FIN30021 Module 9 Suggested Solutions Exercise 9.3 1. Answer the below questions. a. Explain what is meant by a residential mortgage-backed security. By a residential mortgage-backed security (RMBS), we mean a security that is created when residential mortgages are packaged together to form a pool of mortgage loans and then one or more debt obligations are issued backed by the cash flow generated from the pool of mortgage loans. "Backed" means that the principal and interest due to the investors in an RMBS come from the principal and interest payments made by the borrowers whose loans are part of the pool of mortgages. A mortgage loan that is included in an RMBS is said to be securitized, and the process of creating an RMBS is referred to as securitization. b. Describe the sectors of the residential mortgage-backed securities market. The residential mortgage market can be divided into two subsectors based on the credit quality of the borrower: prime mortgage market and subprime mortgage market. The prime sector includes (1) loans that satisfy the underwriting standard of Ginnie Mae, Fannie Mae, and Freddie Mac (i.e., conforming loans); and (2) loans that fail to conform for a reason other than credit quality or because the loan is not a first lien on the property (i.e., nonconforming loans). The subprime mortgage sector is the market for loans provided to borrowers with an impaired credit rating or where the loan is a second lien; these loans are nonconforming loans. The above loans can be securitized in different sectors of the RMBS market. Loans that satisfy the underwriting standard of the agencies are typically used to create RMBS that are referred to as agency mortgage- backed securities (MBS). All other loans are included in what is referred to generically as nonagency MBS. In turn, this subsector is classified into private-label MBS, where prime loans are the collateral, and Subprime MBS, where subprime loans are the collateral. The names Module 9 Page 1
FIN30021 given to the nonagency MBS are arbitrarily assigned. Some market participants refer to private-label MBS as "residential deals" or "prime deals." Subprime MBS are also referred to as "mortgage-related asset- backed securities." In fact, market participants often classify agency MBS and private-label MBS as part of the RMBS market and subprime MBS as part of the market for asset-backed securities. 2. What is a mortgage pass-through security? A mortgage pass-through security, or simply a pass-through, is a security that results when one or more mortgage holders form a collection (pool) of mortgages and sell shares or participation certificates in the pool. From the pass-through, two further derivative mortgage- backed securities are created: collateralized mortgage obligations and stripped mortgage-backed securities. 4. What are subprime mortgage-backed securities? First, let us look at what a mortgage-backed security. A mortgage- backed security (MBS) is an asset-backed asset whose cash flows are backed by the principal and interest payments of a set of mortgage loans. A mortgage pass-through security, or simply pass-through security, is a type of