(45) Introduction to Asset-Backed Securities Flashcards
LOS 54. a: Explain benefits of securitization for economies and financial markets.
The primary benefits of the securitization of financial assets are:
- Reduce the funding costs for firms selling the financial assets
- Increase the liquidity of the underlying financial assets.
- Assets of SPV have bankruptcy remoteness
- Diversification for investors
- Greater credit availability and less concentration risk
- Increased loan origination for banks
LOS 54. b: Describe securitization, including the parties involved in the process and the roles they play.
Securitization: This process involves transferring ownership of assets from the original owners (Consumer Co) into a special legal entity (Consumer Asset Trust - SPV)
Parties to a securitization are a seller of financial assets, a special purpose entity (SPE), and a servicer.
- The seller is the company that originates the loans (provides loan to consumer)
- An SPE is an entity independent of the seller. The SPE buys financial assets from the seller and issues asset-backed securities (ABS) supported by these financial assets to investors
- The servicer carries out collections and other responsibilities related to the financial assets. The servicer may be the same entity as the seller but does not have to be.
The SPE may issue a single class of ABS or multiple classes with different priorities of claims to cash flows from the pool of financial assets.
LOS 54. c: Describe typical structure of securitizations, including credit tranching and time tranching.
Asset-backed securities (ABS) can be a single class of securities or multiple classes with differing claims to the cash flows from the underlying assets. Time tranching refers to classes that receive the principal payments from underlying securities sequentially as each prior tranche is repaid in full (used when all bonds are part of the same bond class). With credit tranching, any credit losses are first absorbed by the tranche with the lowest priority, and after that by any other suboridinated tranches, in order. Some structures have both time tranching and credit traching (Only used for different bond classes).
Time tranching redistributes prepayment risk while credit tranching redistributes credit risk
LOS 54. d: Describe types and characteristics of residential mortgage loans that are typically securitized.
Characteristics of residential mortgage loans include:
- Maturity - 15 or 30 years
- Interest rate: fixed-rate, adjustable-rate, or convertible.
- Amortization: full, partial, or interest-only.
- Lender may make prepayments (payments made in excess of regular payments) - may be penalities for prepayment
- Lockout period (can’t make prepayments during this time)
- Foreclosure provisions: recourse or non-recourse.
The loan-to-value (LTV) ratio indicates the percentage of the value of the real estate collateral that is loaned. Lower LTVs indicate less credit risk. LTV = mortgage/property value
LOS 54. e: Describe types and characteristics of residential mortgage-backed securities, including mortgage pass-through securities and collateralized mortgage obligations, and explain the cash flows and risks for each type. Define an agency/non-agency residential mortgage-backed securities (RMBS).
Agency residential mortgage-backed securities (RMBS) are guaranteed and issued by GNMA, Fannie Mae, or Freddie Mac. Mortgages that back agency RMBS must be conforming loans that meet certain minimum credit quality standards. These are federal agencies and government sponsored agencies
Non-agency RMBS are issued by private companies and may be backed by non-conforming mortgages. These are banks
LOS 54. e: Describe types and characteristics of residential mortgage-backed securities, including mortgage pass-through securities and collateralized mortgage obligations, and explain the cash flows and risks for each type. What are the two types of RMBS? Describe characteristics of Mortgage pass-through securities
Two types of RMBS include: 1) Mortgage pass-through securities and 2) collateralized mortgage obligations. Characteristics include scheduled monthly payments (monthly cash flows) which consist of principal, interest, prepayments, and penalties. The coupon rate for pass-through securties is called the pass-through rate (mortgage rate minus fees). To be included in the pool, each mortgage must contain certain criteria for the underwriters. If all criteria is met, its called conforming. For each pass-through security, a weighted average coupon rate and a weighted average maturity are determined.
LOS 54. e: Describe types and characteristics of residential mortgage-backed securities, including mortgage pass-through securities and collateralized mortgage obligations, and explain the cash flows and risks for each type. Describe the two types of prepayment risks for mortgage pass-through securities?
Contraction Risk: Mortgage rates drop which leads to increased refinancing and prepayments. PSA speed increases but average life decreases.
Extension Risk: Mortgage rates rise which leads to less refinancing and prepayments. PSA speed decreases but average life increases
LOS 54. e: Describe types and characteristics of residential mortgage-backed securities, including mortgage pass-through securities and collateralized mortgage obligations, and explain the cash flows and risks for each type. Define a collateralized mortgage obligation (CMO).
Collateralized mortgage obligations (CMOs) are collateralized by pools of pass-through mortgage securities. CMOs are structured with time tranches that have different exposures to prepayment risks. Cash flows of mortgage related products are redistributed to various tranches. No credit risk
A mortgage backed security is made up of a pool of mortgages (not a mortgage security)
LOS 54. e: Describe types and characteristics of residential mortgage-backed securities, including mortgage pass-through securities and collateralized mortgage obligations, and explain the cash flows and risks for each type. Define a sequential-pay CMO.
In a sequential-pay CMO, all scheduled principal payments and prepayments are paid to each tranche in sequence until that tranche is paid off (bond class 1 gets paid first). The first tranche is to be paid principal and has the most contraction risk and the last tranche to be paid principal has the most extension risk.
LOS 54. e: Describe types and characteristics of residential mortgage-backed securities, including mortgage pass-through securities and collateralized mortgage obligations, and explain the cash flows and risks for each type. Define a planned amortization class (PAC) CMO and support tranches for CMO.
A planned amortization class (PAC) CMO has PAC tranches that receive predictable cash flows as long as the prepayment rate remains within a predetermined range, and support tranches that have more contraction risk and more extension risk than the PAC tranches. Principle paid is made to PAC tranche first, any extra in the month goes to support tranche
PAC tranche have average stable life
Support tranche - a class or tranche in a CMO that protects the PAC tranche from prepayment risk
LOS 54. f: Define prepayment risk and describe the prepayment risk of mortgage-backed securities.
Prepayment risk refers to uncertainty about the timing of the principal cash flows from ABS. Contraction risk is the risk that loan principal will be repaid more rapidly than expected, typically when interest rates have decreased. Extension risk is the risk that loan principal will be repaid more slowly than expected, typically when interest rates have increased.
LOS 54. g: Describe characteristics and risks of commercial mortgage-backed securities.
Commercial mortgage-backed securities (CMBS) are pools of commercial mortgages backed by mortgages on income-producing real estate properties. Because commercial mortgages are non-recourse loans, analysis of CMBS focuses on credit risk of the properties. CMBS are structured in tranches with credit losses absorbed by the lowest priority tranches in sequence.
Each loan within the pool must have a certain debt to service ratio and loan to value ratio or subordination is used
CMBS face balloon risk
Credit risk is lower when there is higher DSC ratio and lower LTV
LOS 54. g: Describe characteristics and risks of commercial mortgage-backed securities. Call (prepayment) protection in CMBS includes?
Call (prepayment) protection in CMBS includes loan-level call protection such as:
- prepayment lockout periods (2-5 years)
- defeasance - borrower purchases securities as collateral to cover remaining principal balance plus an amount to substitue for what the yield would have been
- prepayment penalty points
- yield maintenance charges, and;
- CMBS-level call protection provided by the lower-priority tranches.
LOS 54. g: Describe characteristics and risks of commercial mortgage-backed securities. For investors in commercial mortgage-backed securities, balloon risk in commercial mortgages results in?
Balloon risk is the possibility that a commercial mortgage borrower will not be able to refinance the principal that is due at the maturity date of the mortgage. This results in a default that is typically resolved by extending the term of the loan during a workout period. Thus, balloon risk is a source of extension risk for CMBS investors.
LOS 54. h: Describe types and characteristics of non-mortgage asset-backed securities, including the cash flows and risks of each type. Define asset-backed securities.
Asset-backed securities may be backed by financial assets other than mortgages. Two examples are auto loan ABS and credit card ABS.
