The Securitization Conduit VOL. 1, N O.

3, 1998
http://www.asset-backed.com

MBS Structuring:
Concepts and Techniques
Sunil Gangwani
Deloitte & Touche LLP
Innovations and increasing complexity in mortgage-backed securities warrant a thorough
understanding of the nuances behind these securities. This article will provide a background for
modeling and analyzing mortgage-backed securities. In particular, the three most popular structures
used in todays markets to issue mortgage-backed securities will be discussed. Reference is made to
Norwest Asset Securities Corporation (NASCOR) 1998-28 Trust and Structured Asset Securities
Corporation (SASCO), Series 1998-3 in the context of shifting interest and senior subordinate
over-collateralized structures, respectively.

time in favor of internal credit enhancement because of

the inherent risk of reliance on the credit rating (subject
to possible downgrades over time) of the third party. The
internal credit enhancement is provided by prioritizing
cash flows from a pool of mortgages to support certain
classes of MBS.
In this article, certain concepts and techniques of
mortgage loan securitization will be explored.
Specifically, the ideas behind prepayment and default
analysis on mortgage loans are discussed to assess the
final impact on MBS. The discussion will focus first on
mortgage loans, and second on the three most popular
MBS structures: shifting interest, monoline-wrapped
(insured) and senior subordinate over-collateralized.
One might ask which structures are generally better
performing? The class B certificate in a shifting interest
deal or the class B certificate in an over-collateralized
deal? There is no straightforward answer to this question.
It depends on many factors including, but not limited to:
(a) the issuers historical prepayment and default
performance, (b) the quality of the underlying mortgage
loans (such as loan-to-value ratio and geographic

I. BACKGROUND
Credit risk analysis of mortgage loans in a mortgage
securitization is performed to assess the probability of
default of the underlying mortgage loans. Credit rating
agencies such as Standard & Poors, Moodys, Fitch
IBCA and Duff & Phelps, assist issuers of mortgagebacked securities (MBS) to determine the optimal
credit enhancement levels, and thus the credit rating, for
securities based on (a) the default risk assessment and (b)
the nature of cash flows to MBS. The primary factors that
are considered in assigning a credit rating to MBS (and
hence assessing the probability of timely payment of
interest and principal) are as follows: the type, term, size,
age, loan-to-value ratio of the underlying mortgage
loans; and the dispersion of certain factors such as
property location. All these factors converge into one
single concept called credit enhancement. In the late
1980s and early 1990s, this credit enhancement was
provided by third party corporate guarantees, letters of
credit, reserve funds and pool insurance (external credit
enhancement). However, their use has declined over

26

Exhibit 1. Scheduled Payments

700
600

Amount

500
400

Principal

300

Interest

200
100
336

306

275

245

214

183

153

122

92

61

32

0
Period

concentration) and (c) investor preferences. This article is

not intended to suggest the relative value of one class of
MBS over the other. Instead, it is intended to set forth
some concepts and techniques, so readers may make their
own assessment of value in MBS.
II. MORTGAGE LOANS
The building blocks of MBS are the mortgage loans
secured by residential properties. The interest rate on
mortgages is typically higher than that of comparable
U.S. Treasuries, to reflect the uncertainty of cash flows,
poorer liquidity, borrowers ability to prepay and costs
associated with liquidating a loan in the event of default.
Over a period of time, many different types of mortgage
products have evolved. Among them are fixed rate
mortgages (FRMs), adjustable rate mortgages
(ARMs), balloon mortgages and graduated payment
mortgages (GPMs). Each mortgage loan in a MBS
may have a different interest rate, because its tenor may be
different (e.g. 15 years versus 30 years) or the borrower
characteristics may be different (e.g. more creditworthy
borrowers with higher credit scores may receive lower
interest rates) and so on. All mortgages produce a stream
of monthly payments that include the monthly interest
and scheduled principal repayment. The next few
sections describe the essential cash flow characteristics of
mortgages.
A. Amortization Schedules
The monthly payment (Pmt) of a fixed rate mortgage
loan is calculated to fully amortize the borrowed amount
by maturity (equation 1), except for balloon loans where
the monthly payment is smaller than the amount
required to fully amortize the loan. This smaller payment

in balloons slows amortization and increases the risk in a

securitization arising from a borrowers potential
inability to refinance a mortgage at the end of the balloon
term.
Pmt =

PV * i/12 * (1 + i/12)
(1 + i/12)

(1)

The monthly payment is first allocated to the interest

on the outstanding balance and then to the scheduled
principal to reduce the outstanding balance of the
mortgage loan. The allocation of the scheduled principal
and the interest components of the monthly payment is
shown in Exhibit 1.
Adjustable rate mortgage loans are amortized as
described above except that the interest rates are subject
to certain caps and floors. Generally, interest rates on
ARMs reset periodically (monthly, semi-annually,
annually. . .) based on an index plus a margin. Typical
indices are COFI, Prime, LIBOR and Treasury.
Payments also reset periodically, although the periodicity
of the payment adjustment may not be the same as that of
the interest adjustment. There are four constraints on
ARMs: (a) lifetime cap, (b) lifetime floor, (c) periodic cap
and (d) payment cap. Lifetime caps and floors set a
maximum and minimum interest rate over the life of the
mortgage loan irrespective of current index levels. The
periodic cap limits the change in the coupon from one
period to the next on specified dates called interest rate
adjustment dates. In most cases, depending on the
underlying index on which ARMs reset, the periodic cap
is 1.00%, 1.50% or 2.00%. A payment cap, usually 7.5%,
is the maximum percentage by which the monthly
payment can change. Another point to keep in mind
about ARMs is negative amortization. The payment caps

The Securitization Conduit VOL . 1, NO. 3, 1998

27

Exhibit 2. Prepayments
1600
1400

Amount

1200
1000

250% PSA

800

15% CPR

600
400
200
336

306

275

245

214

183

153

122

92

61

32

0
Perio
together with unequal frequency of adjustment of
interest rates and monthly payments can give rise to
negative amortization, which means that the monthly
payment is not enough to cover interest for that month,
let alone scheduled principal. In this case, the portion of
accrued and unpaid interest is added to the principal
balance of the mortgage loan.
GPMs are characterized by escalating monthly
payments. This product was introduced to serve
borrowers who could not afford a high monthly payment
associated with a FRM. Borrowers are allowed to make a
smaller payment for the first few years, after which the
payment is gradually increased every year for some time.
Both ARMs and GPMs are of concern for MBS investors
because they are frequently made to less creditworthy
borrowers.
B. Prepayment Modeling
Because most borrowers are allowed to prepay their
mortgage balance in full or in part at any time, MBS are
priced with certain prepayment assumptions on the
underlying mortgage loans. How does one forecast
prepayments for MBS? The estimation of prepayments
has become increasingly important to determine the
appropriate market valuation of MBS. The historic
prepayment experience of an issuers pool of mortgages
impacts current prepayment estimates, which further
affect the investment characteristics of the securities such
as average life, duration, convexity, etc. through
contracting (Call risk) or extending (Extension risk)
the term of MBS. At pricing, a certain prepayment rate is
assumed and, in the future, if the prepayment rate falls
below such assumed rate, extension risk arises; the
average life of the MBS becomes longer than previously
anticipated. Defaults and subsequent liquidations also

28

constitute a form of prepaymentsalbeit involuntary.

The prepayments that are passed through to MBS in a
securitization transaction generally result from (i)
voluntarily prepaid amounts which include fully or
partially paid principal amounts, (ii) liquidation
amounts arising from foreclosure and subsequent sale of
the properties and (iii) disqualified loan amounts. It is
important to keep in mind that most prepayments are
full prepayments and are generally a result of
refinancings by borrowers, which are caused by low
interest rates in the economy. Other causes of full
prepayments include turnovers due to personal
reasons such as moving to a different location, moving to
a bigger house, divorce, etc. Partial prepayments may be
caused by a variety of reasons such as a borrower having
some extra cash. However, because of the insignificant
nature of most partial prepayments, they are generally
embodied in the prepayment rate assumptions so as not
to change the amortization schedules.
The end result of the prepayment analysis is to come up
with expected prepayments in a unit of measurement that
investors understand and can use to compare different
underlying pools of collateral. There are at least two
prepayment models that are used for mortgage related
securitizations: (a) constant prepayment rate (CPR
used for FRMs and ARMs) and (b) Public Securities
Association (PSA used for FRMs). Inherent in each
model are the following very important assumptions for
the purpose of projecting cash flows: (a) prepayments are
principal payments made in full, (b) prepayments are
made at the end of the month and (c) there are no
prepayment interest shortfalls.
CPR is the most commonly used unit of measurement
for prepayments. It is an annualized prepayment rate. A
prepayment speed is expressed annually, therefore, it has
to be converted to a monthly equivalent called single

Gangwani

Exhibit 3. PSA
16

Speed (% CPR)

14
12

50% PSA

10

100%PSA
250%PSA

8
6
4
2
169

155

141

127

113

99

85

71

57

43

29

15

0
Period

monthly mortality rate (SMM). SMM is the

percentage of mortgage loans outstanding that are ready
to be prepaid at the end of a period. Equation (2) shows
the link between SMM and CPR.
SMM = 1 - (1 - CPR)

(1/12)

(2)

Note that SMM is not equal to CPR/12 because the

balance (Bal) to apply the prepayment rate to is the
balance after scheduled amortization (Sch), which is
decreasing with time. This point is stated in equation 3.
Prepays = (Bal
Sch ) * (SMM )
n
n -1
n
n

(3)

Exhibit 2 displays the principal and interest payments

from a mortgage loan at 15% CPR. Note that the
principal payments at 15% CPR are front loaded as
compared to 0% CPR.
The PSA curve is a series of annualized prepayment
rates and is dependent on the seasoning of the mortgage
loans, whereas the CPR model is a constant rate at any
time. The PSA curve assumes that the prepayments will
be slow in the beginning, then increase on a straight-line
basis until month 30 and, thereafter, stay constant at
6.0% CPR. 100% PSA means 0.20% CPR in the first
month of the mortgage loan following the origination,
0.40% CPR in the second month and so on until the
prepayment rate peaks at 6.00% CPR as shown in Exhibit
3.
Exhibit 2 also displays principal payments at 250% PSA
for comparison purposes. Note the upward curve
indicating increasing prepayments up to month 30.
Exhibit 4 shows the structure of NASCOR 1998-28
and Exhibit 5 shows the cash flows at a prepayment speed

of 375% PSA. Note that assumed mortgage loans were

used to project the cash flows, which is typical with most
issuers and underwriters. The entire mortgage loan pool
is condensed into a few representative mortgage loans
popularly known as rep lines. These representative
lines of collateral are produced very categorically starting
with the type of mortgage loan (e.g. one-year Treasury,
and LIBOR ARMs and FRMs) followed by groupings of
the stated maturity of each mortgage loan.
C. Default Modeling
Before a loss on a mortgage loan is actually incurred
and transferred to the MBS holder, the mortgage loan is
classified into four different categories.
Current -> Delinquent (30, 60 & 90 days) ->
In foreclosure -> In liquidation
During the delinquency period the borrower is not
making any scheduled mortgage payments. This period
can last a few months, after which the servicer is usually
required to initiate the foreclosure process. The exact
timing of foreclosure is dependent upon the laws of the
state in which the property is located. As time progresses
and the mortgage loans become seasoned, borrowers
generally have less incentive to be delinquent, because
they have built substantial equity in the property and
would stand to lose significantly if the mortgage loan
goes into a foreclosure. In addition, foreclosure and
eviction carry financial and social stigma that a long-term
homeowner attempts to avoid.
Exhibit 6 shows equity build-up in NASCOR 199828. If the borrowers are in financial distress in the third or
seventh year of the loan, they may be better off protecting
their equity of 23% or 27% by any means available to

The Securitization Conduit VOL . 1, NO. 3, 1998

29

Exhibit 4. NASCOR 98-28 Deal Structure

Class
Seniors
A-PO
B-1
B-2
B-3
B-4
B-5
B-6

Balance
$503,688,100
$312,347
$5,716,000
$5,975,000
$1,299,000
$1,299,000
$779,000
$520,231

Loan Type

Balance

Discount
Premium

Coupon
Subordination Avg. Life
6.000%
97.000% 4.56
0.000%
97.000% 4.76
6.000%
3.000% 9.64
6.000%
1.900% 9.64
6.000%
0.750% 9.64
6.000%
0.500% 9.64
6.000%
0.250% 9.64
6.000%
0.100% 9.64

Price

WAM
(Age)
6.1687%
0.2670%
359
6.8083%
0.2670%
358
First Pay: 11/25/98

WALA
(term)
1
2

Gross Rate

$19,073,603
$500,515,075
Settlement: 10/28/98

Servicing Fee

*
*
94.75
93.50
90.50
70.00
59.00
30.00

Exhibit 5. Amortization Schedule at 375% PSA (NASCOR 98-28)

1
2
3
4
5
6

519,588,678
518,167,109
516,415,035
514,333,257
511,923,203
509,186,933

2,822,156
2,814,430
2,804,908
2,793,596
2,780,500
2,765,633

Scheduled
Principal
450,118
451,816
453,230
454,354
455,184
455,716

37
38
39
40
41
42

309,487,264
302,649,743
295,961,083
289,418,076
283,017,581
276,756,526

1,680,893
1,643,757
1,607,430
1,571,894
1,537,133
1,503,128

340,170
334,903
329,717
324,612
319,586
314,637

6,497,350
6,353,757
6,213,290
6,075,883
5,941,469
5,809,984

8,518,413
8,332,417
8,150,438
7,972,389
7,798,187
7,627,750

355
356
357
358
359
360

9,690
7,155
4,710
2,352
78
-

53
39
26
13
0
-

2,381
2,344
2,308
2,272
78
-

154
101
50
2
-

2,587
2,484
2,384
2,286
78
-

Month

Balance

Interest

Prepaid
Principal
971,452
1,300,257
1,628,549
1,955,701
2,281,086
2,604,072

Total
Cash
4,243,726
4,566,503
4,886,686
5,203,650
5,516,770
5,825,422

Exhibit 6. Equity Build-up (NASCOR 98-28)

Equity (Beg. 20%)

120
100
80
60
40
20

Period

30

Gangwani

336

306

275

245

214

183

153

122

92

61

32

Exhibit 7. SDA
0.016

Speed (% CDR)

0.014
0.012

50% SDA

0.01

100% SDA

0.008

250% SDA

0.006
0.004
0.002
336

306

275

245

214

183

153

122

92

61

32

0
Perio
them rather than allow the servicer to liquidate the
mortgage loans at what might be fire-sale prices. In any
case, if the mortgage loan is liquidated and assuming the
property value did not decline, there would have to be
significant losses on the sale to affect the investors in MBS
in those later years. Empirical research shows that most
losses occur between years 2-7. ARMs and GPMs show
the worst results because borrowers are more prone to
rate and payment increase shocks and are therefore more
vulnerable to defaults.
Like prepayments, there is no single way to forecast
and project defaults. Different issuers and underwriters
account for defaults in different ways based on their
modeling capabilities and their views of the mortgage
market. The Standard Default Assumption (SDA)
model was developed by The Bond Market Association
to provide a standard primarily for 30-year fully
amortizing FRMs. SDA was not designed to be used for
balloon mortgages, ARMs or 15-year FRMs. However,
many analysts do use SDA for these types of mortgage
products for lack of better models. SDA assumes that the
default rate will be 0.02% per annum of the outstanding
balance of the mortgage loans in the first month after
origination and will increase at a rate of 0.02% per annum
per month until it reaches 0.60% per annum in the
thirtieth month. The default rate tends to be low in the
early years because if the borrower were not qualified
he would not have been approved for a mortgage loan.
And qualified borrowers are not expected to default
immediately. The default rate stays constant until the
sixtieth month. After sixty months, it starts to decline at
the rate of 0.0095% per annum per month until it reaches
0.03% per annum when it stays constant for the
remainder of its life. Exhibit 7 depicts the variation of
default rates with the age of the mortgage loans in a pool.
Another measure of defaults is Constant Default Rate

(CDR) which is expressed as an annualized percentage

of mortgage loans that go bad in a pool. The concept is
the same as that of CPR for prepayments. A point to note
is that when a mortgage loan goes into default, it takes
several months for the servicer to actually foreclose on the
property and liquidate the mortgage. For analytical
purposes, it is generally assumed that the time to
liquidation is 12 months for residential mortgages.
During the recovery period for such loans, it is often
assumed that the servicer will advance the scheduled
principal and interest payments on the defaulted loans. A
loss severity percentage, which is equal to the percentage
of the outstanding balance of the loan which is not
recovered, is assumed to have taken into account all costs
associated with the foreclosure as well as the repayment of
advances as described below.
D. Compensating Interest and Servicer Advances
Another factor that needs attention is the
compensating interest. The scheduled mortgage
payments include 30 days of interest on the previous
months balance. However, if borrowers were to prepay
fully on the 16th , they are obligated to pay only 15 days of
interest, resulting in a shortfall of interest to MBS. This
shortfall is usually allocated in a pre-determined priority
in multi-class MBS structures. Some issuers require the
servicer to cover such interest shortfall, but only up to an
amount equal to the aggregate servicing fee due that
period. Curtailments (partial prepayments) also result in
interest shortfall that is generally allocated to MBS. The
servicer does not have to cover such shortfalls in all cases.
Some issuers such as Countrywide, IndyMac and General
Electric Capital (GE Cap) will require the servicer to
compensate for such shortfalls while others such as
NASCOR and Residential Funding Corporation

The Securitization Conduit VOL . 1, NO. 3, 1998

31

(RFC) will allocate such shortfalls to the MBS.

In addition to compensating interest, servicers are also
required to advance scheduled payments of principal and
interest for delinquent mortgage loans until they are
cured or until foreclosure procedures begin. Some
discretion is allowed. The servicer essentially loans money
from its own account to the trust. When the delinquent
mortgage loan is eventually foreclosed, the servicer is
reimbursed from the liquidation proceeds before any
funds are remitted to the trust. The forms of advancing
vary from mandatory to optional. Most transactions
do have some form of advancing. The servicer can
exercise some discretion in advancing funds, in that if it
deems the funds will be unrecoverable, it may not
advance. The effect of advancing is to smooth out the
cash flows to the MBS. Some issuers who require
mandatory advancing are Countrywide, IndyMac,
NASCOR, SASCO, and RFC. In transactions where a
master servicer is present, it will often act as a back-up
servicer for advancing.
III. CREDIT TRANCHING
Most MBS carry a credit rating from one or more of the
top four rating agencies. The credit rating on an MBS
indicates the likely protection investors in such MBS
have from losses on the underlying mortgage loans. A
good rating also implies an expectation of timely
payment of interest and principal on the MBS. If one has
a pool of mortgage loans, it is very unlikely that such pool
will be AAA rated in its entirety. How can one be
creative enough to carve out a portion from this pool of
assets to make that piece likely to receive timely interest
and principal payments (at the expense of the other
portion)? Both rating agencies and issuers work towards
the goal of carving out the maximum amount of such
pieces by analyzing the quality of the collateral and
specifically studying the historical losses of similar pools
of mortgage loans. The result is the creation of many
securities with credit grades ranging from AAA, AA
and A to the unrated first-loss piece. In this way,
AAA is credit enhanced by AA and AA is credit
enhanced by A and so on. Any losses are first borne by
the lowest rated security.
In the mid 1980s, a self-enhanced (internal credit
enhancement) structure to prioritize cash flows was
developed and was appropriately named the SeniorSubordinate (Sr-Sub) structure. The Sr-Sub
structure creates at least two classes of securities. The
senior class, which is generally AAA or AA rated, has
priority in payment of interest and principal over the
subordinate class. The subordinate class, also referred to
as the first-loss piece, absorbs any losses arising from

32

defaults. Because of the priority of distributions over the

subordinate class, the senior class receives a higher credit
rating. It is important to note that the level of
subordination alone does not determine the credit rating
of the senior class. Primarily, it is the quality of the
underlying mortgage loans that sets the precedence for a
credit rating. For example, for a high quality pool of
mortgage loans, one might obtain a 96% AAA senior
class, whereas from a poorer quality pool one might only
obtain 70%. The subordination provides protection in
addition to the natural protection against losses
provided by the quality of the mortgage loans.
The Sr-Sub structure, with certain twists such as
shifting interest and over-collateralization, allocates a
disproportionate amount of principal to the senior class.
In such structures, the principal cash flows are prioritized
for the senior class to provide it with increased
protection. In a 96%/4% Sr-Sub ratio, if 2% of the
principal was returned and allocated entirely to the senior
class, the new split after such allocation becomes 95.9%/
4.1%, resulting in the addition of 0.1% more credit
support from the previous period. Why is there a shift
devised in the context of MBS? This is best explained by
the fact that most of the good mortgage loans in a pool
prepay in the early part of their life whereas the bad
mortgage loans representing higher credit risk in a pool
continue to pay only the contractual payments.
Borrowers backing bad mortgage loans perhaps cannot
raise more cash to prepay or do not have the ability to
refinance in a declining interest rate environment. The
accelerated reduction in the pool balance caused by mere
prepayments does not actually reduce the credit risk. In
fact, on a percentage basis it increases such risk for the
senior class. In order to compensate for the increased
percentage of bad mortgage loans in the pool,
principal cash flows are moved away from the subordinate
class to the senior class, which receives all or a
disproportionate share of the principal collections.
Taking this concept further in time somewhat changes
the story. All mortgage loans in a seasoned pool might
be considered to be good mortgage loans because the
borrowers have already made a series of regular monthly
payments and have built significant equity in the property
(and therefore have less incentive to default).
The following three sections describe three popular
structures for mortgage securitizations.

A. Shifting Interest Structure

This is one of the classic structures that were devised to
credit tranche a securitization. In this structure, the
subordinate class share of prepayments is allocated to the

Gangwani

Consider the structure for NASCOR 1998-28 in

Exhibit 4 with a Sr-Sub ratio of 97 to 3. The senior
percentage includes the ratio-stripped class A-PO. Since
class A-PO is rated AAA, it has priority of principal
payments from the discount loans. The principal
payments from (a) the premium loans and (b) the nonPO portion of the discount loans are made available to
the other classes. The non-PO principal distribution
amount (PDA) is calculated as follows:

Exhibit 8. Shifting Interest Step Down Percentages

FRM

ARM

Years

Shifting %

Years

Shifting %

100%

10

100%

70%

80%

60%

60%

40%

40%

20%

20%

Maturity

0%

Maturity

0%

SrPDA = (Sch + USch ) * Sr(non - PO)%

n
n
n
n -1
+ USch * (1 Sr(non - PO)%
) * Shift%
n
n -1
n
SubPDA

senior class. The scheduled principal payments are

allocated pro-rata between the two classes. The theory
behind disproportionate allocation of principal was
explained earlier. The term shifting interest is actually
a misnomer. It is not the interest collected that is shifted
away from the subordinate class but rather principal
during times of increasing credit risk in the mortgage
pool. This shifts the subordinates percentage owned
in the principal cash flow.
The most often used shifting interest structure
allocates to the senior class, the senior class share of
unscheduled principal (voluntary prepayments and
involuntary liquidations) and a certain percentage of the
subordinate class share of unscheduled principal (which
percentage is stepped down with time as shown in
Exhibit 8). The scheduled principal is paid pro-rata to the
two classes. Note that after year 10 (for FRMs) and year
15 (for ARMs), if certain conditions are met, both classes
are paid their pro-rata share of scheduled and
unscheduled principal, so the subsequent ratio of the
senior class to the subordinate class remains constant
(absent losses allocated to the subordinate class).

= Sch

+ USch

- SrPDA

(4)

(5)

Exhibit 9 shows how the subordination level is built at

different prepayment levels both with and without losses.
The next step is to understand how losses are allocated
to these securities. But first lets recap the fact that credit
support afforded to the senior class comes in three forms:
(i) each period the senior class is given priority to receive
interest and principal, (ii) principal prepayments are
allocated disproportionately in favor of the senior class
and (iii) losses from foreclosures are allocated first to the
subordinate class. It would appear that issuers would like
to maximize the issuance of the senior class, and rating
agencies would like to maximize the issuance of the
subordinate class so that the ratings of the senior class are
always as good as at issuance. The whole idea in the
structural analysis is generally to favor senior securities.
However, there are at least two instances where the
subordinate class may get added priority. The first case is
when the subordinate class percentage share in the
mortgage pool becomes twice that at issuance, in which
case the step down or shifting percentage is allowed to fall
to a lower level. The second case is when there is no

Exhibit 9. Subordination Levels (NASCOR 98-28)

14
12
100% PSA

375% PSA
6

375% PSA 100% SDA

4
2
183

153

122

92

61

32

0
1

10

Perio

The Securitization Conduit VOL . 1, NO. 3, 1998

33

Exhibit 10. NASCOR 98-28

Classes B-1 through B-6
Interest to seniors, principal to seniors, interest to
subordinates and principal to subordinates (IPIP)
750% PSA

750% PSA
50% SDA

750% PSA
100% SDA

750% PSA
200% SDA

6.9

6.9

6.9

7.2

7.2

7.2

6.9
6.6

7.7

7.7

7.7

-55.9

12.4

12.4

-0.5

-94.9

15.8

-0.2

-92.8

-99.9

32.2

-98.5

-99.9

-99.9

Interest to seniors, interest to subordinates, principal to

seniors, and principal to subordinates (IIPP)
750% PSA

750% PSA
50% SDA

750% PSA
100% SDA

750% PSA
200% SDA

6.9

6.9

6.9

6.9

7.2

7.2

7.2

6.6

7.7

7.7

7.7

-55.8

12.4

12.4

-0.5

-94.5

15.8

-0.2

-92.4

-99.9

32.2

-97.9

-99.9

-99.9

interest subordination. Typically, the senior class is

structured to receive prioritized interest and principal
before any cash is distributed to the subordinate class
(interest subordination). However, a handful of
mortgage securitizations are structured to prioritize
interest to the subordinate class before distributing any
principal to the senior class. The order of priority of
interest and principal can determine the potential return
to the investors in the lower-rated subordinate classes. In
essence, there are two types of priorities: (a) interest to
seniors, interest to subordinates, principal to seniors and
principal to subordinates (IIPP) and (b) interest to
seniors, principal to seniors, interest to subordinates and
principal to subordinates (IPIP). If the loss allocation
is limited by the recoveries (or a fraction thereof), the
cash flows to the subordinate class are practically
undisturbed in both IIPP and IPIP methodologies.
However, the loss allocation based on the liquidated
balance (or a fraction thereof) coupled with the IPIP
payment priority can cause severe cash flow shortfall to
the subordinate class. NASCOR 1998-28 is based on
IPIP methodology. If it were based on IIPP, the yield to
maturity of subordinate classes would be impacted in
certain scenarios as shown in Exhibit 10. The difference
is minimal to the higher rated classes.
Irrespective of the type of structure, it makes sense to
protect the senior class or the next higher rated class from

34

any losses. The senior class is protected from shortfalls

and losses at the expense of the subordinate class. So the
losses, when realized, are allocated to the subordinate
class or the lowest rated class outstanding at the time.
When losses occur, the allocation of recovered principal
to the senior class can be calculated in one of several ways:
(a) as the senior prepayment percentage of recoveries
(e.g. NASCOR), (b) as the lesser of (i) the senior
prepayment percentage of recoveries and (ii) pro-rata
share of liquidated balance (e.g. GE Cap, ABN AMRO
Mortgage Corporation and Countrywide), (c) as the
lesser of the (i) recoveries and (ii) senior prepayment
percentage of liquidated balance (e.g. SASCO), (d) as
the pro-rata share of liquidated balance and (e) as the
lesser of the (i) senior prepayment percentage of
recoveries and (ii) senior prepayment percentage of the
lesser of (x) recoveries and (y) liquidated balance (e.g.
Bank of America). The subordinate class receives any
remaining principal amount. To the extent the principal
collected is insufficient to pay the allocated principal, the
subordinate class is written down until its principal
balance is reduced to zero. Once the subordinate class is
reduced to zero, the realized losses are allocated to the
senior class (pro-rata to multiple senior tranches). If the
balance of the subordinate class is written down
completely it is seldom written back up except in certain
type of structures as described below.
As mentioned earlier, before any losses are realized,
mortgage loans go through periods of delinquency,
foreclosure and liquidation. If delinquencies are rising in
a pool, it represents a warning for future losses. The loss
and delinquency triggers prevent credit support from
stepping down in a deteriorating collateral performance
environment. After a certain threshold of delinquencies,
principal payments due to the subordinates are diverted
to the seniors. Some issuers (e.g. NASCOR) are
conservative and will require absolutely no principal
payments to be distributed to the subordinate class, while
others (e.g. SASCO) will allow the pro-rata share of
scheduled principal payments and none of the
prepayments to be distributed to the subordinate class.
Two tests are performed each period when delinquencies
and realized losses exist in a mortgage pool. The first test
is based on 60+ day delinquency. If the average (rolling
or summation) delinquent balance over a given number
of months is greater than 50% of the credit support
provided by the subordinate class, then the step down or
shifting of prepayments in favor of the subordinate class
does not take place. The second test is based on the
cumulative realized losses. It states that the cumulative
realized losses as a percentage of the original pool balance
must not be more than a certain percentage (usually,
30%, 35%, 40%, 45% or 50% on each shifting interest

Gangwani

Exhibit 11.
NASCOR 98-28 Approximate Maximum SDA
Class

100% PSA

375% PSA 750% PSA

B-6

10 SDA

15 SDA

25 SDA

B-5

25

35

65

B-4

45

70

125

B-3

65

105

190

B-2

160

270

500

60 % Recovery
0 Month Lag

date) of the credit support. Another fact incorporated

into deals such as NASCOR 1998-28 structures is that if
the senior percentage at any time rises to more than the
initial senior percentage, 100% of the prepayments are
allocated to the seniors.
Here is some more common sense. The smaller the
subordinate class, the more leveraged it is. In other
words, it is more likely to get wiped out quickly for the
same amount of losses. By the same token, the smaller the
size of the senior class the higher the prepayment risk for
such class. The same amount of prepayments will be
allocated to the smaller senior class thereby creating
leverage. Exhibit 11 shows the approximate threshold of
cumulative losses before each subordinate class is wiped
out in NASCOR 1998-28.
B. Monoline Insured Structure
In the mid to late 1990s, an increasing number of new
home equity lenders adopted this structure for a number
of reasons, the foremost being the ability to issue AAA
investments. A slightly higher fee and a viable structure
were all that was needed to obtain funding from the
capital markets for such issuers. Generally, monoline
insurance companies such as Municipal Bond Insurance
Corporation (MBIA), Financial Security Assurance
(FSA), Financial Guaranty Insurance Corporation
(FGIC) and Ambac Assurance Corporation
(AMBAC) guarantee timely payment of interest and
ultimate return of principal for a certain class of bonds.
Rating agencies rate these bonds as AAA (or the rating
of the insuring entity) based on the claims-paying ability
of the monolines. Depending on the quality and type of
collateral, the fee charged by monolines can vary from
approximately 8 basis points (bps) to over 50 bps. A
typical monoline wrapped structure will have a single
class of security credit enhanced first by the excess cash
flow in the transaction and then by the insuring entity.
In a monoline-wrapped securitization, the underlying
mortgage loans generate higher coupon income,

compared to the coupon on the liabilities. The difference

between the asset income and liability is called excess
spread. This excess spread is trapped in the deal by way
of paying down more principal on the bonds than is
actually received on the collateral, thereby creating
overcollateralization (OC). To simplify matters, lets
assume the net weighted average coupon (WAC) on
the collateral is 11% and the WAC on the bonds is 7%.
The difference between the two, which is 4%, is called the
excess spread or net interest margin (NIM). This
difference is akin to a WAC IO strip. This excess cash flow
can be (a) used to cover any losses on the underlying
collateral, (b) used to pay down the bonds faster than the
collateral or (c) released to the issuer in the form of
residual cash flow. The required OC varies from deal to
deal and is dependent on the riskiness of the collateral
and the past performance of the issuer. ARMs and GPMs
may have higher targeted OC requirements than FRMs
to account for the higher risk associated with interest and
payment shocks to borrowers. All the excess cash flow is
used to pay down the bonds until the step down date. If
certain conditions are met, the step-down date occurs at
the later of the 30th month (or starting in the 24th month
and decreasing in steps up to the 30th month) or when the
current OC level is twice the original level. In effect, if the
original required OC was 3.0% of the original balance,
the current OC must be at least 6.0% of the current
outstanding balance for the transaction to step down
(which means the deal has paid down to 50% of the
original balance).
There are delinquency and cumulative loss triggers
that affect the step down date in such securitizations.
Monolines have certain controls that dictate whether the
step down should occur if performance of the collateral
deteriorates. If the step down does not occur, amounts
that would have otherwise been distributed to the
residual holder are paid as principal to the senior class
holders. The next section describes the actual application
and thresholds in a structure somewhat similar in concept
to the monoline wrapped structure.
C. Senior Subordinate OC Structure
In the early part of 1997, the Senior-Subordinate
structure with OC (Sr-Sub OC) was introduced in the
mortgage market. Since then, this structure has rapidly
rivaled the monoline-wrapped structure. Like monolinewrapped structures, (most) Sr-Sub OC structures also
provide for an overcollateralization to be built over time
by using excess cash flow. The excess cash flow is used in
the form of principal to pay down the bonds in a predetermined order of priority thereby building the OC.
The Sr-Sub OC structure differs from monoline-

The Securitization Conduit VOL . 1, NO. 3, 1998

35

Exhibit 12. SASCO 98-3 Deal Structure

Coupon

Target
Subordination

Class

Balance

Avg. Life

A-1

$296,914,000 5.7500%

A-2

$296,913,000 5.9375%

49.2%

6.28

100.00

M-1

$95,028,000 6.1875%

24.5%

8.02

100.00

M-2

$50,029,000 6.4875%

11.5%

7.90

100.00

$30,787,000 6.8375%

3.5%

7.50

100.00

49.2%

Settlement: 3/30/98

Price

1.03

100.00

First Pay: 4/25/98

Exhibit 13. Senior Paydown (SASCO 98-3)

90

9% CPR

80

35% CPR

70

18% CPR 5% CD

60
%

50
40
30
20
10
197

183

169

155

141

127

113

99

85

71

57

43

29

15

Period

wrapped structure in that it is a multi-tranche selfenhanced structure. The credit support to the higher
rated classes is provided by (a) the OC and (b) the lower
rated classes.
Exhibit 12 shows the structure of SASCO 1998-3.
The initial requirement for OC was 1.75% of the initial
balance of the mortgage loans and the initial total
subordination for the senior class was 22.85%.
The step down date in this structure is the later of the
36th month or until a specified senior enhancement
percentage (49.20% for SASCO 1998-3) is met. Until
this date all principal including excess cash flow is
directed to the most senior classes in order of rating. If
the senior class pays down fully prior to the step down
date, the other classes receive principal sequentially until
the 36th month and thereafter pay down to maintain the
targeted subordination levels. These targeted subordination levels are generally twice the initial subordination
levels (including any initial required OC). In SASCO
1998-3, the initial subordination for class A was 22.85%.
The initial required OC was 1.75%, so the targeted
subordination for class A is equal to 2*(22.85+1.75)% or
49.20%. Similarly, for class M1, the targeted

36

subordination is equal to 24.5%, and so on. In a no-loss

scenario, once the targeted subordination levels are met
for each class of securities, the excess cash flow is released
to the residual holder.
Exhibit 13 shows how the senior class is paid down at
different prepayment levels both with and without losses.
Note that at 35% CPR, the senior class pays down from
approximately 77.15% to 8.75% of the outstanding
balance of the mortgage loans at the end of period 36,
after which period it is locked out for some time until the
target subordination levels for each class are met.
A small variation from the above structure is a Sr-Sub
OC structure with 0% required OC. Here, all the excess
cash flow is used to either mitigate the losses or is released
to the residual class. Realized losses that are not covered
by the excess cash flow are allocated to write down the
lowest rated subordinate class. However, in subsequent
periods if there is any excess cash left after covering
current losses, that excess cash is not released to the
residual holder but is instead used to pay down the senior
class and write up the subordinate class to the extent of
previous write downs. Saxon 1998-2 and Saxon 1998-3
were structured without any OC requirement. However,

Gangwani

the subordination levels were targeted to reach twice the

original levels for each class of security.
As mentioned in the earlier section, there are
delinquency and cumulative loss triggers that are used to
determine whether there will be a step down of OC. Most
securitizations with such structures have delinquency
triggers based on six-month rolling 60+ day
delinquencies. There are some differences in delinquency
trigger thresholds and actual application for different
grades of collateral and different structures. However, in
all cases, the triggers are periodically checked for step
down of disproportionate allocation of principal to the
outstanding senior class. The trigger is tested every
month by determining the six month rolling average of
collateral that is 60+ days delinquent (including
foreclosures, bankruptcies or REOs). This rolling
average delinquent amount is then multiplied by a fixed
number called a multiplier which varies from 1.4 2.5.
From this delinquency amount, the excess cash flow for
the prior three months is subtracted. The resulting
amount is called the net delinquency calculation
amount. If that amount is less than the target, a step
down is permitted. Generally, this target is the same as
the senior OC target.

described that build a foundation for cash flow analysis

for MBS. Specifically, we looked at the types of mortgage
loans, amortization schedules and prepayment and
default models for mortgage loans. These concepts and
techniques are all considered in determining the most
appropriate structure for the MBS. Three popular
structures were discussed herein. The actual structure
used depends on the costs associated with such structures
(e.g. monoline insurer fee, rating agency fee,
accountants fee, etc.), the current interest rate
environment and investor liquidity and duration
concerns. Ultimately, investing in an MBS should be
undertaken only after performing scenario analysis taking
into account the concepts discussed herein and views of
the economic environment.
ACKNOWLEDGMENTS
All the information herein was gathered from materials provided by
(a) the credit rating agencies: Standard & Poors, Moodys, Fitch IBCA
and Duff & Phelps, (b) The Bond Market Association and (c) various
issuers of public MBS. The author would also like to thank Allen S.
Thomas and other members of the Securitization Transactions Team at
Deloitte & Touche LLP who spent hours reading many drafts of the
manuscript and who provided many useful comments on the
manuscript.

IV. CONCLUSION
The viability of securitizations depends on the ratings
assigned to MBS. The spreads to the treasury yield curve
and prices of MBS rely on such ratings. The higher the
ratings the lower the spreads, which in turn maximizes
the proceeds or any retained excess spread in a
securitization. Ratings are assigned taking into
consideration a number of factors such as the quality of
collateral and priority of cash flow, among many others.
In this article, some concepts and techniques were

SUNIL GANGWANI is a Senior Manager in the Securitization

Transactions Team at Deloitte & Touche LLP, New York. Sunils
primary focus is the modeling and structuring of domestic and
international mortgage-backed and asset-backed transactions. Sunil has
extensive experience in performing and non-performing cash flow
transactions backed by assets such as commercial and residential
mortgages, automobile loans, equipment leases, credit card receivables,
corporate high-yield bonds, senior bank loans, tax liens and stranded
assets. Sunil has spent the last five years as a Senior Manager in the
Securitization Transactions Team, and prior to that he was a member of
the securitization group of Arthur Andersen for three years.

The Securitization Conduit VOL . 1, NO. 3, 1998

37