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Reading 45: Introduction to Asset-Backed Securities (ABS) - Coggle Diagram
Reading 45: Introduction to Asset-Backed Securities (ABS)
Securitization
Benefits
Reduce funding costs for firm that securitize financial assets
Increase liquidity for the financial assets
Offers investors exposure to new asset classes
Process
Seller or depositor: originates assets and sells to issuer
Issuer/ Special Purpose Entity (SPE) or Special Purpose Vehicle (SPV): Sell ABS securities; buy assets
Investors: Buy securities, receive cash flows
Servicer: collect payment (often the seller does this service)
Notes
The SPV is bankruptcy remote from the sellera
ABS issued by the SPV may have a higher credit rating than bonds issued by seller
Lower cost of funds with securitization than by issuing corporate bonds
Structures
The SPV may either:
Issue only one class of bond, or
Issue different bond classes with rules for distributing the principal and interest paid to the SPV
Time tranching:
Tranche 1 bonds receive all principal repayments until paid off, then Tranche 2 receives all principal payments, etc. (Tranche 1 has higher priority than Tranche 2)
Credit trancing:
Trance C bonds bears any credit losses up to their par value. then trance B bonds bear credit risk, then finally tranche A bonds
Tranche B and C bonds are subordinated to Tranche A Bonds
Tranche A bonds are senior bonds and carry a higher credit rating than tranche B or C bonds
Residential Mortgage Loans
Loans with residential real estate as collateral
Loan-to-value ratio (LTV):
percentage of collateral value that is borrowed
Lower LTV → Lower probability of default, greater recovery percentage
Characteristics
Maturity: typically 15-30 years, sometimes 40-100 years
Interest rate: Fixed, adjustable (ARM), convertible between fixed and adjustable
Amortization: Full, partial (balloon payment), interest-only
Prepayment provision: May have penalty
Recourse or non-recourse loans:
Both recourse and non-recourse loans allow lenders to seize collateralized assets after a borrower fails to repay a loan.
After collateral is collected, lenders of recourse loans may still go after a borrower's other assets if they have not recouped all of their money.
With a non-recourse loan, lenders can collect the collateral, but may not go after the borrower's other assets.
Strategic default:
A strategic default is a decision by a borrower to stop repaying a mortgage obligation.
when the market value of a property has fallen below the amount due on the mortgage.
Rather than waiting for conditions to change, the mortgage holder walks away from the property and the debt.
Agency RMBS:
Only conforming loans may be included in agency RMBS
issued by government agency (e.g., GNMA) or government-sponsored enterprise (e.g., FNMA, FHLMC)
Non-agency RMBS
Issued by private entities; underlying loans do not have government guarantee
Nonagency RMBS have more credit risk and therefore need credit enhancement
Credit enhancements
Internal
Reserve funds
Cash reserve funds
Excess spread funds
Overcollateralization
Face value < underlying collateral value
Excess used to absorb losses
Senior/ subordinated structure
Subordinated tranches (Junior bonds)
Shifting interest mechanism: stops payments to the subordinated tranche if collateral quality deteriorates
External
Corporate guarantee by seller
Bank letter of credit
Bond insurance
Mortgage Pass-through Securities
Securitization
Pool mortgages to diversify risk, then shares of the pool are sold to investors
Investor receive a pro-rata share of all cash flows
Weighted average maturity (WAM): Maturities weighted by outstanding principal of mortgages in pool
Weighted average coupon (WAC):
the interest rate on the underlying pool of mortgage
weighted by outstanding principal of mortgages in pool
WAC = Pass-through rate + rate for servicing or administration
A pass-through security is a pool of fixed-income securities backed by a package of assets.
Each security in the pass-through pool represents a large number of debts, such as hundreds of home mortgages or thousands of car loans.
Collateralized Mortgages Obligations (CMOs)
Cash flows relocated to different tranches, each with different contraction/ extension risk
Created from pass-through MBS (the collateral) for investors with different risk needs
Can meet the asset / liability requirement of different investors
Contraction risk:
borrowers payback principal sooner than anticipated
When interest rate decrease → prepayment increase (more refinancing) → Shorten MBS life
Extension risk:
Interest increase → prepayments decrease→ longer average MBS life
borrowers defer prepayments due to market conditions.
Risks can be reallocated, but not eliminated
Sequential pay structure
All tranches receive interest
Lower tranche receive all principal first until paid off, then moving up to higher tranche
Each sequential pay CMO tranche has mix of contraction and extension risk
For sequential Pay CMO
Higher Tranche has higher Contraction Risk but lower Extension Risk
Lower Tranche has lower Contraction Risk but higher Extension risk
PAC/ support structure
PAC Tranche
Schedule principal payments with range of 2 prepayment rates (initial PAC collar)
No extension risk nor contraction risk while within the PAC collar
PAC tranche has more predictable cash flows and average life
Support Tranche
Provide prepayment protection to PAC tranches
So that PAC tranche can have predictable payment
Has much higher Contraction and Extension risk than PAC Tranche, even within the PAC collar
Extension risk: When prepayments fall, support tranche average life increases by more than PAC
Contraction risk: When prepayments increase, support tranche average life decreases by more than PAC
To compensate for the risk, investors are rewarded with higher return
Prepayment Risk:
Prepayment are principal repayments in excess of scheduled amounts
Measure of prepayment rate
Single monthly mortality rate (SMM):
Percentage by which prepayments reduce principal balance, compared to no prepayments
is the monthly measure of prepayment rate or prepayment speed
Conditional prepayment rate (CPR):
Annualized prepayment rate,
based on weighted-average-coupon WAC, interest rate, prior prepayment
indicate the % of outstanding mortgage pool balance (at the beginning of year) to be paid by the end of year
Weighted Average life: Less than WAM because of prepayments
Public Securities Association (PSA) prepayment benchmark
Monthly series of annual prepayment rates
Assume monthly prepayment rate increases as pool ages
100 PSA = 100% of PSA
200 PSA = 2 x (CPR of 100 PSA)
Commercial MBS
Commercial MBS (CMBS)
are backed by income-producing real estate
Apartments
Warehouse
Shopping center
Office building
Health-care facilities
Senior housing
Hotel/ resort
Characteristics
Non-recourse loans, partially amortizing, balloon payment
Balloon risk is a type of extension risk for CMBS
Analysis focuses on risk of property
Debt service coverage ratio
= \( \frac{Net.Operating.Income}{Debt.Service}\)
Loan-to-value ratio
= \( \frac{mortgage}{appraised.value} \)
Call Protection
Loan level
Prepayment lockout (2-5 years) (no principal payment)
Defeasance
Prepayment penalty points
Yield maintenance charges
CMBS Structure
Sequential tranches
Other types of ABS
Auto Loan ABS
Prepayments may result from
Sold/ traded-in/ paid early
Wrecked/ stolen, loan prepaid with insurance proceeds
Need credit enhancement
Amortizing loans
Credit Card ABS
Backed by pool of credit card receivables, nonamortizing loan
Therefore, no prepayment risk
Lockout period
No principal repaid
Principal payments by card holders used to purchase more receivables
Early (rapid) amortization provisions
Early amortization reduces the amount of time before an investor will receive the repayment of their principal from an asset-backed security (ABS) purchase
are included to enhance credit quality
Collateralized Debt Obligations (CDOs)
Collateral is a pool of debt obligations
Corporate, emerging market bonds (CBOs)
Leveraged bank loans (CLOs)
MBS and ABS (structured finance CDOs)
Collateral pool is managed to generate cash flows to make promised payments
Unlike auto-, mortgage-, credit card- loans, this does not have scheduled cash-flows
CDOs are not classified as ABS
Typical Structure
Senior tranches: 70-80% of total, floating rate
Mezzanine tranches:
fixed coupon
Credit rating: Subordinated < Mezzanine < Senior
Equity (subordinated) tranche: Provide prepayment and credit protection
when risk test is failed, CDO is deleveraged by reducing senior bond class
Types
Synthetic CDOs: Take on economic risks (but not legal ownership) of underlying assets during a credit default swap rather than a cash market position
Arbitrage CDOs:
Generate return on spread between collateral and funding costs