The recent Springleaf subprime residential mortgage-backed securitization may be a good indication of what subprime RMBS will look like going forward. The deal, named Springleaf Mortgage Loan Trust 2011-1, sold $292 million worth of triple-A rated securities backed by $497 million worth of still-performing subprime mortgages. It is the first subprime residential securitization since the financial crisis. (The other post-crisis private residential securitizations have been of jumbo prime loans.) Most importantly, Springleaf is a hopeful sign that securitization markets are continuing to evolve and revitalize, and in a way that is prudent and sustainable.
Already, post-financial crisis commercial-mortgage backed securities have earned the moniker of “CMBS 2.0” for their enhanced deal structures that provide more protection for investors. As noted in FT Alphaville, Structured Credit Investor, and Housing Wire, key aspects of CMBS 2.0 deals include better underwriting standards (including lower loan-to-value ratios), fewer interest-only loans, more aggressive loan documentation, less complicated deal structures and leverage, more loans in the collateral pool, risk-retention, loan-level disclosures, buyers for the riskiest first-loss "B-piece," and operating advisors that monitor special servicers. All of these CMBS 2.0 practices and structures are what I refer to as credit risk transfer (CRT) governance mechanisms. Their purpose is to protect investors by helping to overcome the inherent incentive misalignments and informational problems of securitizations (and other types of CRT transactions).
Likewise, the Springleaf deal may harbinger of subprime RMBS 2.0. In terms of credit ratings, only 59% of Springleaf's securities obtained a triple-A rating. By contrast, in a typical pre-crisis subprime securitization, upwards of 90 percent of the deal were triple-A rated. Notably, only 59% of Springleaf's securities were able to achieve a triple-A rating despite its abnormally high level of structural protections (i.e., credit enhancement) for investors. Springleaf is reported to have a credit enhancement at the 51.15% level, which means that triple-A investors will not suffer any cash flow losses unless the underlying subprime loans experience more than 51.15% in losses. Springleaf's credit enhancement was achieved in part through the underlying subprime loans paying 5% more in interest than the 4% paid out to Springleaf's triple-A investors (excess spread), and the subprime loans having about twice the face value of the triple-A securities issued by Springleaf (overcollateralization). Before the crisis, by contrast, it typically only took a 22% level of credit enhancement to get that upwards of 90% subprime securities rated triple-A.
Accordingly, if Springleaf is any indication, in subprime RMBS 2.0 a little credit enhancement will not go a long way. For any given deal, expect to see a much smaller portion of securities being highly rated and much more credit enhancement. Like CMBS 2.0, subprime RMBS 2.0 will also likely include issuer risk retention. In Springleaf, the issuer held onto both senior and subordinated tranches. And as noted by Adam Tempkin, despite the smaller portion of triple-A rated securities, larger credit enhancement, and risk retention, RMBS 2.0 can still be profitable for issuers.
Some commentators have expressed concern about subprime RMBS obtaining a triple-A rating even after the financial crisis. For example, Felix Salmon argues that the Springleaf deal means that too much attention is still being paid to triple-A ratings. Although ratings are indeed too central to our system, regulators and market participants are currently working to reduce their importance, which is no easy task. But more importantly, the fact that in Springleaf it took more than double the pre-crisis credit enhancement to achieve about a one-third smaller portion of triple-A rated securities indicates that an important lesson from the financial crisis has been learned; namely, that there were way too many triple-A securities being chased by far too little credit enhancement. In fact, the reduction to 59% triple-A securities is consistent with estimated loss projections for investment grade tranches in pre-crisis subprime RMBS, which are between 15% and 45%.
