Fixed Income Securitisation: ABS/MBS Flashcards
Securitisation Process
Step 1: A bank making loans or a corporation extending credit to customers (originator) creates a pool of debt-based assets.
Step 2: The pool of assets (collateral) is sold to a separate legal entity, referred to as a special purpose entity (SPE).
Step 3: The SPE issues f ixed-income securities (ABSs) supported by the cash flows from the collateral (i.e., the borrowers making repayments on their loans). These ABSs are purchased by investors, such as pension funds or fixed-income funds, that deem the risk/reward of the underlying collateral to be attractive.
Benefits of Securitisation to Issuers (Originators)
- Increased Business Activity: are able to lend more. Post securitsation - bank receives proceeds which can then be used to make more loans
- Improved Profitability: charge fee to SPE for initial transaction
- Lower Capital Reserves for banks: removes credit risk by selling to SPE
- Improved Liquidity: can use securitisation to sell illiquid loan portfolios
Benefits of Securitisation to Investors
- Tailored Risk & Return: allows SPE to create securities aligned with risk/return profiles of inv
- Access: to collateral pool w/o special expertise
- Liquidity: ABSs are liquid securities that can be sold easier than underlying collateral
Benefits of Securitisation to Economies/Financial Markets
- Decreased Liquidity Risk: ABSs are more liquid
- Improved market efficiency: liquidity allows investors to set equilibrium prices
- Lower financing costs for originators: lower costs than issuing debt/equity directly to investor
- Lower Leverage for originators: Allows originators to grow their business without increasing debt on their balance sheet
Risks to Investors in ABSs
- Uncertain cash flows: can vary in timing and size
- Credit Risk of collateral is passed through to investors in the ABS
Disinterested Trustee
A trustee is also appointed to oversee the safekeeping of collateral and cash lows due to the ABS investors and provide information to ABS holders
Bankruptcy Remote
A decline in the financial position of the Originator does not affect the value of the claims of ABS owners to the cash flows from the trust collateral owned by the SPE. Thus, it is bankruptcy remote from the originator. Also, ABS owners have no claim on other assets of Originator - only on collateral sold to SPE.
Covered Bonds
Senior debt obligations of f inancial institutions
that are similar to ABSs. However, the underlying assets (the cover pool), while segregated from other assets of the issuer, remain on the balance sheet of the issuing corporation (i.e., no SPE is created). Covered bonds are issued primarily by European, Asian, and Australian banks, and the cover pool typically consists of mortgage loans (though other types of assets can be used).
Dual Recourse
In the event of issuer default, covered bond investors have the dual recourse of claims on both the cover pool and, in contrast to a securitization involving an SPE, claims over other assets of the issuers that have not been pledged as collateral for other debt (referred to as unencumbered assets)
Mitigation of Risk faced by Bond Investors
- The mortgages that make up the cover pool are subject to upper limits on loan-to-value ratios
- The value of the collateral is usually higher than the face value of covered bonds issued (referred to as overcollateralization).
- The cover pool is monitored by a third party to ensure adherence to these conditions.
These credit enhancements, along with dual recourse, result in covered bonds generally having lower yields than comparable ABSs.
ABS/Covered Bonds difference
- Cover pool remains on the balance sheet of the issuer, the issuer will not bene it from any reduction in required capital reserves that would occur under a securitization.
- Unlike an ABS, in which the pool of assets is f ixed at issuance, a covered bond requires the issuer to replace or augment nonperforming or prepaid assets in the cover pool so that it always provides for the covered bond’s promised interest and principal payments. Covered bonds typically are not structured with credit tranching.
Hard-Bullet Covered Bond
Defaults if the issuer fails to make a scheduled payment, leading to the acceleration of payments to covered bondholders.
Soft-Bullet Covered Bond
May postpone the originally scheduled maturity date by as much as a year, should a payment on the covered bond be missed—effectively postponing default and associated payment acceleration.
Conditional pass-through covered bond
A conditional pass-through covered bond converts to a pass-through bond on the maturity date if any payments remain due, meaning that any payments subsequently recovered on the cover pool are passed through to investors.
Overcollateralization
Occurs when the value of the collateral exceeds the face value of the ABS.
Excess spread
An excess spread feature builds up reserves in the ABS structure by earning higher income on the collateral than the coupon promised to ABS investors. This income can then be used to absorb credit losses in the collateral.
Credit Tranching/Subordination
The ABS is structured with multiple classes of securities (referred to as tranches), each with a different priority of claims to the cash flows of the collateral. Tranches ranked as subordinated absorb credit losses first (up to their principal values), thereby providing protection to senior tranches against credit losses. The level of protection for the senior tranche increases with the proportion of subordinated bonds in the structure.
Most senior tranche aka the equity tranche
Why is credit tranching also called a waterfall?
Because in liquidation, each subordinated tranche would receive only the “over low” from the more senior tranche(s) if they are repaid their principal value in full.
What types of assets ABSs be backed by?
F inancial assets including business loans, accounts receivable, or automobile loans.
In fact, any asset that generates a future stream of cash lows could be used as collateral for securitization, including music royalties or franchise license payments. Each of these types of ABS has different risk characteristics, and their structures vary to some extent as well.
Credit Card ABS
Credit card receivable-backed securities are ABSs backed by pools of credit card debt owed to banks, retailers, travel and entertainment companies, and other credit card issuers.
The cash low to a pool of credit card receivables includes inance charges (i.e., interest), membership and late payment fees, and principal repayments. Credit card receivables are nonamortizing loans; however, borrowers can choose to repay principal at their discretion. Interest rates on credit card receivables can be ixed or loating, typically subject to a cap (i.e., a maximum rate that the credit card lender can charge).
Lockout Period or Revolving Period
Period during which ABS investors only receive interest and fees paid on the collateral. If the underlying credit card holders make principal payments during the lockout period, these payments are used to purchase additional credit card receivables, keeping the overall value of the pool relatively constant.
Amortization Period of Credit Card ABSs
Once the lockout period ends, the amortization period of the ABS begins, and principal payments made on the underlying collateral are passed through to security holders. Credit card ABSs typically have an early (rapid) amortization provision that provides for earlier amortization of principal when it is necessary to preserve the credit quality of the securities, akin to an acceleration of payment for a debt issuer when credit conditions worsen.
Solar ABSs
backed by loans to homeowners wishing to inance the installation of solar energy systems to reduce their energy bills. These loans are offered by specialist inance companies or the inancing subsidiaries of solar energy companies.
Solar ABSs are attractive to investors focused on environmental, social, and governance (ESG) factors because, through investing in the solar ABS, they are providing funds for homeowners to switch to a renewable energy source. Solar loans themselves can be secured on the solar energy system itself or on the homeowner’s property as a junior mortgage, providing extra security to ABS investors.
Internal Credit Enhancement Methods for Solar ABSs
- Good Credit Score
- Overcollateralization
- Excess Spread
- Subordination
Solar ABSs: Pre-funding period
Allows the trust to make investments in solar-related loans for a fixed time period after raising funds through issuing the ABS. A pre-funding period allows the ABS structure to invest in a larger, more diversi fied pool of solar-related investments.
Collateral manager
What sets CDOs apart from regular ABSs is that CDOs have a collateral manager who dynamically buys and sells securities in the collateral pool to generate the cash to make the promised payments to investors.
