At DXM, we utilize advanced technology to increase the efficiency of pricing and risk allocation in residential mortgage finance. This will result in higher risk adjusted profitability for banks, investment bank sponsors, non-bank originators and investors.
Unlike other major capital markets, the multi-trillion dollar residential mortgage securitization markets have lagged in their deployment of innovative technologies and, hence, efficiency.
Certain of these securitization markets continue to use trading practices often based on government regulated/subsidized pricing and legacy dealer risk allocation techniques.
Since 2008, some of those practices have caused major private investor groups to limit or eliminate their participation in private label mortgage securitizations (“PLS”).
With DXM innovation, these markets can become more efficient and more profitable with less risk thus, attracting potentially significant levels of new private-sector liquidity.
Using an artificial intelligence platform on top of current Wall St. infrastructure, DXM enables:
- The creation of uncapped floating rate tranches (with risk reduction unavailable today)
- The acquisition of interest rate and prepayment risk in swap format (with no risk of principal loss from mortgage defaults and above market risk adjusted ROE)
- The transfer of prepayment risk on whole loans, MBS etc. even without securitization
These innovations for mortgage-backed instruments enable customization at any level of risk or maturity
Standard residential mortgages generally have interest rate, prepayment and credit risks for a fixed maturity of 30 years.
Currently these risks and maturity cannot be split on an efficient basis. This creates inefficient risk allocation and use of capital by banks, thus limiting profit, mortgage availability and market liquidity.
DXM uniquely achieves those objectives with wide ranging implications:
- Enables customization of mortgage-backed instruments for any maturity (30 days to 30 years), duration or convexity.
- Creates new liquidity, thus expanding the private label mortgage securitization market.
- For example, will attract interest rate and other risk specific investors seeking floating rate instruments
DXM Securitization Benefits
Benefits
Investment banks can generate new upfront fee income drop of up to 75 bps by creating custom structures without taking balance sheet or interest rate risk.
Banks can increase risk-adjusted ROE.
Interest rate and credit risk investors can achieve yields above T-bills on floating rate assets that reprice every 30 days.
Money Market Mutual Funds can achieve higher yield than that provided by the FED’s overnight reverse repo facility.
Minimizes Risk and Cost
DXM enables securitization auctions among mortgage originators and investors, without any sponsor execution risk. Sponsors act as riskless principal intermediaries without additional investment or balance sheet risk. They conduct an auction for:
1) Investors seeking floating rate tranches who indicate their desired spread; and
2) Swap counterparties willing to pay fixed / receive float who indicate their desired fixed rate.
The auction process can easily match floating rate buyers with swap counterparties. The sponsor can also sell a portion of the senior tranche through this process. If no match occurs, no transactions are executed. Execution fees are paid by the participants in the auction and not the securitization sponsor.
DXM can create an uncapped floater and an interest rate swap from the full size of the senior tranche. The technology can also, simultaneously, create floating rate instruments with any desired cap.
In standard securitizations, the inverse floater buyer assumes the interest rate and prepayment risk. Even with subordination, inverse floaters have the risk of principal loss from borrower defaults. Because of such transaction specific risk, inverse floaters cannot be aggregated across securitizations – creating highly illiquid instruments. And the transaction specific credit risk can render interest rate risk hedges ineffective.
And because the DXM structure is in swap format, investors for the first time have the flexibility to combine the interest rate and prepayment risk from a senior tranche with a floating rate instrument of their choice… (such as a CLO) to create the equivalent of a fixed-rate senior tranche with any desired risk/duration profile. And DXM also provides investors with the flexibility to change these combinations at any time.
In current securitizations, the inverse floater typically only attracts interest from investors who believe rates will remain stable or fall. In DXM enabled securitizations, investors with a broader range of views (e.g., rates will rise, rate will fall, etc.) will likely have an interest in the swap. Having a larger group of investors bidding on the senior tranche may result in better execution for the securitization sponsor.
A DXM Mortgage Swap is a standard interest rate swap that has an embedded short position in a prepayment option. The prepayment option mirrors the option embedded in a portfolio of whole loans, a tranche of private label securitization, or a pool of agency mortgage-backed securities (MBS).
As the principal balance on the underlying mortgages declines due to scheduled amortizations or prepayments, the notional balance on a Mortgage Swap declines by the identical amount. Mortgage Swaps also replicate a critical feature of government guaranteed MBS – the notional balance also declines to reflect the decline in the underlying mortgage balance due to borrower defaults.
Thus, the receive fixed/pay float counterparty has no risk of principal loss from borrower defaults even at a 100% default rate on the underlying mortgages. Mortgage Swaps replicate a leveraged position in agency MBS. Both MBS and Mortgage Swaps only have interest rate and prepayment risk, regardless of the credit quality of the underlying mortgages.
A Mortgage Swap can have multiple entities contributing the underlying assets that create the reference pool for the notional balance. These entities use Mortgage Swaps to transfer some portion or all of the interest rate and prepayment risk to third parties. DXM enables these entities (the pay fixed/received float counterparty) to obtain basis risk free hedges for their specific pool of mortgages. The notional balance used to calculate payments for any pay fixed counterparty is based solely on its own mortgages. Consider a Mortgage Swap where ten banks (Bank 1 – Bank 10) have contributed mortgages. The prepayments and defaults on mortgages contributed by Banks 2 – 10 have no bearing on the payments for Bank 1.
Conversely, with DXM received fixed/pay float counterparties have aggregate and diversified exposure to the entire pool of mortgages. Consider our previous example with a pool contributed by ten banks. Assume that there are twenty investors receiving fixed/paying float on that Mortgage Swap. The payments for each investor are based on the combined balance of all ten banks. Therefore, with DXM enabled fungibility, investors do not have idiosyncratic prepayment risk exposure to any specific bank, thus providing additional risk diversification.
As with agency MBS, certain investors (i.e., received fixed/pay float counterparties) do not have a desire to assume 30 years of interest rate and prepayment risk. In such cases, investors can use the DXM platform to transfer (hedge) the prepayment risk inherent in their particular swap. Example prepayment hedges include:
Offsetting Mortgage Swap. An investor can execute an offsetting Mortgage Swap with lower legal final maturity. For example, an investor with received fixed/paying float on a 30 year Mortgage Swap can execute a 10 year Mortgage Swap (paying fixed/receive float). The 30 year investor would then have only tail prepayment risk. The investor in the 10 year swap would have a position equivalent to a 10 year sequential CMO, but with a hard legal final maturity of 10 years. Such investor would then have a structure with only call risk and no extension risk.
Interest Rate Caps. An investor can also purchase an interest rate cap to limit the floating rate payments on the Mortgage Swap. The notional balance on the cap will track the notional balance on the Mortgage Swap. The maturity of the cap need not match the maturity of the Mortgage Swap. Using this strategy, the investor in a 30 year Mortgage Swap can purchase protection, for example, for 7 years. The seller can combine the cap with positions in cash instruments to create synthetic capped floating rate agency MBS of any desired legal final maturity.
Creation of sequential CMOs or capped floating rate MBS requires significant capital and carries significant execution risk. The structuring process for these instruments typically generates illiquid residual instruments (e.g., support bonds, inverse floating rate securities, principal only strips) that dealers must warehouse. And dealers have no means to hedge the significant idiosyncratic prepayment risk inherent in such structures.
The DXM platform enables the creation of more desirable instruments, without creating such illiquidity and without the idiosyncratic prepayment risk. DXM transaction execution can be accomplished through a ‘best efforts’ auction process, essentially eliminating balance sheet risk by the participants.
