What began several years ago as an esoteric asset class, collateralized bond obligations (CBOs) backed by mortgage-related securities have transformed from a niche product to a significant asset class. Mortgage CBOs are securities collateralized primarily by an actively managed portfolio of residential mortgage-backed securities (MBS), adjustable-rate mortgages (ARMs), and collateralized mortgage obligations (CMOs), with smaller exposures to asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS). Since 1995, Fitch IBCA has rated more than $14 billion of such transactions. Issuance in 1998 and 1999 exceeded $5 billion each year. Structures have varied over the years as dictated by market conditions and investor demand, and Fitch IBCA expects continued innovation. However, the primary focus of the rating analysis - the market value risk of the underlying assets - remains unchanged, since ratings are based primarily on the credit enhancement provided by the market value of the collateral. This report discusses the development of the mortgage CBO and trends that Fitch IBCA believes will lead to further expansion of this market.
The term CBO was originally used to describe transactions backed by high yield corporate debt. The goal in these transactions is to profit from the arbitrage between the high yielding collateral and the low cost debt of the CBO issuer. The CBO market experienced explosive growth over the past five years due to the re-emergence of the high-yield debt market and a robust economy. It is not mere coincidence that the mortgage CBO market developed in conjunction with the corporate CBO market, as that asset class gained acceptance as a viable investment. In either case, investors share similar motivations, in that they want to gain exposure to a particular market segment (i.e. high-yield bonds or mortgages) while being insulated from the risks traditionally associated with such markets.
In a corporate CBO, the primary risk is a credit event, such as a default or a rating downgrade, that would affect the performance or market value of the underlying collateral. For equity holders, who absorb the first layer of losses, the success of the transaction depends on the investment manager's ability to manage credit risk. However, since most of the collateral in a mortgage CBO is U.S. treasury, agency, and other highly rated debt, the primary risk is not that of a credit event, but rather how interest rate and prepayment volatility will affect the market value of the underlying collateral. Therefore, the equity holders in a mortgage CBO rely on the investment manager's ability to manage duration and prepayment risk.
The debt markets recently have been difficult for all fixed-income managers and the mortgage market has not been an exception. Beginning in the summer of 1998 with the Russian debt crisis and the accompanying flight to quality, credit and swap spreads widened to near historic levels. In an attempt to calm a jittery market, the Federal Reserve lowered interest rates, which, in the mortgage market, led to an uptick in prepayments. The swap markets settled down in the first half of 1999 and rising interest rates eliminated many refinancing opportunities. This consequently led to a decrease in prepayment risk. However, beginning in the summer of 1999, swap spreads widened again, reaching an all-time high in August 1999. But this time, the widening was accompanied by a continued rise in interest rates. Commercial paper spreads also widened due to a combination of Year 2000 fears and the default of a large issuer of funding agreements.
This market has presented significant challenges for mortgage investment managers, including managers of mortgage CBOs, most of whom have performed in line with the mortgage market. While mortgages, on a duration-adjusted basis, have outperformed the three-month London Interbank Offered Rate (LIBOR) by approximately 160 basis points over the past five years, in the past 18 months, the spread between mortgages and LIBOR has inverted.
These factors contributed to a tough market for mortgage CBOs, as evidenced by declining net asset values (NAVs), but in all cases, the rated debt has performed in line with expectations and there have been no rating actions. Transactions that employ variable leverage have performed as they were designed to: where necessary, due to a decline in market values, transactions funded with reverse repurchase agreements were partially deleveraged in an orderly manner to maintain required subordination levels. The widening of CP spreads put further pressure on transactions funded with CP, but there is still substantial room before any market value trigger events would be breached.
Innovations and Trends
In a market value CBO, the market value of the underlying collateral provides credit enhancement to the debt issued by the CBO. Factors that will affect the market value in any mortgage portfolio include substantial volatility in interest rates, changes in prepayment speeds, widening of mortgage spreads, and credit events. These risks can be mitigated through the benefits of diversification, structural protection, and the expertise of an investment manager with proven experience in the mortgage market. Nonetheless, in determining the amount of subordination required for the rated debt issued by the mortgage CBO, Fitch IBCA will assume that the portfolio composition is the most aggressive as allowed by the portfolio guidelines, and then apply severe economic stresses to that portfolio to determine the potential market value loss. The market value loss is assumed to occur at the point of transaction termination, and such loss would continue through an unwind period in a portfolio liquidation. The potential loss translates into the required subordination.
A new initiative that Fitch IBCA has been developing is the application of individual advance rates for a variety of MBS and ABS. Applying differing advance rates to various asset classes would allow the required subordination to vary in step with the portfolio composition. Thus, more conservative portfolios should have less market value volatility and, therefore, the rated debt will need less subordination. Fitch IBCA believes the development and application of asset-specific advance rates will lead to a more straightforward rating methodology, as well as subordination requirements that more appropriately match the level of risk in the portfolio.
Fixed Leverage Vs. Variable Leverage
To date, mortgage CBOs have employed two funding strategies: one is a fixed-leverage structure that uses CP for the majority of its funding; the other is a variable-leverage structure that uses internal leverage for the majority of its funding.
With the fixed-leverage structure, the CP is fully funded and the portfolio is fully invested after a short ramp-up period. The CP has partial liquidity support from a bank facility, as well as internal liquidity, if needed, through the sale of the underlying assets. There is a market value test that, if breached, would cause an early termination of the transaction.
Thereafter, the portfolio would be liquidated to repay the CBO debt. The market value trigger is set low enough so that normal market value fluctuations would not cause a termination event.
With the variable leverage structure, leverage is created internally through mortgage market financing techniques, such as reverse repurchase agreements and trading in the forward market. With this structure, the required subordination is a fixed percentage, but the amount will vary with the market value of the collateral. If a market value decline caused a subordination requirement to be breached, the investment manager has the ability to deleverage the structure to bring the subordination back into compliance. If a subordination test is breached and cannot not be corrected within the applicable cure period, it would cause an early termination and the portfolio would be liquidated. With the variable leverage structure, asset-specific advance rates may be more applicable because, rather than deleveraging the structure, the investment manager can trade out of riskier assets and into less volatile assets.
Fitch IBCA believes both structures are viable funding alternatives and each will continue to be used and evolve with structural innovations, investor demand, and market conditions. The choice of one over the other will depend on which funding alternative best suits the investment strategy.
Mortgage CBOs have taken a conservative view toward credit risk, and almost all the collateral to date has been either U.S. treasury and agency securities, CMOs created from agency collateral, or AAA' rated MBS and ABS . Since most managers in mortgage CBOs seek to leverage their ability to manage duration and convexity risk, their focus has been on identifying market sectors and individual securities where they can extract relative value. While most mortgage CBOs have allowances for AA' and A' rated securities, to date, these buckets have not been fully utilized. Notwithstanding, investment managers have been expressing a desire to move toward lower and below investment-grade securities to enhance yield, and Fitch IBCA sees this trend continuing. The securities being sought are mostly mezzanine and subordinate tranches of mortgage-related products, such as home equity loans and jumbo mortgages, so the asset class still fits within the realm of the investment manager's expertise.
Market Value Vs. Cash Flow Structures
Consistent with the trend toward lower rated (and higher yielding) assets, Fitch IBCA expects to see heightened interest in applying the "cash flow" methodology of analysis. In a cash flow structure, credit enhancement is achieved primarily from the excess spread between the high yielding assets and the low cost debt issued by the CBO. Depending on the particular collateral assets, market value advance rates may require significant (and perhaps onerous) subordination to address the relative illiquidity of some of these assets. In this situation, a cash flow structure may be more efficient.
Fitch IBCA's cash flow methodology has established default and recovery assumptions for various ABS. However, the intent of including these in a CBO was to allow for a small bucket of structured product in a well diversified portfolio. For any portfolio with excessive sector concentrations, the default rates are typically stressed beyond established levels. Also, some unique issues are raised regarding how to apply the cash flow variability of mortgage assets into a cash flow structure. Fitch IBCA believes the cash flow structure has significant potential to allow a CBO to safely invest in higher yielding, yet less liquid, securities. While the issues addressed are not insurmountable, structural innovations and market appetite for such a product will dictate development of this sector, and it has yet to be determined if a true trend is developing.
In November 1999, Fitch IBCA began to include mortgage CBO surveillance on its web site. This was in response to investor and issuer demand, which Fitch IBCA believes will add to more transparency in the mortgage CBO market. The surveillance includes the deal summary, capital structure, and portfolio attributes such as asset allocation, credit quality distribution, leverage, effective duration, compliance tests, and NAVs. Fitch IBCA updates this information monthly to reflect the most current portfolio characteristics.
Fitch IBCA maintains an active investor relations program to ensure that investors are aware of and understand Fitch IBCA's rating and underlying credit opinions. Fitch IBCA often posts presale reports on its web site for any interested investors. These reports summarize the underlying analysis employed to achieve the expected ratings. Once the rating process is completed for a transaction, Fitch IBCA usually publishes a research report detailing the transaction's structure and explaining the analysis supporting the rating. The information detailed in the report helps investors understand Fitch IBCA's methodology. Fitch IBCA regularly speaks to and meets with investors to explain the rating rationale for various transactions. By maintaining active investor relations, Fitch IBCA provides issuers with feedback regarding investors' opinions and concerns.