6.6 ABS instrument and market features Flashcards
Covered bonds
senior debt obligations issued by financial institutions and backed by a segregated pool of assets
typically mortgage loans although ships and aircraft have occasionally been pledged as collateral
why are Covered bonds not true asset-backed securities
they were first issued more than two centuries before pre-dating the relatively recent development of securitization
The important differences between a covered bond and an ABS:
Covered bond investors who have dual recourse, meaning that they have claims against both the issuer and the assets in the segregated pool.
The loans pledged to back a covered bond remain on the originating bank’s balance sheet rather than being transferred to a special legal entity.
Covered bond issues are typically with only one bond class per credit pool, while the underlying assets for an ABS support multiple tranches with different risk exposures.
The issuer of a covered bond must replace any loan in the pool that is deemed to be non-performing.
overcollateralization
The total value of the pool of assets pledged as collateral is greater than the face value of the covered bond
gives investors even greater protection against credit risk.
A hard-bullet covered bond
triggers a default as soon as the issuer fails to make a payment and investors receive their cash flows from the underlying mortgages on an accelerated schedule.
soft-bullet covered bond
delays the default declaration and acceleration of payments to investors until a new final maturity date, which is typically up to one year after the original maturity date.
conditional pass-through covered bond
converts to a pass-through security on the original maturity date and continues making payments until all commitments to investors have been met
why are covered bonds usually less risky and trade at lower yields than otherwise similar ABS
Because of the multiple layers of credit protection and redemption regimes
In order to mitigate credit risk, ABS are structured with various forms of what?
credit enhancement
–> may be internal or external in nature
external credit enhancements
include cash collateral accounts, letters of credit, and financial guarantees from banks or insurers.
Internal credit enhancements
structure the underlying assets to absorb potential losses.
Common mechanisms include overcollateralization, excess spread, and credit tranching (subordination).
As with covered bonds, overcollateralization of ABS involves making the value of the underlying assets greater than the face value of the liabilities that they are backing.
Excess spread
created by issuing ABS obligations with a coupon rate that is lower than the rate on the underlying loans
For example, a 4% coupon ABS based on 6% mortgages will build up cash reserves from the excess spread that can be used to make ensure that ABS investors continue to receive their contractual payments in the event of future loan defaults.
Credit tranching
involves the use of a waterfall structure with subordinated tranches that reduce credit risk for more senior tranches by absorbing the first losses from defaults on the underlying loans
Creating multiple tranches to absorb losses sequentially allows investors to choose their preferred level of exposure to credit risk.
Less senior tranches will appeal to investors who are willing to accept more credit risk in exchange for higher expected returns.
Non-amortizing loans
such as credit card debt, do not have scheduled principal repayments
Asset-backed securities based on these types of obligations are typically structured with a revolving (lockout) period
the amortization period starts at the end of the lockout period and continues until the stated maturity date of the ABS
Any principal repayments received during this second phase are distributed to ABS holders according to their tranche rather than used to acquire replacement loans for the pool.
revolving (lockout) period
period during which any principal repaid is reinvested to acquire an equivalent amount of additional loans\
the amortization period starts at the end of the lockout period and continues until the stated maturity date of the ABS
Credit Card Receivable ABS
Credit card issuers use securitization to remove receivables from their balance sheets.
From their perspective, the benefits of securitization include capital efficiency, lower funding costs, reduced default risk exposure, and additional fee income.
The cash flows generated by a pool of securitized credit card receivables include principal repayments, interest charges, and fees for late payments or annual memberships
only pass cash flows from interest charges and fee payments along to security holders during the lockout period, while principal repayments are reinvested.
Rapid (early) amortization provisions
used to ensure that they protect the credit quality of the ABS if specific events occur
For example, if default rates are higher than expected and there is ABS is at risk of becoming undercollateralized, a rapid amortization provision is triggered and investors have their principal returned on an accelerated schedule.
This protection is particularly beneficial during periods of deteriorating macroeconomic conditions.
Solar finance programs
allow homeowners to install solar energy systems by either renting equipment (solar leases), or borrowing funds directly from a manufacturer in a solar loan that is amortizing like a mortgage or auto loan
The initial cost of installation is recouped in the form of lower utility costs.
Solar loans may be backed by a lien on the equipment or they may be structured as home improvement loans, which effectively makes them subordinated mortgages.
Combining multiple liens together reduces the default risk of a solar ABS.
The credit quality of solar loan borrowers
typically relatively high and solar ABS investors receive additional protection against default risk from credit enhancements, such as overcollateralization, subordination, and excess spreads
It is common for solar ABS to include a pre-funding period after the close of the transaction during which additional assets may be added to the pool. This provision benefits investors by
diversifying the pool.
Collateralized Debt Obligations
a broad term for securities that are backed by a diversified pool of debt obligations.
technically not an ABS. Rather, a collateral manager issues debt and uses the proceeds to purchase a portfolio of assets that provide cash flows for investors.
The objective is to generate returns in excess of the coupon rate paid to bondholders, which makes managerial skill a paramount consideration for investors.
effectively highly leveraged portfolios with tranches that have different levels of risk. Senior tranches are the least risky and have the lowest coupon rates, while equity tranches offer the highest expected returns. Mezzanine tranches fall between the senior and equity tranches in terms of riskiness and expected return.
The equity tranches do not pay a coupon rate. Rather, these investors receive the residual return in excess of payments to more senior tranches and the CDO manager’s fees
examples of CDOs include:
Collateralized bond obligations (CBOs): Backed by corporate and emerging market bonds
Collateralized loan obligations (CLOs): Backed by bank loans
Structured finance CDOs: Backed by ABS, RMBS, CMBS, and other CDOs
Synthetic CDOs: Backed by credit default swaps and other structured securities
market value CLO structure
tranches accrue value based on the market value of the portfolio
synthetic CLO structure
the collateral pool is created using derivative positions rather than by holding underlying assets
the most commonly used CLO structure
Cash Flow CLO that establishes rules to allocate interest payments and principal repayments across various tranches.
covered bonds have the following features:
Collateral remains on the issuer’s balance sheet rather than being transferred to a separate entity.
There is only one bond class per pool of assets rather than multiple tranches with different risk/return profiles.
Investors have dual recourse to both the pledged assets and the issuer, while ABS investors only have recourse to the collateral pool.
Upon a bankruptcy affecting a covered bond, the first available safeguards to protect against potential losses are the:
a) ringfenced loans.
b) unencumbered assets of the issuer.
c) assets added by the collateral manager during ramp-up.
a) ringfenced loans.
In the case of bankruptcy covered bond investors, they have dual recourse with the first safeguard being the ringfenced loans in the cover pool that underlie the covered bond transaction
Which investor tranche plays a key role in determining CLO viability?
a) Senior
b) Equity
c) Mezzanine
b) Equity
Investors in equity tranches take on equity-like risks with the potential to earn returns comparable to equities. Moreover, these residual tranche investors play a key role in whether a CLO is viable or not; the CLO structure has to offer competitive returns for this tranche. Facing these risk/return possibilities puts them in the position of the marginal, price-setting investors.
The inclusion of assets into a CLO collateral pool is completed:
a) during a subsequent ramp-up period.
b) prior to the close of the CLO transaction.
c) between ramp-up and loan maturity on meeting certain requirements.
c) between ramp-up and loan maturity on meeting certain requirements.
After the ramp-up period but before underlying collateral pool loans mature, the collateral manager may replace loans in the portfolio as long as the new asset meets the portfolio selection criteria
