(54) 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 to the securitizing entity.
- Increase the liquidity of the underlying financial assets.
LOS 54. b: Describe securitization, including the parties involved in the process and the roles they play.
Parties to a securitization are a seller of financial assets, a special purpose entity (SPE), and a servicer.
- The seller is the firm that is raising funds through the securitization.
- 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.
- 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. 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.
LOS 54. d: Describe types and characteristics of residential mortgage loans that are typically securitized.
Characteristics of residential mortgage loans include:
- Maturity
- Interest rate: fixed-rate, adjustable-rate, or convertible.
- Amortization: full, partial, or interest-only.
- Prepayment penalties.
- 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.
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. Non-agency RMBS are issued by private companies and may be backed by non-conforming mortgages.
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 key characteristics of agency/non-agency residential mortgage-backed securities (RMBS).
Key characteristics of RMBS include:
- Pass-through rate, the coupon rate on the RMBS.
- Weighted average maturity (WAM) and weighted average coupon (WAC) of the underlying pool of mortgages.
- Conditional prepayment rate (CPR), which may be compared to the Public Securities Administration (PSA) benchmark for expected prepayment rates.
Non-agency RMBS typically include credit enhancement. External credit enhancement is a third-party guarantee. Internal credit enhancement includes reserve funds (cash or excess spread), overcollateralization, and senior/subordinated structures.
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 residential MBS. CMOs are structured with tranches that have different exposures to prepayment risks.
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. The first tranche is to be paid principal 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.
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.
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 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.
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
- defeasance
- 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.
LOS 54. h: Describe types and characteristics of non-mortgage asset-backed securities, including the cash flows and risks of each type. Define auto loan asset-backed securities.
Auto loan ABS are backed by automobile loans, which are typically fully amortizing but with shorter maturities than residential mortgages. Prepayments result when autos are sold or traded in, stolen or wrecked and paid off from insurance proceeds, refinanced, or paid off form the borrower’s excess cash.
