CFA 54: Introduction to Asset Backed Securities

Question 1

asset-backed securities (ABS)

Benefits of Securitization for Economies and Financial Markets

Answer 1

Fixed-income securities backed, or collateralized, by a pool (collection) of assets, such as loans and receivables. The special legal entity then uses the assets as collateral, and the assets’ cash flows are used to pay the interest and repay the principal owed to the holders of the asset-backed bonds.

Question 2

securitized assets

Benefits of Securitization for Economies and Financial Markets

Answer 2

Assets that are typicall used to create asset backed bonds. Some examples would be residential mortgage loans, commerical mortgage loans, automobile loans, student loans, bank loans, and credit card debt.

Question 3

securitization

Benefits of Securitization for Economies and Financial Markets

Answer 3

Moving assets from the owner of the assets into a special legal entity.

Question 4

special purpose vehicle (SPV)

The Securitization Process

Answer 4

A non-operating entity created to carry out a specified purpose, such as leasing assets or securitizing receivables; can be a corporation, partnership, trust, limited liability, or partnership formed to facislatate a specific type of business activity. Also called special purpose entity or variable interest entity.

Question 5

waterfall

The Securitization Process

Answer 5

Because ABS usually include different bond classes or tranches, the prospectus must specify the priority and amount of payments in the even that the cash flows generated by the pool of securitized assets is insufficient to make all cash payments to security holders. The structure adopted in a securitization transaction is commonly referred to as the waterfall because of the cascading flow of payments between bond classes.

Question 6

prepayment risk

The Securitization Process

Answer 6

The uncertainty that the cash flows will be different from the scheduled cash flows as set forth in the loan agreement due to the borrowers’ ability to alter payments, usually to take advantage of interest rate movements. For example, borrowers tend to pay off part or all of their loans when interest rates decline, refinancing at a lower interest rate if necessary. This risk can be mitigated for investors by time tranching.

Question 7

subordination

The Securitization Process

Answer 7

A common structure where there is more than one bond class. The bond classes differ as to how they will share any losses resulting from defaults of the borrowers whose loans are in the pool of loans. The bond classes are classified as senior bond classes or subordinated bond classes, and the structure is called a senior/subordinated structure. Losses are realized by the subordinate bond classes before any losses are realized by the senior bond classes.

Question 8

credit tranching

The Securitization Process

Answer 8

Redistributing the credit risk associated with the collateral.

Question 9

mortgage loan

Residential Mortgage Loans

Answer 9

A loan secured by the collateral of some specified real estate property that obliges the borrower (often someone wishing to buy a home) to make a predetermined series of payments to the lender (often initially a bank or mortgage company).

Question 10

foreclosure

Residential Mortgage Loans

Answer 10

Allows the lender to take possession of the mortgaged property and then sell it in order to recover funds toward satisfying the debt obligation.

Question 11

loan-to-value ratio (LTV)

Residential Mortgage Loans

Answer 11

Ratio of the property’s purchase price to the amount of the mortgage.

Question 12

amortizing loans

Residential Mortgage Loans

Answer 12

Loans with the gradual reduction of the amount borrowed over time. Assuming no prepayments are made by the borrower, the periodic mortgage payments made by the borrower consist of interest payments and scheduled principal repayments. Can be partially or fully amortized.

Question 13

interest-only loan

Residential Mortgage Loans

Answer 13

A loan with no scheduled principal repayment for a certain number of years.

Question 14

prepayment option

Residential Mortgage Loans

Answer 14

A mortgage loan may entitle the obrrower to prepay all or part of the outstanding mortgage principal prior to the scheduled due date teh pr

Question 15

prepayment penalty mortgages

Residential Mortgage Loans

Answer 15

A mortgage that stipulates some sort of monetary penalty when a borrower prepays within a certain time period after the mortgage is originated.

Question 16

recourse loan

Residential Mortgage Loans

Answer 16

A loan where the lender has a claim against the borrower for the shortfall between the amount of the mortgage balance outstanding and the proceeds received from the sale of the property.

Question 17

non-recourse loan

Residential Mortgage Loans

Answer 17

A loan where the lender does not have a claim against the borrower for the shortfall between the amount of the mortgage balance outstanding and the proceeds received from the sale of the property. The lender can only look to the property to recover the outstanding mortgage balance. US mortgages are typically non-recourse. European loans are typically recourse loans.

Question 18

agency RMBS

Residential Mortgage-Backed Securities

Answer 18

In the United States, securities backed by residential mortgage loans and guaranteed by a federal agency or guaranteed by either of the two GSEs (Fannie Mae and Freddie Mac).

Question 19

non-agency RBMS

Residential Mortgage-Backed Securities

Answer 19

In the United States, securities issued by private entities that are not guaranteed by a federal agency or a GSE.

Question 20

mortgage pass-through security

Residential Mortgage-Backed Securities

Answer 20

A security that is created when one or more holders of mortgages form a pool of mortgages and sell shares or participation certificates in the pool. A pool can consist of several thousand or only a few mortgages. When a mortgage is included in a pool of mortgages that is used as collateral for a mortgage pass-through security, the mortgage is said to be securitized.

Question 21

pass-through rate

Residential Mortgage-Backed Securities

Answer 21

A mortgage pass-through security’s coupon rate. The pass-through rate is less than the mortgage rate on the underlying pool of mortgages by an amount equal to the servicing and other fees. The pass-through rate that the investor receives is said to be “net interest” or “net coupon”.

Question 22

weighted average coupon rate (WAC)

Residential Mortgage-Backed Securities

Answer 22

Found by weighting the mortgage rate of each mortgage loan in the pool by the percentage of the mortgage outstanding relative to the outstanding amount of all the mortgages in the pool.

Question 23

weighted average maturity (WAM)

Residential Mortgage-Backed Securities

Answer 23

Found by weighting the remaining number of months to maturity for each mortgage loan in the pool by the amount of the outstanding mortgage balance.

Question 24

weighted average life (average life)

Residential Mortgage-Backed Securities

Answer 24

A measure that gives investors an indication of how long they can expect to hold the MBS before it is paid off. In other words, the average life of the MBS is the convention-based average time to receipt of all principal repayments (scheduled principal repayments and projected prepayments).

Question 25

contraction risk

Residential Mortgage-Backed Securities

Answer 25

The risk that when interest rates decline, the security will have a shorter maturity than was anticipated at the time of purchase because homeowners refinance at now-available lower interest rates. A security becoming shorter in maturity when interest rates decline has two adverse consequences. First, the proceeds received must now be reinvested at lower interest rates. Second, if the bond is prepayable or callable, its price appreciation is not as great as that of an otherwise identical bond that does not have a prepayment or call option.

Question 26

extension risk

Residential Mortgage-Backed Securities

Answer 26

The risk that when interest rates rise, fewer prepayments will occur because homeowners are reluctant to give up the benefits of a contractual interest rate that now looks low. As a result, the security becomes longer in maturity than anticipated at the time of purchase. From the investor’s perspective, the value of the security has fallen because interest rates are higher whereas the income they receive (and can potentially reinvest) is typically limited to the interest payment and scheduled principal repayments.

Question 27

collateralized mortgage obligations (CMO)

Residential Mortgage-Backed Securities

Answer 27

When cash flows of mortgage-related products are redistributed to various tranches. The mortgage-related products from which the cash flows are obtained are considered the collateral. Note that in contrast to a mortgage pass-through security, the collateral is not a pool of mortgage loans but a mortgage pass-through security. In fact, in actual deals, the collateral is usually a pool of mortgage pass-through securities, hence the reason market participants sometimes the terms “collateral” and “mortgage pass-through security” interchangeably. The creation of a CMO cannot eliminate prepayment risk; it can only distribute the various forms of this risk among various classes of bondholders. The CMO’s major financial innovation is that the securities can be created to closely satisfy the asset/liability needs of institutional investors, thereby broadening the appeal of mortgage-backed products.

Question 28

support tranches

Residential Mortgage-Backed Securities

Answer 28

non-PAC (planned amortization class) that absorbs the prepayment risk first. Because PAC tranches have limited (but not complete) protection against both extension risk and contraction risk, they are said to provide two-side prepayment protection.

Question 29

collateral manager

Collateralized Debt Obligations

Answer 29

Buys and sells debt obligations for and from the CDO’s portfolio of assets (the collateral) to generate sufficient cash flows to meet the obligations to the CDO bondholders.