Mortgage Backed Securities and Credit Enhancements

Subjective Real Estate Valuation G. JASON GODDARD

Chapter 9 Outline Chapter Highlights Types of Mortgage Backed Securities Residential MBS and Subjectivity Commercial MBS and Subjectivity MBS and Investor Preference

Chapter Definitions Agency Guarantees: external credit enhancement for mortgage pools where the government explicitly or implicitly guarantees the credit offering. CDO: Collateralized Debt Obligation CMBS: Commercial Mortgage Backed Securities. Collateralized Mortgage Obligation (CMO) A mortgage-backed security that generates separate cash flows for different classes of securities called tranches. Tranches have varying loan maturities and prepayment risks and offer varying expected returns for investors. Convexity: Measure of the non-linear relationship of bond prices to changes in interest rates. Covered bonds: Securitization model utilized in Europe and Asia whereby the lender keeps the loans on their balance sheet and has the flexibility to change the loans within the portfolio which is eligible for investment.

Chapter Definitions Credit Enhancement: Techniques used to improve the creditworthiness of a borrower. External Credit Enhancements: Techniques used to enhance a borrower s, or securitization structures creditworthiness that involves third party guarantees such as a Letter of Credit or Monoline Insurance. Herfindahl Index: effective loan count concentration measure in CMBS; also known as Herf score. Internal Credit Enhancements: Techniques used to enhance securitization structure s creditworthiness that involves injections of capital by the securities issuer or originator. Non-recourse financing: Where no personal liability is available to the lender for a loan.

Chapter Definitions Over-collateralization: An internal credit enhancement technique in which the originator transfers a pool of collateral loans to the SPV that has a higher par value (usually 5 to 10%) than that of the issued securities. This means that the SPV holds a larger pool of assets than would be necessary if the loans in the pool pay as expected. Private-Label Securities: A mortgage-backed security or other bond created and sold by a company other than a Government Sponsored Enterprise (GSE).The security frequently is collateralized by loans that are ineligible for purchase by Freddie Mac or Fannie Mae. Real Estate Mortgage Investment Conduit (REMIC): A type of special purpose vehicle, created by the Tax Reform Act of 1986, that holds commercial and residential mortgages in trust and issues interests in these mortgages in the form of securities to investors.

Chapter Definitions RMBS: Residential mortgage backed securities. Structural Credit Enhancements: Techniques used by securitizations to distribute risk among Bonds, such that some of them provide protection to those that enjoy a higher priority. Underwriter: banks, investment banks and brokers that sell the securities in a public offering or place them privately, often retaining a portion of the issuance for their own account.

Types of Mortgage Backed Securities Mortgages Assets (ABS) Loans CMBS Retail Multi-Family Office Industrial Hotels Self-Storage Timber Auto Aircraft Time share Student loan Consumer Credit Equipment CLOs Business Loans Bridge Loans RMBS CDOs Single Family Multi-Family Single Family Rental Reverse Mortgages Anything with projected future income stream Covered Bonds Residential Commercial Public Sector Securitization Nomenclature

Residential MBS and Subjectivity Agency Guarantees vs. Private Label Issuance Implied impact on underwriting to achieve agency acceptance Tranches of various asset class within MBS Waterfall repayment structure Mix of regions, property values, and underwriting criterion

Residential MBS and Subjectivity Making Sense of Convexity Bond Yield Data Bond Yield Data Face Value Annual Interest Rate Years to Maturity Coupon Value of Bond 1,000.00 $ 10.00% $ $965.29 Face Value Annual Interest Rate Years to Maturity Coupon Value of Bond 1,000.00 $ 10.00% 80.00 $ $965.29 2 2 80.00 Bond Yield Data Bond Yield Data Face Value Annual Interest Rate Years to Maturity Coupon Value of Bond 1,000.00 $ 11.00% $ $948.62 Face Value Annual Interest Rate Years to Maturity Coupon Value of Bond 1,000.00 $ 9.00% 80.00 $ $982.41 2 2 80.00 % Change from Rate Increase % Change from Rate Decrease Price at 10% Price at 11% % Change $965.29 $948.62 -1.76% Price at 10% Price at 9% % Change $965.29 $982.41 1.74% Convexity 0.0236% Convexity Formula: Price if Rate Rises Price if Rate Falls Initial Price of Bond $948.62 $982.41 $965.29 (Price if Rate Rises + Price if Rate Falls) - (Initial Price of Bond * 2) ((Initial Price of Bond * 2) * (1%)2) Then Multiply result by (1%)2) Making Sense of Convexity

Commercial MBS and Subjectivity $250 $200 $150 $100 $50 $0 2000 2003 2005 2007 2010 2012 2014 2015 2017 2019 1999 2001 2002 2004 2006 2008 2009 2011 2013 2016 2018 2020 Highs and Lows in the US CMBS Market (annually in billions)

Commercial MBS and Subjectivity Open Period Prepayment Period Lockout Period Origination Maturity Commercial Loan Payment Timeline

Commercial MBS and Subjectivity CMO Waterfall

Commercial MBS and Subjectivity Self-Storage Market Primary Players CC Units 248 204 78 150 150 120 240 325 375 94 66 200 2,250 Std Units Totals Market % Property 147 600 392 280 350 43 49 375 75 247 28 175 2,761 395 804 470 430 500 163 289 700 450 341 94 375 5,011 7.88 16.04 9.38 8.58 9.98 3.25 5.77 13.97 8.98 6.81 1.88 7.48 100.00 1,006.20 Alten Storage All American Storage Iron Guard Affordable Fred's Uncle Bill's Orange Diamond Rocket Man Storage Semper Fi Store More Storage Chest Storage Camp U-Store-It Totals HHI Score Market Concentration in a Given Self-Storage Market

Commercial MBS and Subjectivity Loan 1 2 3 4 5 6 7 8 9 10 Total Pool 1 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 100% Pool 2 25% 20% 15% 10% 10% 4% 4% 4% 4% 4% 100% Pool 3 40% 30% 10% 5% 5% 2% 2% 2% 2% 2% 100% Pool 4 60% 20% 5% 5% 5% 1% 1% 1% 1% 1% 100% Pool 5 30% 12% 15% 7% 5% 4% 4% 6% 8% 9% 100% ? 2 ?? ? Herf 10 7 4 2 6 ???? ????? = 1 ?=1 Herf Scores for Five Small Loan Pools

MBS and Investor Preference CDO Reading List Pages in CDO2 Prospectus Pages in ABS CDO Prospectus Pages in RMBS Prospectus Number of ABS CDO tranches in CDO2 Number of RMBS in a typical CDO Number of mortgages in a typical RMBS No. of Pages 300 300 200 125 150 5,000 Total Pages to Read for CDO2 Investor: Pages to read for ABS CDO Investor: Maximum Number of Mortgages in a CDO2: Maximum Mortgages in ABS CDO: 1,125,000,300 93,750,000 30,300 750,000 CDO Reading List

MBS and Investor Preference Type Office Retail Office Hotel Apt Retail Storage Retail Apt Warehouse Office Totals Location Boston MA LA CA Dallas Tx Miami FL Fort Lee NJ Chas SC Seattle WA Montreal Qe Chicago IL Baltimore MD New York NY Loan 8,750,000 $ 14,500,250 $ 21,250,500 $ 8,750,000 $ 21,750,675 $ 16,350,735 $ 18,500,725 $ 26,050,650 $ 32,750,415 $ 16,580,390 $ 35,750,900 $ 220,985,240 $ NOI 650,000 1,100,500 $ 1,450,000 $ 975,000 $ 1,650,000 $ 1,350,000 $ 1,550,500 $ 1,890,000 $ 2,675,000 $ 1,450,000 $ 2,850,000 $ 17,591,000 $ Value 11,500,000 $ 17,850,000 $ 25,600,000 $ 18,500,000 $ 30,000,000 $ 28,750,000 $ 29,500,750 $ 34,500,000 $ 42,500,000 $ 30,000,000 $ 46,700,000 $ 315,400,750 $ $ Bond 1 Contents

MBS and Investor Preference Type Apt Hotel Office Retail Warehouse Apt Hotel Retail Storage Retail Apt Hotel Office Warehouse Storage Hotel Totals Location Hackensack NJ Myrtle Beach SC Milwaukee WI Portland OR Kingston ON Miami FL New York NY WS NC St Louis MO Austin TX San Diego CA Vancouver BC Quincy MA Shelton CT Forest Hills NY Des Moines IA Loan 1,000,000 $ 3,500,000 $ 65,600,000 $ 2,750,000 $ 1,999,000 $ 12,500,000 $ 86,500,000 $ 4,500,000 $ 2,710,000 $ 18,500,000 $ 13,750,000 $ 65,600,450 $ 5,550,000 $ 7,260,050 $ 1,150,060 $ 3,850,000 $ 296,719,560 $ NOI 85,000 265,000 4,835,000 $ 205,600 $ 156,500 $ 936,000 $ 8,450,000 $ 350,000 $ 207,650 $ 1,350,000 $ 1,115,000 $ 5,150,000 $ 315,000 $ 500,000 $ 107,500 $ 386,985 $ 24,415,235 $ Value 1,250,000 $ 4,650,000 $ 82,500,000 $ 3,850,000 $ 2,750,000 $ 16,750,000 $ 125,000,000 $ 6,100,000 $ 3,650,000 $ 28,250,000 $ 21,600,500 $ 88,500,000 $ 6,450,000 $ 9,500,000 $ 1,560,000 $ 6,100,000 $ 408,460,500 $ $ $ Bond 2 Contents

MBS and Investor Preference Property Type % Office Retail Apt Hotel W-House Storage Total 30% 26% 25% 4% 8% 8% 100% Type Office Retail Office Hotel Apt Retail Storage Retail Apt Warehouse Baltimore MD Office New York NY Totals Herf Loan Count 11 Location Boston MA LA CA Dallas Tx Miami FL Fort Lee NJ Chas SC Seattle WA Montreal Qe Chicago IL Loan 8,750,000 14,500,250 $ 21,250,500 $ 8,750,000 $ 21,750,675 $ 16,350,735 $ 18,500,725 $ 26,050,650 $ 32,750,415 $ 16,580,390 $ 35,750,900 $ 220,985,240 $ 9.39 20,089,567 $ NOI 650,000 1,100,500 $ 1,450,000 $ 975,000 $ 1,650,000 $ 1,350,000 $ 1,550,500 $ 1,890,000 $ 2,675,000 $ 1,450,000 $ 2,850,000 $ 17,591,000 $ Value 11,500,000 $ 17,850,000 $ 25,600,000 $ 18,500,000 $ 30,000,000 $ 28,750,000 $ 29,500,750 $ 34,500,000 $ 42,500,000 $ 30,000,000 $ 46,700,000 $ 315,400,750 $ ADS 516,537 855,990 1,254,476 $ 516,537 $ 1,284,003 $ 965,229 $ 1,092,149 $ 1,537,842 $ 1,933,348 $ 978,787 $ 2,110,475 $ 13,045,375 $ DCR 1.26 1.29 1.16 1.89 1.29 1.40 1.42 1.23 1.38 1.48 1.35 1.35 DY LTV Herf % 4% 7% 10% 4% 10% 7% 8% 12% 15% 8% 16% 100% 9.39 $ $ $ $ 7.43% 7.59% 6.82% 11.14% 7.59% 8.26% 8.38% 7.26% 8.17% 8.75% 7.97% 7.96% 76.09% 81.23% 83.01% 47.30% 72.50% 56.87% 62.71% 75.51% NE US 77.06% Western 55.27% SE US 76.55% NW US 70.06% Central US Int'l Total Region % 30% 7% 19% 8% 24% 12% 100% Avg. Loan Size Practical Analysis of CMBS Bond 1

MBS and Investor Preference Property Type % Office Retail Apt Hotel W-House Storage Total 24% 9% 9% 54% 3% 1% 100% Type Apt Hotel Office Retail Warehouse Apt Hotel Retail Storage Retail Apt Hotel Office Warehouse Storage Hotel Totals Loan Herf Loan Count Location Hackensack NJ Myrtle Beach SC Milwaukee WI Portland OR Kingston ON Miami FL New York NY WS NC St Louis MO Austin TX San Diego CA Vancouver BC Quincy MA Shelton CT Forest Hills NY Des Moines IA Loan 1,000,000 $ 3,500,000 $ 65,600,000 $ 2,750,000 $ 1,999,000 $ 12,500,000 $ 86,500,000 $ 4,500,000 $ 2,710,000 $ 18,500,000 $ 13,750,000 $ 65,600,450 $ 5,550,000 $ 7,260,050 $ 1,150,060 $ 3,850,000 $ 296,719,560 $ 5.20 17,454,092 $ NOI Value 1,250,000 $ 4,650,000 $ 82,500,000 $ 3,850,000 $ 2,750,000 $ 16,750,000 $ 125,000,000 $ 6,100,000 $ 3,650,000 $ 28,250,000 $ 21,600,500 $ 88,500,000 $ 6,450,000 $ 9,500,000 $ 1,560,000 $ 6,100,000 $ 408,460,500 $ ADS 59,033 206,615 $ 3,872,551 $ 162,340 $ 118,007 $ 737,910 $ 5,106,336 $ 265,648 $ 159,979 $ 1,092,107 $ 811,701 $ 3,872,577 $ 327,632 $ 428,581 $ 67,891 $ 227,276 $ 17,516,183 $ DCR 1.44 1.28 1.25 1.27 1.33 1.27 1.65 1.32 1.30 1.24 1.37 1.33 0.96 1.17 1.58 1.70 1.39 DY LTV Herf % 0% 1% 22% 1% 1% 4% 29% 2% 1% 6% 5% 22% 2% 2% 0% 1% 100% 5.20 85,000 265,000 4,835,000 205,600 156,500 936,000 8,450,000 350,000 207,650 1,350,000 1,115,000 5,150,000 315,000 500,000 107,500 386,985 24,415,235 $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 8.50% 7.57% 7.37% 7.48% 7.83% 7.49% 9.77% 7.78% 7.66% 7.30% 8.11% 7.85% 5.68% 6.89% 9.35% 10.05% 8.23% 80.00% 75.27% 79.52% 71.43% 72.69% 74.63% 69.20% 73.77% NE US 74.25% Western 65.49% SE US 63.66% NW US 74.12% Central US 86.05% Int'l 76.42% Total 73.72% 63.11% 72.64% Region % 34% 5% 7% 1% 31% 23% 100% 17 Avg. Loan Size Practical Analysis of CMBS Bond 2

Alphabet Soup Securitization

Alphabet Soup Securitization

Chapter 9 Questions Questions for Discussion Discuss the primary differences between RMBS and CMBS loans. Describe how the Herfindahl Index can be helpful in determining the risk of a mortgage bond pool. Elaborate on the benefits and pitfalls of pari passu loans within CMBS loan structures. Explain how did the CMBS structures change after the crash of the market after 2008? Describe negative convexity and how it might impact RMBS risk assessment.

Chapter 9 Questions Questions for Discussion What is a CMBS vintage and how can it be used for comparison purposes? Explain the basic difference between covered bonds and RMBS/CMBS structures. Outline other areas of finance and economics where the Herf score could be helpful. Describe the CMO waterfall concept and how it pertains to investor cash flows. What is an agency guarantee and why are they only present in RMBS vs. CMBS?

Chapter 9 Market Vignette Questions for Discussion Would a higher or lower Herf score be desirable from a bond ratings perspective and why? Discuss the strategy for creating this new CMBS offering. Are there any improvements that you would suggest? What are some weaknesses of the approach discussed in this market vignette? What might Daffy and Lucy be missing in their assessment of the large loan exposure being included in the mortgage bond? What additional questions might you have when contemplating purchasing a mortgage bond?