6.6 ABS instrument and market features

Question 1

Covered bonds

Answer 1

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

Question 2

why are Covered bonds not true asset-backed securities

Answer 2

they were first issued more than two centuries before pre-dating the relatively recent development of securitization

Question 3

The important differences between a covered bond and an ABS:

Answer 3

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.

Question 4

overcollateralization

Answer 4

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.

Question 5

A hard-bullet covered bond

Answer 5

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.

Question 6

soft-bullet covered bond

Answer 6

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.

Question 7

conditional pass-through covered bond

Answer 7

converts to a pass-through security on the original maturity date and continues making payments until all commitments to investors have been met

Question 8

why are covered bonds usually less risky and trade at lower yields than otherwise similar ABS

Answer 8

Because of the multiple layers of credit protection and redemption regimes

Question 9

In order to mitigate credit risk, ABS are structured with various forms of what?

Answer 9

credit enhancement

–> may be internal or external in nature

Question 10

external credit enhancements

Answer 10

include cash collateral accounts, letters of credit, and financial guarantees from banks or insurers.

Question 11

Internal credit enhancements

Answer 11

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.

Question 12

Excess spread

Answer 12

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.

Question 13

Credit tranching

Answer 13

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.

Question 14

Non-amortizing loans

Answer 14

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.

Question 15

revolving (lockout) period

Answer 15

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

Question 16

Credit Card Receivable ABS

Answer 16

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.

Question 17

Rapid (early) amortization provisions

Answer 17

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.

Question 18

Solar finance programs

Answer 18

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.

Question 19

The credit quality of solar loan borrowers

Answer 19

typically relatively high and solar ABS investors receive additional protection against default risk from credit enhancements, such as overcollateralization, subordination, and excess spreads

Question 20

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

Answer 20

diversifying the pool.

Question 21

Collateralized Debt Obligations

Answer 21

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

Question 22

examples of CDOs include:

Answer 22

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

Question 23

market value CLO structure

Answer 23

tranches accrue value based on the market value of the portfolio

Question 24

synthetic CLO structure

Answer 24

the collateral pool is created using derivative positions rather than by holding underlying assets

Question 25

the most commonly used CLO structure

Answer 25

Cash Flow CLO that establishes rules to allocate interest payments and principal repayments across various tranches.

Question 26

covered bonds have the following features:

Answer 26

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.

Question 27

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.

Answer 27

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

Question 28

Which investor tranche plays a key role in determining CLO viability?

a) Senior

b) Equity

c) Mezzanine

Answer 28

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.

Question 29

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.

Answer 29

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