Mortgage Securitization Tranche Models and Subprime-Era Losses
Summary
The document outlines how mortgage securitizations were modeled and divided into rated tranches. The response describes using historical mortgage default and loss data, applying stress scenarios, estimating pool cash flows and subordination, and sizing tranches against assumed losses. Expected losses for rated classes were also compared with the long-run default experience of similarly rated corporate bonds. It notes that multiple agency models and deal structures existed, rather than one universal method.
The proposed failure mechanism was that models treated mortgage pools as diversified and relied on prior regional downturns, which did not capture a nationwide housing collapse. Re-securitizing subordinated mortgage bonds added leverage to losses: once defaults and severities exceeded expectations, junior protection could be exhausted and senior classes exposed. The response itself flags uncertainty about the precise rating criteria and presents the modeling account as a generalization. It provides no dataset or quantitative analysis, so it is an explanatory summary rather than a complete reconstruction of any particular deal.
Key ideas
- Tranche sizing drew on historical default and loss experience, stress assumptions, and modeled pool cash flows.
- Subordination and excess interest were intended to absorb losses before senior tranches.
- Models relied on diversification assumptions that did not account for a broad housing downturn.
- Re-securitization increased sensitivity to mortgage defaults and loss severity.
- Different rating models and deal structures were used, so practices were not uniform.
Tags
Full text
# What was the probability distribution used for Mortgage Backed Securities (MBSs) during the subprime crisis? # What was the probability distribution used for Mortgage Backed Securities (MBSs) during the subprime crisis? The probability distribution used for mortgage backed securities divided them into tranches. If tranch#1 was worth 10 million USD, they got paid in full while the rest got paid partially. Most of them defaulted. What was the probability distribution used? And what is the statistics behind what they did? ## Answer by Si Chen (score 3) https://quant.stackexchange.com/a/68343 I think you're asking about the different tranches in a multi-tranch mortgage securitization such as a Collateralized Mortgage Obligation (CMO) was sized, and what the math behind it was. This was how they did it: - They used historical default statistics (probability of default and loss in the event of default) from prior episodes of high mortgage defaults, such as Texas in the early 1980's and New England in the early 1990's. - Then they calculated a "stress scenario" that was 2x or 3x that level. - Based on that, they calculated the cash flows of the pool, including the excess interest (mortgage note rate minus the coupon rates of the bonds issued) and subordination. - From the excess cash flow, they sized the tranches so that a single A-rated tranche would get paid back in the event of the stress scenario. (Note: Not sure if that's exactly where the single A subordination was. Please check the Mortgage Rating Criteria from the rating agencies to verify.) - The expected losses of each of the rated classes was supposed to be similar to the expected loss of a similarly rated corporate bond, based on their long-term default experiences. And this is where they went wrong: - In their models, they always assumed that diversification of collateral pool would reduce overall losses, because up until 2008, there was never a national (or global) real estate recession. - The loss experiences in 2008 were much worse than they ever expected. As a point of reference, look at Fannie Mae's historical loss experiences, and Fannie Mae collateral was (relatively) better quality. - With re-securitizations, their model was calculating the expected loss. When you re-securitize a subordinated bond (BBB) into tranches of AAA and lower-rated bonds, you assumed that there would be more defaults but the lower-rated bonds would protect the higher rated ones. But you were also creating a leveraged bet on defaults and losses in the event of default. Once the underlying mortgages defaulted at far higher rates, the subordination of the BBB bonds were wiped out much more quickly, leading to losses on the AAA bonds. ## Answer by C8H10N4O2 (score 0) https://quant.stackexchange.com/a/60497 There was no one single method for RMBSs, but S&P's LEVELS model or equivalent was often used with structuring. A common, vanilla structuring was into a "six pack" plus I/O strip, the six pack being AAA, AA, and so forth. In other words, seven tranches. There were many structures, however. Moody's Mortgage Metrics (M3) was another common model used. Fitch ResiLogic was another. By way of example, here's an archived prospectus from 2006: https://www.sec.gov/Archives/edgar/data/1366182/000112528206003776/b413822_424b.txt In this case we have five senior tranches (each AAA) and several mezzanine tranches (AA+ down to BBB-).
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