an LTV of 80% but a CLTV of 90%.

Income Ratios In order to ensure that borrower obligations are consistent with their income, lenders calculate income ratios that compare the potential monthly payment on the loan to the applicant's monthly income. The most common measures are called front and back ratios. The front ratio is calculated by dividing the total monthly payments on the home (including principal, interest, property taxes, and homeowners insurance) by pretax monthly income. The back ratio is similar, but adds other debt payments (including auto loan and credit card payments) to the total payments. In order for a loan to be classified as prime, the front and back ratios should be no more than 28% and 36%, respectively. (Because consumer debt figures can be somewhat inconsistent and nebulous, the front ratio is generally considered the more reliable measure, and accorded greater weight by underwriters.)

Documentation Lenders traditionally have required potential borrowers to provide data on their financial status, and support the data with documentation. Loan officers typically required applicants to report and document income, employment status, and financial resources (including the source of the down payment for the transaction). Part of the application process routinely involved compiling documents such as tax returns and bank statements for use in the underwriting process. However, a growing number of loan programs have more flexible documentation requirements, and lenders typically offer programs with a variety of documentation standards. Such programs include programs where pay stubs and tax returns are not required (especially in cases where existing customers refinance their loans), as well as "stated" programs (where income levels and asset values are provided, but not independently verified).

Characterizing Prime versus Subprime Loans

The primary attribute used to characterize loans as either prime or subprime is the credit score. Prime (or A-grade) loans generally have FICO scores of 660 or higher, income ratios with the previously noted maximum of 28% and 36%, and LTVs less than 95%. Alt-A loans may vary in a number of important ways. Alt-A loans typically have lower degrees of documentation, are backed by a second home or investor property, or have a combination of attributes (such as large loan size and high LTV) that make the loan riskier. While subprime loans typically have FICO scores below 660, the loan programs and grades are highly lender-specific. One lender might consider a loan with a 620 FICO to be a B-rated loan, while another lender would grade the same loan higher or lower, especially if the other attributes of the loan (such as the LTV) are higher or lower than average levels.

Interest Rate Type

Fixed-rate mortgages have an interest rate (or note rate) that is set at the closing of the loan (or, more accurately, when the rate is "locked"), and is constant for the loan's term. Based on the loan's balance, interest rate, and term, a payment schedule effective over the life of the loan is calculated to amortize the principal balance.

Adjustable-rate mortgages (ARMs), as the name implies, have note rates that change over the life of the loan. The note rate is based on both the movement of an underlying rate (the index) and a spread over the index (the margin) required for the particular loan program. A number of different indexes can be used as a reference rate in determining the loan's note rate when the loan "resets," including the London Interbank Offered Rate (LI-BOR), one-year Constant Maturity Treasury (CMT), or the 12-month Moving Treasury Average (MTA), a rate calculated from monthly averages of the one-year CMT. An ARM's note rate resets at the end of the initial period and subsequently resets periodically, subject to caps and floors that limit how much the loan's note rate can change. ARMs most frequently are structured to reset annually, although some products reset on a monthly or semiannual basis. Since the loan's rate and payment can (and often does) reset higher, the borrower can experience "payment shock" if the monthly payment increases significantly.

Traditionally, ARMs had a one-year initial period where the start rate was effective, often referred to as the "teaser" rate (since the rate was set at a relatively low rate in order to entice borrowers.) The loans reset at the end of the teaser period, and continued to reset annually for the life of the loan. One-year ARMs, however, are no longer popular products, and have been replaced by loans that have features more appealing to borrowers.

There are two broad types of ARM loans. One is the fixed-period ARM or hybrid ARM, which have fixed initial rates that are effective for longer periods of time (3-, 5- 7-, and 10-years) after funding. At the end of the initial fixed-rate period, the loans reset in a fashion very similar to that of more traditional ARM loans. Hybrid ARMs typically have three rate caps: initial cap, periodic cap, and life cap. The initial cap and periodic cap limit how much the note rate of the loans can change at the end of the fixed period and at each subsequent reset, respectively, while the life cap dictates the maximum level of the note rate.

At the opposite end of the spectrum is the payment-option ARM or negative amortization ARM. Such products are structured as monthly-reset ARMs that begin with a very low teaser rate. While the rate adjusts monthly, the minimum payment is adjusted only on an annual basis and is subject to a payment cap that limits how much the loan's payment can change at the reset. In instances where the payment made is not sufficient to cover the interest due on the loan, the loan's balance increases in a phenomenon called "negative amortization." (The mechanics of negative amortization loans are addressed in more depth later in this chapter.)

Amortization Type

Traditionally, both fixed and adjustable rate mortgages were fully amortizing loans, indicating that the obligor's principal and interest payments are calculated in equal increments to pay off the loan over the stated term. Fully amortizing, fixed rate loans have a payment that is constant over the life of the loan. Since the payments on ARMs adjust periodically, their payments are recalculated at each reset for the loan's remaining balance at the new effective rate in a process called recasting the loan.

A recent trend in the market, however, has been the growing popularity of nontraditional amortization schemes. The most straightforward of these innovations is the interest-only or IO product. These loans require only interest to be paid for a predetermined period of time. After the expiration of the interest-only or lockout period, the loan is recast to amortize over the remaining term of the loan. The inclusion of principal to the payments at that point amortized over the remaining (and shorter) term of the loan causes the loan's payment to rise significantly after the recast, creating payment shock analogous to that experienced when an ARM resets.

The interest-only product was introduced in the hybrid ARM market, where the terms of the interest-only and fixed-rate periods were contiguous. A by-product of the interest-only ARM can be large changes in the borrower's monthly payment, the result of the combination of post-reset rate increases and the introduction of principal amortization. However, fixed-rate, interest-only products have recently grown in popularity. These are loans with a 30-year maturity that have a fixed rate throughout the life of the loan, but have a fairly long interest-only period (normally 10 years, although 15-year interest-only products are also being produced.) The loans subsequently amortize over their remaining terms. These products were designed to appeal to borrowers seeking the lower payments of interest-only products without the rate risk associated with adjustable rate products.

Another recent innovation is the noncontiguous interest-only hybrid ARM, where the interest-only period is different from the duration of the fixed rate period. As an example, a 5/1 hybrid ARM might have an interest-only period of 10 years. When the fixed period of a hybrid ARM is concluded, the loan's rate resets in the same fashion as other ARMs. However, only interest is paid on the loan until the recast date. These products were developed to spread out the payment shock that occurs when ARM loans reset and recast simultaneously.

Credit Guarantees

The ability of mortgage banks to continually originate mortgages is heavily dependent upon the ability to create fungible assets from a disparate group of loans made to a multitude of individual obligors. These assets are then sold (in the form of loans or, more commonly, MBS) into the capital markets, with the proceeds being recycled into new lending. Therefore, mortgage loans can be further classified based upon whether a credit guaranty associated with the loan is provided by the federal government or quasi-governmental entities, or obtained through other private entities or structural means.

Loans that are backed by agencies of the federal government are referred to under the generic term of government loans. As part of housing policy considerations, the Department of Housing and Urban Development (HUD) oversees two agencies, the Federal Housing Administration (FHA) and the Department of Veterans Affairs (often referred to simply as the Veterans Administration or VA), that support housing credit for qualifying borrowers. The FHA provides loan guarantees for those borrowers who can afford only a low down payment and generally also have relatively low levels of income. The VA guarantees loans made to veterans, allowing them to receive favorable loan terms. These guarantees are backed by the U.S. Department of the Treasury, thus providing these loans with the "full faith and credit" backing of the U.S. government. Government loans are securitized largely through the aegis of the Government National Mortgage Association (GNMA or Ginnie Mae), an agency also overseen by HUD.

So-called conventional loans have no explicit guaranty from the federal government. Conventional loans can be securitized either as "private-label" structures or as pools guaranteed by the two government-sponsored enterprises (GSEs), namely Freddie Mac (FHLMC) and Fannie Mae (FNMA). The GSEs are shareholder-owned corporations that were created by Congress in order to support housing activity. While neither enterprise has an overt government guaranty, market convention has always reflected the presumption that the government would provide assistance to the GSEs in the event of financial setbacks that threaten their viability. As we will see later in this chapter, the GSEs insure the payment of principal and interest to investors in exchange for a guaranty fee, paid either out of the loan's interest proceeds or as a lump sum at issuance.

Conventional loans that are not guaranteed by the GSEs can be securitized as private-label transactions. Traditionally, loans were securitized in private-label form because they were not eligible for GSE guarantees, either because of their balance or their credit attributes. A recent development is the growth of private-label deals backed either entirely or in part by loans where the balance conforms to the GSEs' limits. In such deals, the originator finds it more economical to enhance the loans' credit using the mechanisms of the private market (most commonly through subordination) than through the auspices of a GSE.

Loan Balances

The agencies have limits on the loan balance that can be included in agency-guaranteed pools. The maximum loan sizes for one- to four-family homes effective for a calendar year are adjusted late in the prior year. The year-over-year percentage change in the limits is based on the October-to-October change in the average home price (for both new and existing homes) published by the Federal Housing Finance Board. Since their inception, Freddie Mac and Fannie Mae pools have had identical loan limits, because the limits are dictated by the same statute. For 2006, the single-family limit is $417,000; the loan limits are 50% higher for loans made in Alaska, Hawaii, Guam, and the U.S. Virgin Islands.

Loans larger than the conforming limit (and thus ineligible for inclusion in agency pools) are classified as "jumbo" loans and can only be securitized in private label transactions (along with loans that do not meet the GSEs' required credit or documentation standards, irrespective of balance). While the size of the private-label sector is significant (as of the second quarter of 2006, approximately $1.7 trillion in balance was outstanding), it is much smaller than the market for agency pools. Moreover, as the conforming balance limits have risen due to robust real estate appreciation, the market share of agency pools relative to private label deals has grown.

Mortgage loans can prepay for a variety of reasons. All mortgage loans have a "due on sale" clause, which means that the remaining balance of the loan must be paid when the house is sold. Existing mortgages can also be refinanced by the obligor if the prevailing level of mortgage rates declines, or if a more attractive financing vehicle is proposed to them. In addition, the homeowner can make partial prepayments on their loan, which serve to reduce the remaining balance and shorten the loan's remaining term. As we will discuss later in this chapter, prepayments strongly impact the returns and performance of MBS, and investors devote significant resources to studying and modeling them.

To mitigate the effects of prepayments, some loan programs are structured with prepayment penalties. The penalties are designed to discourage refinancing activity, and require a fee to be paid to the servicer if the loan is prepaid within a certain amount of time after funding. Penalties are typically structured to allow borrowers to partially prepay up to 20% of their loan each year the penalty is in effect, and charge the borrower six months of interest for prepayments on the remaining 80% of their balance. Some penalties are waived if the home is sold, and are described as "soft" penalties; hard penalties require the penalty to be paid even if the prepayment occurs as a result of the sale of the underlying property.

In a previous section, we noted that obligors have the ability to prepay their loans before they mature. For the holder of the mortgage asset, the borrower's prepayment option creates a unique form of risk. In cases where the obligor refinances the loan in order to capitalize on a drop in market rates, the investor has a high-yielding asset pay off, and it can be replaced only with an asset carrying a lower yield. Prepayment risk is analogous to "call risk" for corporate and municipal bonds in terms of its impact on returns, and also creates uncertainty with respect to the timing of investors' cash flows. In addition, changing prepayment "speeds" due to interest rate moves cause variations in the cash flows of mortgages and securities collateralized by mortgage products, strongly influencing their relative performance and making them difficult and expensive to hedge.

Prepayments are phenomena resulting from decisions made by the borrower and/or the lender, and occur for the following reasons:

Prepayments attributable to reasons other than refinancings are referred to under the broad rubric of "turnover." Turnover rates tend to be fairly stable over time, but are strongly influenced by the health of the housing market, specifically the levels of real estate appreciation and the volume of existing home sales. Refinancing activity, however, generally depends on being able to obtain a new loan with either a lower rate or a smaller payment, making this activity highly dependent on the level of interest rates, the shape of the yield curve (since short rates strongly influence ARM pricing), and the availability of alternative loan products. In addition, the amount of refinancing activity can change greatly as the result of seemingly small changes in rates.

The paradigm in mortgages is thus fairly straightforward. Mortgages with low note rates (that are "out-of-the-money," to borrow a term from the option market) normally prepay fairly slowly and steadily, while loans carrying higher rates (and are "in-the-money") are prone to experience spikes in prepayments when rates decline. Clearly, this paradigm is dependent on the level of mortgage rates.

It is important to understand how changes in prepayment rates impact the performance of mortgages and MBS. Since prepayments increase as bond prices rise and market yields are declining, mortgages shorten in average life and duration when the bond markets rally, constraining their price appreciation. Conversely, rising yields cause prepayments to slow and bond durations to extend, resulting in a greater drop in price than experienced by more traditional (that is, option-free) fixed income products. As a result, the price performance of mortgages and MBS tends to lag that of comparable fixed maturity instruments (such as Treasury notes) when the prevailing level of yields increases.

This phenomenon is generically described as negative convexity. The effect of changing prepayment speeds on mortgage durations, based on movements in interest rates, is precisely the opposite of what a bondholder would desire. (Fixed income portfolio managers, for example, extend durations as rates decline, and shorten them when rates rise.) The price performance of mortgages and MBS is, therefore, decidedly nonlinear in nature, and the product will underperf orm assets that do not exhibit negatively convex behavior as rates decline.

Figure 18.4 shows a graphic representation of this behavior. Investors are generally compensated for the lagging price performance of MBS through higher base-case yields. However, the necessity of managing negative convexity and prepayment risk on the part of investors involves fairly active management of MBS portfolios, and creates both higher hedging costs and the possibility of losses due to estimation and modeling error. In turn, this creates the desire on the part of some investors to limit their exposure to prepayments by investing in bonds where prepayment risk is transferred within the structure. This type of risk mitigation is central to the structured MBS market.

Analysis of the credit exposure in the mortgage sector is different from the assessment of credit risk in most other fixed income instruments because it requires:

In a prior section, some of the factors (credit scores, LTVs, etc.) that are used to gauge the creditworthiness of borrowers and the likelihood of a loan to result in a loss of principal were discussed. Many of the same measures are also used in evaluating the creditworthiness of a mortgage pool. For example, weighted average credit scores and LTVs are routinely calculated, and stratifications of these characteristics (along with documentation styles and other attributes) are used in the credit evaluation of the pool. In addition to these characteristics of the loans, the following metrics are also utilized in the a posteriori evaluation of a mortgage pool or security.

Delinquencies

These measures are designed to gauge whether borrowers are current on their loan payments or, if they are late, stratifying them according to the seriousness of the delinquency. The most common convention for classifying delinquencies is one promulgated by the Office of Thrift Supervision; this "OTS" method classifies loans as follows:

Figure 18.4. Performance Profile of Hypothetical Fixed Maturity Bond versus MBS

Defaults

At some point in their existence, many loans that are associated with delinquencies become current or "cure," as the condition leading to the delinquency (e.g., job loss, illness, etc.) resolves itself. However, some portion of the delinquent loan universe ends up in default. By definition, default is the point where the borrower loses title to the property in question. Default generally occurs for loans that are 90+ days delinquent, although loans where the borrower goes into bankruptcy may be classified as defaulted at an earlier point in time.

Loss Severity

Since the lender has a lien on the borrower's property, much of the value of the loan can be recovered through the foreclosure process. Loss severity measures the face value of the loss on a loan after foreclosure is completed. Depending on the type of loan, loss severities can average in the area of 20% to 40%, and can be heavily influenced by the loan's LTV (since a high LTV loan leaves less room for a decline in the value of the property in the event of a loss). However, in the event of a default, loans with relatively low LTVs can also result in losses, generally for two reasons:

In light of these factors, the process of evaluating the credit-adjusted performance of either a group of loans involves first gauging the expected delinquencies, defaults, and loss severities of the pool or security based on its credit characteristics. Subsequently, loss-adjusted yields and returns can be generated. It should be noted that investors in some segments of the MBS market do not engage in detailed credit analysis; buyers of agency pools, for example, generally rely on the guaranty of the agency in question. In addition to buyers of mortgages in whole-loan form, credit analysis is primarily undertaken by investors in the subordinate tranches of private label deals. As one might expect, the performance of subordinates is highly sensitive to the credit performance of the collateral pool. This is both because of their role in protecting the senior classes from losses, as well as the sequential nature of loss allocations within the subordinate classes.