Fixed Income Research

Net Interest Margin Securitizations in the Home Equity Loan Market

April 27, 2001
Brian Hargrave 212-526-8311 Arthur Chu 212-526-8311

SUMMARY
Net interest margin securitizations (NIMs) offer a shorter-duration alternative for investors seeking to take credit exposure in the home equity loan (HEL) sector. Todays NIMs are structured to a shorter average life and, therefore, are less leveraged to credit assumptions compared with those issued in the past. In addition, many of these NIMs benefit from mortgage insurance, prepayment penalties, embedded derivatives, and immediate cash flow. Investors should focus on loss, prepayment, and reference interest rate risk characteristics in evaluating particular NIM securities. Loss exposure, which is generally the most significant risk to the NIM, is largely concentrated in the front end of the default curve. We expect the market for NIM securities to expand dramatically as investors recognize the structural advantages of taking HEL credit exposure in the front end of the default curve and believe NIMs will tighten versus standard HEL BBBs.

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The author would like to thank Will Gajate, Matt Lewis, and Alan Randmere for their valuable input.

Publications: L. Pindyck, A. DiTizio, B. Davenport, W. Lee, D. Kramer, S. Bryant, J. Threadgill, R. Madison, A. Acevedo This document is for information purposes only. No part of this document may be reproduced in any manner without the written permission of Lehman Brothers Inc. Under no circumstances should it be used or considered as an offer to sell or a solicitation of any offer to buy the securities or other instruments mentioned in it. We do not represent that this information is accurate or complete and it should not be relied upon as such. Opinions expressed herein are subject to change without notice. The products mentioned in this document may not be eligible for sale in some states or countries, nor suitable for all types of investors; their value and the income they produce may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors. Lehman Brothers Inc. and/or its affiliated companies may make a market or deal as principal in the securities mentioned in this document or in options or other derivative instruments based thereon. In addition, Lehman Brothers Inc., its affiliated companies, shareholders, directors, officers and/or employees, may from time to time have long or short positions in such securities or in options, futures or other derivative instruments based thereon. One or more directors, officers and/or employees of Lehman Brothers Inc. or its affiliated companies may be a director of the issuer of the securities mentioned in this document. Lehman Brothers Inc. or its predecessors and/or its affiliated companies may have managed or co-managed a public offering of or acted as initial purchaser or placement agent for a private placement of any of the securities of any issuer mentioned in this document within the last three years, or may, from time to time perform investment banking or other services for, or solicit investment banking or other business from any company mentioned in this document. This document has also been prepared on behalf of Lehman Brothers International (Europe), which is regulated by the SFA. 2001 Lehman Brothers Inc. All rights reserved. Member SIPC.

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MOTIVATION FOR ISSUANCE

The securitization of home equity loans is an established and well-accepted financing strategy for mortgage originators. In the typical structure, the originator retains a residual (or first loss) position in the securitization, which is marked at some value and must be financed in much the same way as any other on-balance sheet asset. This residual is the excess cash flow generated by the collateral after paying the trusts debt service. The originator usually retains, rather than sells, the residual for two primary reasons: first, when the originator is also the servicer of the loans, the residual helps align the incentives of the originator with those of the ABS investors. Second, the originator is effectively retaining a piece of the capital structure that does not trade with great frequency or efficiency in the capital markets. Conceivably, the originator gains more on a net present value basis by holding the residual than by selling it into the capital markets. On the other hand, originators create HELs at a cost greater than par, while typically receiving only par proceeds from securitization. Although the originator may profit over time by holding the residual, this strategy is cash flow negative in the short term. Hence, liquidity constraints may make holding 100% of the residual less attractive. In addition, the leveraged nature of the residual has led to numerous highly publicized writedowns as prepayments or credit losses exceeded initial forecasts. As such, the earnings volatility caused by holding a residual position may also make holding 100% of the residual less attractive. Issuance of a net interest margin security (NIM) allows the issuer to monetize a portion of this residual position while still maintaining economic exposure to the securitization through a smaller secondary residual position. As an example, we show a representative HEL securitization structure in Figure 1. In the first panel (Structure #1), we show the typical residual position at the bottom of the capital structure. In the second panel (Structure #2), we divide the residual position into a NIM and secondary residual position. From this perspective, a NIM represents the resecuritization of the more senior tranche of the residual.

EVOLUTION OF THE NIM MARKET

While NIM securities date back to the mid-1990s, HEL NIM issuance emerged more recently in 1997/early-1998. Given the volatility in collateral performance originated in this time period and the impact this performance has on residuals, it is no surprise that many issuers were faced with significant writedowns of their residual positions. Consequently, the HEL NIMs that were issued generally performed poorly. HEL NIM issuance re-emerged in 2000 due to a confluence of factors. The growth of lender-paid mortgage insurance, increased comfort of rating agencies with subprime collateral, and investor demand for subordinate securities all contributed to this reappearance. However, the more recent NIMs

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Figure 1.

HEL Securitization Structure Structure #1 Structure #2

AAA Collateral Balance

AAA

AA A BBB

AA A BBB NIM Secondary Residual

Residual

differ from their more seasoned counterparts in several respects. They are generally shorter in average life and window, carry less credit leverage, and benefit from the increased presence of prepayment penalties in subprime collateral. They are, as a result, gaining increased acceptance among subordinate ABS investors. The purpose of this report is to explain the structural characteristics of NIMs within the context of the HEL securitization structure and also to examine NIM performance relative to other similarly rated securities. Our conclusions can be summarized as follows: Todays NIMs are structured to a shorter average life and, therefore, are less leveraged to credit assumptions compared with those issued in the past. In addition, many of these NIMs benefit from mortgage insurance, prepayment penalties, and immediate cash flow, all of which reduce performance uncertainty. The relevant variables for NIM analysis include collateral losses, prepayments, and reference interest rates, in approximate order of importance. Credit is of the utmost importance due to its impact on both excess spread and overcollateralization release cash flows, with higher-than-expected losses in the early months of the transaction having the greatest impact. At current levels, NIMs offer relative value to standard BBB securities from the underlying securitization. BBB- NIMs should trade approximately 30 bp wider than their BBB counterparts, while six month seasoned NIMS should trade approximately 20 bp wider than unseasoned NIMs rated one notch lower.

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We expect the market for NIM securities to expand as investors recognize the advantages of taking HEL credit exposure in the front end of the loss curve.

PROPERTIES OF RESIDUALS
In a typical HEL structure, the residual may receive cash flow from the following sources: Excess SpreadThe difference between the net weighted average coupon (WAC) of the collateral and the WAC of the bonds outstanding in the underlying securitization represents excess spread in the structure (shown in Figure 2). In HEL securitizations, this excess spread is typically subordinated to cover collateral losses. The residual holder is entitled to receive monthly excess spread once a target overcollateralization level has been reached and losses for the month (if any) have been covered. Overcollateralization ReleaseThe difference between the collateral balance and the sum of the bonds outstanding represents overcollateralization (O/C) in a securitization structure (also shown in Figure 2). O/C is built to a target level by applying excess spread to the payment of bond principal. Furthermore, the specified target level of O/C is generally allowed to step down once certain conditions are met. This stepdown releases principal cash flow to the residual holder. Prepayment PenaltiesIn addition, the residual holder may or may not hold the Class P security, which consists of prepayment penalty cash flow. While this security is completely separate from the residual and generally not subordinated, it is often included in a NIM securitization. We will discuss the implications of prepayment penalties later in this report.

Figure 2.

Excess Spread and Overcollateralization

Interest Cash Flow Excess Spread Current Collateral WAC

Principal Balance

Current Bond WAC

Current Collateral Balance

Current Bonds Outstanding

OverCollateralization

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SENIOR/SUBORDINATE STRUCTURAL RECAP

The release of excess spread and O/C to the residual depends upon the securitizations position with respect to the following three phases (shown in Figure 3): 1) Overcollateralization BuildWhen the O/C level is below target, excess spread is used to build additional O/C. When this occurs, neither excess spread nor overcollateralization will be released to the residual holder.

Figure 3.

Senior/Subordinate Overcollateralization Levels and Residual Cash Flow*

O/C, $
O/C Build O/C at Target O/C Stepdown O/C Release

Time

Residual Cash Flow, $

O/C Build O/C at Target

O/C Stepdown

O/C Release

Excess Spread CF

Time * Zero loss scenario.

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2) Overcollateralization at TargetOnce the O/C level has been built to the target, but stepdown is yet to occur, the residual holder is generally entitled to excess spread cash flow, after allowing for collateral losses, while O/C remains in the structure. 3) Overcollateralization StepdownOnce the stepdown test is met, the O/C level is generally set at a percentage of the current balance and, thus, allowed to step down over time. As a result, the residual holder can potentially realize cash flow from both overcollateralization in excess of target and excess spread. Structures engineered with an eye toward NIM securitizations may differ in subtle but important ways from the generic structure. First, some securitizations are structured with an O/C Holiday (typically 3-9 months), which allows excess spread to flow immediately to the residual for a predetermined time period, before O/C is built. Another structural variation allows the residual to receive cash flow immediately by funding the O/C to its target at deal issuance. Both of these types of structures have been used in past NIM securitizations. By allowing cash flow to be received by the residual immediately, a NIM with more desirable properties is produced. Without immediate residual cash flow, the NIM would effectively be locked out for the period of O/C build, increasing the average life and risk of the security. With this cash flow structure in mind, we identify the critical variables that drive residual cash flows in Figure 4. The variables have been listed in their approximate order of importance, recognizing the potential for variation due to collateral and structural differences. The relative importance of losses versus prepayments merits further explanation. Losses and prepayments have a similar impact on the IO-like properties of the residualthat is, they both reduce the collateral balance and, therefore, the associated excess spread cash flow. However, losses have two

Figure 4.
Variable

Residual Cash Flow Variables

Securitization Impact Losses reduce excess spread and possibly O/C levels Residual Cash Flow Effect Lower current cash flows and also lower future cash flows if O/C is reduced below target Lower expected future cash flows

Collateral Losses

Collateral Prepayments

Lower collateral balance causes reduced excess spread (in dollars)

Reference Interest Rates

Higher rates on floating rate Lower current cash flows liabilities reduce excess spread on hybrid loans prior to reset

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additional impacts: current excess spread is reduced due to its subordination, and future cash flows from O/C release may be reduced as current O/C levels fall. Intuitively, if a residual is worth 5% of the aggregate collateral value, then a prepayment means 5% of the prepaid collaterals par value is lost (in the absence of prepayment penalties). On the other hand, if a borrower defaults with a 50% loss severity, then 55% of the defaulted principal (50% loss + 5% prepayment) is lost. In the two examples, the residual is approximately ten times as leveraged to defaults as it is to prepayments. Clearly, decreasing the loss severity will decrease this leverage. This is, in fact, one of the primary benefits of mortgage insurance, which we discuss later. Reference interest rate differences arise when fixed or hybrid collateral is included in securitizations financed by floating-rate securities. For example, a securitization backed by 2/28 collateral that issues floating-rate notes will be exposed to movements in reference interest rates for the first two years. During that period, upward movements in LIBOR will increase the cost of funds for the securitization (the LIBOR-based notes), while the loans in the underlying pool remain fixed rate prior to reset. As a result, excess spread is reduced by the upward move in LIBOR. The opposite is also true: downward moves in LIBOR increase excess spread in the structure, prior to the loan reset date.

NIM STRUCTURE: THE RESIDUAL FRONT END

Having described residual cash flows, we now turn specifically to the properties of NIMs. A NIM essentially takes a subset of the residual cash flow and designates it as principal. The corresponding interest cashflow stream is simply based on a coupon rate (generally fixed rate). The size of a NIM is of critical importance in determining its investment characteristics, as it is the primary determinant of the degree to which the NIM inherits the volatility of the residual cash flow. This aspect of the NIM merits a more detailed discussion. In Figure 5, Panel A, we provide a hypothetical cash flow stream for a residual position in a HEL securitization. Subsequently, in Panel B, we divide this cash flow between NIM principal and interest, as well as secondary residual cash flow. All residual cash flows in excess of the NIM coupon amount are paid to the NIM as principal, until it is fully paid off. This clearly distinguishes the NIM as the front end of residual cash flows. To illustrate the impact of NIM sizing, in panel C, we increase the initial size of the NIM by 35%. As a result, NIM interest absorbs a larger portion of the residual cash flows. This increase has two effects: first, for a given expected residual cash flow level, the larger the NIM balance, the longer the average life of the NIM. Second, as the interest component becomes a larger portion of the expected residual cash flow and the average life increases, the risk of the NIM cash flows increases. That is to say, the larger the portion of the residual cash flow allocated to interest payments and the longer the repayment horizon, the more sensitivity

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Figure 5.
A.

Residual and NIM Cashflow

Residual Cash Flow

Residual

Time

B.
Residual Cash Flow

NIM Principal

Secondary CF NIM Interest

Time

C.
Residual Cash Flow

NIM Principal

Secondary CF NIM Interest

Time

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the NIM will have to cash flow risks such as losses and prepayments. Consequently, we would expectand it is, in fact, the casethat sizing correlates directly to credit rating in NIM securitizations.

STRUCTURAL DETAILS
Our subsequent analysis will be based on an underlying securitization and NIM structure with the characteristics shown in Figure 6. In this analysis, we assume that the NIM and the securitization are executed simultaneously. We will discuss the implications of issuing NIMs on seasoned securitizations later.
Figure 6.

As summarized in Figure 7, The NIM cash flows are composed of the following: Excess spread, which flows immediately to the NIM due to a nine-month spread holiday structured in the underlying securitization and any months thereafter assuming that losses and O/C targets permit;

Figure 6.
Collateral Loan Type

Securitization and NIM Structure

74% 2/28 hybrids, 18% 3/27 hybrids, 7% Fixed Rate, 1% Other 2/28: 10.5% first 2 yrs., 6mL + 600 bp after 3/27: 10.7% first 3 yrs., 6mL + 600 bp after Fixed: 10.9% 6 months average 91% have penalties; typically 6 mos. interest on 80% of balance Senior-Subordinate, LIBOR floater structure 1mL + 29 bp, weighted average at issuance 99% with coverage to 60 LTV or LTV < 60 9 Month Spread Holiday, 0.25% of Orig. Target with no stepdown provision 6.5% (BBB), 7.0% (BBB-) of Current Collateral Balance 7.50% Fixed Rate 6% Strike, Amortizing Structure based on expected prepayments over the first 36 months Maintained at 3 Months Interest on Current Balance 100% of received penalties pledged to NIM

Weighted Average Collateral Coupon

Collateral Seasoning at Deal Issuance Prepayment Penalties Securitization Structure Bond Coupon Mortgage Insurance O/C NIM NIM Size Note Rate Interest Rate Cap Reserve Fund Prepayment Penalties

10

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Figure 7.

NIM Cash Flow Sources

Excess Spread

Prepayment Penalties

NIM

Reserve Account

Cap Payments

100% of the prepayment penalties; An interest rate cap to protect the NIM against reference interest rate risk on the hybrid loans; and A reserve fund established as added protection for NIM interest payments

For the purposes of our analysis, we have developed a set of base case assumptions for forecasting cash flows (detailed assumptions are shown in the Appendix). Qualitatively, these assumptions were developed as follows: Default RateA single default rate vector, incorporating a 12-month lag, is applied to all underlying loans. This vector is based on historical observations of default rates in similar HEL collateral. Despite the six-month seasoning of the collateral, the 12-month lag reflects the length of the foreclosure and liquidation processes and the fact that none of the collateral is more than 60 days delinquent at deal issuance (as per REMIC rules). Recovery RateA single recovery rate is applied to all loans. Due to the presence of mortgage insurance, this recovery rate is higher than expected on non-MI loans of similar LTV. Prepayment RateIndividual prepayment vectors are applied to the different underlying loan types (i.e. 2/28, 3/27, fixed rate). The specific vectors are consistent with historical prepayment rates for each loan type. Prepayment PenaltiesThe impact is modeled by reducing prepayments on loans with penalties by 30%, during the time the penalties are in place. This logic is applied based on the actual penalty term in the underlying loan. LIBORThe forward LIBOR curve is used to project collateral and bond cash flows.

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Figure 8 illustrates the residual cash flows from this structure, under base case assumptions. With no O/C stepdown, all cash flows are from either excess spread or prepayment penalties. In Figure 9, we show the allocation of these residual cash flows to the NIM and secondary residual, again under base case assumptions.

Figure 8.
Cash Flow

Base Case Residual Cash Flow Projections

Excess Spread

Penalties 1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58 61 64 67 70 73 76 79 82

Month

Figure 9.
Cash Flow

Base Case NIM Cash Flow Projections

NIM Principal Secondary Residual NIM Interest 1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58 61 64 67 70 73 76 79 82

Month

12

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SENSITIVITY ANALYSIS
In our analysis, we will show two NIM sizings, one based on a BBB rating and one based on a BBB- rating. This will allow us to examine the impact of NIM sizing on the profile of the securities. In addition, for the purpose of comparison, we will show the sensitivity of the standard BBB security from the same underlying securitization (typically the B1 or BV1 class). As the BBB security we are analyzing has a floating-rate coupon, we will analyze it in terms of 1-month LIBOR DM, while the fixed-rate NIMs will be viewed relative to LIBOR on a swapped-out basis. These three bonds are summarized under base case assumptions in Figure 10. Generally speaking, the NIM itself is more sensitive to loss assumptions than prepayments. This is shown in Figure 11, which details the spread of the BBB NIM security under a range of loss and prepayment assumptions. Under base case losses, the NIM illustrates virtually no prepayment sensitivity, while under base case prepayments, the NIM begins to show a reduced spread at 400% of base case losses. In the following section, we will further dissect these and other sensitivities.

Figure 10. Base Case Bond Assumptions

% of Collat. Balance 0.5 6.5 7.0

BBB Bond BBB NIM BBB- NIM

Price 100-00 99-09 98-31

DM/Spread Average Life Window 1mL+195 bp 3.28 yr Months 37-51 Swaps+361 0.87 Months 1-24 Swaps+391 0.94 Months 1-27

Figure 11. Loss and Prepayment Sensitivities

BBB NIM spread to swaps curve, bp % of Base Case Loss Curve 200% 300% 350% 400% 359 358 357 356 360 358 357 299 360 358 291 (26) 355 76 (230) -

% of Base Case Prepayment Curve

75% 100% 125% 150%

100% 360 361 362 361

450% 217 (16) -

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Losses
Somewhat surprisingly, the BBB bond from the underlying securitization actually shows a yield loss before the BBB NIM at multiples of our loss rate assumption (Figure 12). This is due primarily to the short average life of the BBB NIM0.87 years, versus 3.28 for the BBB. As shown in Figure 13, the NIM is largely paid off by the time losses begin to occur in the collateral pool, while the BBB life extends into the peak period of losses. As a result, the BBB has more leverage to multiples of the loss curve . Comparatively, the BBB- NIM profile more closely resembles that of the standard BBB, but still consistently outperforms the BBB in terms of return.

Figure 12. Sensitivity to Loss Assumptions, Spread bp

% of Base Case Loss Curve 200% 300% 350% 195 195 5 360 358 357 388 384 14

BBB BBB NIM BBB- NIM

100% 195 361 391

400% (950) 299 (326)

450% (16) -

Figure 13. NIM and BBB Factor Relative to Expected Default Rate
Factor
1.0 0.8 0.6 0.4 0.2 0.0 0 10 20 30 40 50 60
BBB Factor NIM Factor CDR

CDR
15 12 9 6 3 0

Month

14

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In sharp contrast, stressing different regions of the default curve yields dramatically different results. When the front end of the loss curve is stressed, the NIM is affected more than the BBB. Conversely, when the back end of the loss curve is stressed, the BBB demonstrates more sensitivity. In Figure 14, we illustrate our base case default curve, as well as front-end and back-end stresses. The front-end stress essentially shifts the curve forward six months and then multiplies the entire curve by the given stress level. This causes losses to occur sooner or, viewed another way, causes losses to be higher earlier in the life of the loans. Such a stress is quite aggressive; we have analyzed over 1,000 actual HEL pools and found that 93% of the pools had less than 15 bp of losses in the first 12 months, with 38% exhibiting less than 5 bp. Intuitively, the lag in loss emergence is due to structural factors in the residential lending business. Foreclosure proceedings are initiated, at the earliest, once a loan becomes sixty days delinquent. At this point, state foreclosure laws largely dictate the progression toward disposition. Based on historical data, the time from last payment to actual disposition varies greatly, from less than one year in states such as Texas, to nearly two years in states like New York. The back-end stress utilizes the same ramp as the base case curve, but shifts all portions of the curve after month 36 up by the given stress multiple. Economically, this represents an increase in defaults as the underlying 2/28 loans reset upward and the borrowers experience payment shock. The details of each scenarios impact

Figure 14. Front and Back-End Loss Stresses

CDR
12 Base Case Front Stress Back Stress

0 0 10 20 30 40 50 60

Loan Age

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are shown in Figure 15. In the front-end stress scenario, both NIMs take a yield loss at the 300% stress level, while the BBB holds up to 350%. When the back end is stressed, the BBB takes a yield loss at 350%, while the BBB NIM holds up to 450% of the stress scenario, and the BBB- begins to deteriorate at 400%. The reason for these sensitivities are similar: namely, the NIM has a shorter average life and, thus, more exposure to the front end of the loss curve; the longer BBB security has more exposure to the back end of the curve.

Prepayments
The NIM securities exhibit minimal spread movement across a wide range of prepayment assumptions , consistent with the BBB bond, as shown in Figure 16. Importantly in the case of the NIM, even at 150% of our base case speeds, excess spread in the structure is sufficient to support the principal and interest cash flows. As shown in the Appendix, 150% of the base case assumption is extremely severe, implying prepayments of over 90 CPR at the reset date of the hybrid ARMs. By way of comparison, the secondary residual behind the NIM is much more sensitive to prepayment assumptions, as this security takes on more of the characteristics of an interest-only (IO) strip.

Figure 15. Impact of Front and Back-End Loss Stresses, Spread bp

% of Loss Curve 300% 350% 195 (223) (550) (612) -

100% Front-End Stress BBB BBB NIM BBB- NIM Back-End Stress BBB BBB NIM BBB- NIM 195 356 386

200% 195 349 373

400% -

450% -

195 361 391

195 361 390

203 361 390

361 378

361 157

361 (17)

Figure 16. Sensitivity to Prepayment Assumptions, Spread bp

% of Base Case Prepayment Curve 75% 100% 125% 150% 195 195 195 202 360 361 361 361 390 391 390 369

BBB* BBB NIM BBB- NIM

* Note: DM increase for BBB at 150% assumption due to coupon step-up after call date.

16

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Reference Interest Rates

Recall from Figure 6 that the 2/28 and 3/27 collateral coupon rate is fixed for an initial period, while the liabilities of the securitization are floating for their life. This mismatch creates added risk for the NIM, as an increase in LIBOR will increase the cost of funding in the securitization while not increasing the coupon on the collateral prior to reset. As a result, excess spread available to the NIM would be reduced. Recent structures have mitigated this risk somewhat by embedding an amortizing cap that is pledged to the NIM trust (not the underlying securitization). However, the movement of reference interest rates is significant to the NIM in spite of the interest rate cap included in the securitization structure. This is primarily because the strike on the cap is out of the money by approximately 95 bp, based on current one-month LIBOR of 5.05% and a 6% cap strike. As shown in Figure 17, parallel shifts in the LIBOR curve have a much more dramatic impact on the NIM as compared with the BBB. This reverses the loss profile seen previously, in which the BBB showed a yield loss at lower stress levels than the NIM. Higher LIBOR levels, all else being equal, cause the NIM to be more leveraged to loss rates. The yield loss at lower loss stresses is due to the extension of the NIM, which is priced at a slight discount in our analysis. We note that sensitivity to reference interest rates will vary greatly from deal to deal, depending on the proportion of hybrid collateral and the specific nature of derivative securities embedded in the structure.

PREPAYMENT PENALTIES
Prepayment penalties have two effects on the NIM security. First, penalties reduce voluntary prepayments over the term for which the penalty applies. This increases the dollar amount of excess spread in the securitization during the initial years, which correspond to the life of the NIM. Second, prepayment penalties represent

Figure 17. Impact of Parallel Shift in LIBOR Curve

bp yield loss versus same stress at forward LIBOR % of Base Case Loss Curve 200% 300% 350% 400% (170) (306) (49) (111)

100% BBB Up 50 in LIBOR Up 100 in LIBOR BBB NIM Up 50 in LIBOR Up 100 in LIBOR BBB- NIM Up 50 in LIBOR Up 100 in LIBOR -

450% (83) (267)

(9) (21)

(11) (25)

(96) (637)

(819) (1,464)

(17) (33)

(21) (49)

(552) (1,002)

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an additional source of cash flow in some structures, including our example, in which the NIM receives 100% of the prepayment penalties collected prior to its maturity. In our analysis, we have assumed that 100% of eligible prepayment penalties are actually collected. Penalty enforcement is generally very stringent in the current environment, since the secondary market pays significantly more for penalty versus non-penalty loans. However, it may not be realistic to assume that penalties will not be waived under any circumstances. For example, a servicer may waive the penalty if it results in a more favorable disposition of a delinquent loan (e.g., to facilitate a short sale). In Figure 18, we show the NIMs exposure to variations in this collection assumption. In our example, a 10% reduction in penalty collection equates to roughly a 2 bp loss in spread on both the BBB and the BBB- NIM. Such a small impact can be explained by Figure 8, which shows the small proportion of penalty cash flows relative to total residual cash flows (and, therefore, NIM cash flows in the front end). However, at lower penalty collection rates, the NIM takes on more prepayment leverage. As an extreme example, at a 50% penalty collection rate and 150% of the base case prepayment assumption, the BBB NIM earns sub-LIBOR returns.

IMPACT OF COLLATERAL AND UNDERLYING SECURITIZATION SEASONING

The previous analysis simulated a situation in which a NIM and the underlying securitization are executed simultaneously. It is always possible, though, to issue NIMs after a transaction has seasoned. Given the recent growth in the NIM market and the large amount of securitized HELs currently outstanding, the potential issuance from seasoned securitizations is substantial. Our analysis shows the impact of increased seasoning on a NIM securitization to be significant, with the NIM becoming much more leveraged to the credit performance of the collateral. As a deal seasons, the NIM size for a given credit rating decreases, reflecting the fact that seasoning exposes a NIM to higher losses earlier in its life. Mechanically, this is captured by the rating agency loss curves, which are based on deal age. In our analysis, we illustrate the effect of seasoning by assuming that the NIM is issued six

Figure 18. Sensitivity to Prepayment Penalty Collection Rate, spread bp

50% 350 376 60% 353 379 70% 355 382 80% 357 385 90% 359 388 100% 361 391

BBB NIM BBB-NIM

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months after the underlying securitization. This reduces the size of the BBB NIM from 6.5% to 5.9%, which somewhat mitigates the credit leverage of the security. Nonetheless, as shown in Figure 19, the seasoned NIM remains much more leveraged compared with a NIM completed at the same time as the underlying securitization. We would expect NIMs from seasoned securitizations to trade at wider levels relative to NIMs from newly issued underlying securitizations, in spite of their similar ratings. On the other hand, seasoned NIMs benefit from the increased visibility of collateral performance. That is to say, performance history, even as little as six months worth, can provide insight into future collateral performance. In contrast, investors in NIMs from new securitizations must rely solely on origination data to project collateral performance.

TRIGGERS
The impact of performance triggers varies greatly from deal to deal. However, it is generally the case that failed triggers cause principal payments to be directed toward the more senior securities, prevent stepdown of the O/C target, and, in certain cases, cause the O/C target to increase. The consequent reduction in residual cash flow may or may not affect the NIM, depending on the timing of the failed trigger. To the extent that trigger failure occurs late in the NIMs life, the impact will be minimal. This is similar to the impact of back-end loss stresses, which we discussed previously. In our example, the underlying securitization is structured with a delinquency trigger based on a multiple of the senior enhancement percentage. This trigger affects the residual cash flow only after month 36, when the NIM is expected to be paid off.

MORTGAGE INSURANCE
The effect of mortgage insurance (MI) on both the underlying securitization and the NIM is significant. MI affects the subordination levels in the underlying securitization and the sizing of the NIM, as well as the expected losses on the

Figure 19. Impact of Seasoning on Loss Sensitivity, spread bp

% of Base Case Loss Curve 200% 300% 350% 400% 360 355 358 (230) 357 299 -

100% BBB NIM New Securitization BBB NIM 6 Months Seasoned 361 361

450% (16) -

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collateral pool. (For a more detailed explanation of the mechanics and effects of MI, refer to our February 12, 2001, MBS & ABS Weekly Outlook.) We can make the following generalizations regarding the impact of MI: NIMs structured from an underlying securitization that does not have a significant amount of MI coverage will be sized much smaller. In order for the NIM to begin cash flowing immediately, a non-MI structure would likely have to include an upfront O/C deposit. While the cost of the MI premium reduces excess spread in the NIM structure, non-MI NIMs are generally more leveraged to loss rate assumptions.

The increased loss leverage can be viewed most clearly in the dynamics of the full residual (shown in Figure 20). In this analysis, the MI and non-MI residuals were priced at constant yield under base case defaults, as well as up/down 1 CDR. The prices are recorded as a percentage of the base case price. Whereas the non-MI residual varies in price by over 100% for a 1 CDR stress, the MI residual varies by only 30%. This clearly demonstrates the increased loss leverage of the non-MI residual, which, in turn, would translate into increased NIM loss leverage.

RELATIVE VALUE
The previous discussion highlighted the profile differences between NIMs and standard HEL BBBs. NIMs offer relative value versus standard BBBs for the following reasons: NIMs trade at much wider spreads (swaps + 360 to 400 bp) versus BBBs (LIBOR + 190 to 200 bp), despite their shorter spread durations. However, NIMs are less leveraged to credit assumptions, all else being equal. NIMs begin cash flowing immediately, while the BBB is locked out prior to the stepdown date. As a result, NIMs are more sensitive to front-end credit stresses, while the standard BBB is more sensitive to the back end. The NIM and BBB exhibit similar performance across various prepayment assumptions. While the NIM does have more exposure to reference interest rates, embedded derivatives mitigate much of this risk under reasonable default assumptions.

Figure 20. Residual Loss Leverage

% of Base Case Price Base Case CDR +1 CDR -1 CDR 100% 53% 159% 100% 84% 116%

Non-MI Residual MI Residual

Range 106% 32%

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Rating Agency Approach

Generally speaking, the rating agency approach begins with the definition of base case loss and prepayment assumptions. These base case assumptions are then stressed and combined with predefined stresses of forward LIBOR. Moodys, for example, evaluates a yield table varying from 85% to 115% of base case prepayments and base cumulative losses +/- 150 bp (with the base case defined by the rating agency). Furthermore, Moodys ties forward LIBOR stresses to specific rating levels. For example, a Baa rating requires LIBOR to be increased by 300 bp evenly over three years, then dropped 200 bp over the next year, remaining 100 bp over the initial level. Depending on deal specifics, prepayment penalty collection, WAC drift, and trigger stresses may also be taken into account. The focus of the rating agency evaluation process is on identifying the range of scenarios for which the NIM is able to pay 100% of its principal balance. This will determine whether a given NIM size and coupon are consistent with a particular rating level. Based on our previous discussion, larger NIM sizing and higher coupon rates will generally cause a NIM to have a longer average life and, consequently, more exposure to changing loss and prepayment assumptions. The rating agency evaluation is consistent with this conclusion, as these NIMs will generally demonstrate weaker profiles across the agency-defined stresses.

BBB- NIMs are clearly more leveraged to credit assumptions than their BBB counterparts. In Figure 21, we have defined the zero spread loss multiple to be the multiple of our base case loss curve at which the NIM yield is flat to the swaps curve. Under our assumptions, the BBB breaks at approximately 450% of the base case loss curve, while the BBB- breaks at approximately 350%. However, the investor is compensated in spread, with approximately a 30 bp pickup in our example. In the CMBS subordinate market, BBB/BBB- spreads are currently roughly 40 bp and have ranged from 25 to 60 bp historically. While the CMBS subordinate is a longer-duration asset, a BBB/BBB- nominal spread difference of 30 bp appears to represent fair value in the HEL NIM market. BBB seasoned NIMs exhibit incremental credit leverage relative to BBB- NIMs from unseasoned securitizations. In Figure 21, we have included the loss multiple of the 6-month seasoned NIM discussed previously, as well as a 12-month seasoned structure. Based on our analysis, six months of seasoning is roughly equivalent to a give of 60-70 percent in loss coverage. As discussed above, the relationship between the BBB/BBB- unseasoned NIMs equates to a 100 percent reduction in loss coverage being valued at 30 bp in nominal spread. Based on this relationship, we estimate that seasoned NIMs should trade approximately 20 bp wider for every six months in seasoning relative to unseasoned NIMs with an initial rating one notch lower.

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Lehman Brothers

Figure 21. NIM Loss Coverage

Zero Spread Loss Multiple (%) 450 350 290 220

BBB NIM BBB- NIM BBB 6 mo. Seasoned NIM BBB 12 mo. Seasoned NIM

CONCLUSION
Todays NIMs are structured to a shorter average life and, therefore, are less leveraged to credit assumptions compared with those issued in the past. In addition, many of these NIMs benefit from mortgage insurance, prepayment penalties, embedded derivatives, and O/C holidays/upfront O/C, all of which reduce uncertainty. Investors should focus on loss, prepayment, and reference interest rate risk characteristics in evaluating particular NIM securities. Loss exposure, which is generally the most significant risk to the NIM, is largely concentrated in the front end of the default curve. NIM investors are offered a degree of protection due to structural lags in the foreclosure process, which will remain in place even as other risk factors, such as economic uncertainty, increase. At current levels, BBB NIMs offer relative value to standard BBB securities from the same underlying securitization. We expect the market for NIM securities to expand as investors recognize the advantages of taking HEL credit exposure in the front end of the loss curve.

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APPENDIX: DETAILED BASE CASE ASSUMPTIONS

Default Vector
CDR, %
12

0 0 12 24 36 48 60

Deal Age (Months)

Recovery rate = 15% for all loans. Prepayment Vectors (without Prepayment Penalties)*
CPR, %
70 60 50 40 30 20 10 0 0 12 24 Loan Age (Months) 36 48 Fixed ARMs 2 28 3 27

*Loans with prepayment penalties prepay at 70% of the respective vector during the penalty period, and 100% of the vector after the penalty expires.

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LIBOR Rates, As of March 2, 2001

Rate %
8

4 1-Mo. LIBOR 6-Mo. LIBOR 2

0 0 30 60 90 120 150 180 210 240 270 300 330 360

Month