Intro to Asset-Backed securities

Question 1

Benefits of securitization

- to banks

Answer 1

• allows banks to increase loan origination, monitoring, and collections
• reduces need of intermediaries
• increased efficiency and profitability
  
  • active trading in secondary markets

Question 2

Benefits of securitization

- to borrowers

Answer 2

• lowers the cost of borrowing for homeowners

Question 3

Time tranching

Answer 3

*prepayment risk cannot be eliminated, but can be redistributed

• time tranching distributes the prepayment risk to different tranches
• if borrowers prepay, the lowest tranche will be prepaid before the top tranche

Question 4

subordination/credit tranching

Answer 4

similar to time tranching

- losses are first absorbed by lowest tranche

Question 5

a firm can _____ its funding cost through securitization rather than issuing corp bonds

Answer 5

can lower its funding cost

Question 6

LTV from a mortgage loan lense

Answer 6

= amount on mortgage loan / the property’s purchase price

• a lower LTV means less likelyhood of borrower default or better chance to recover funds after selling the property

Question 7

Non-agency RMBS v Agency

Answer 7

Agency

• Ginnie Mae: backed by govt
• Fannie Mae/Freddie Mac: backed by quasi govt agency

Non-agency

• credit risk is an issue
• will use credit enhancement to reduce credit risk

Question 8

Prepayment risk

Answer 8

prepayment risk cannot be eliminated but can be redistributed
has two components
- contraction risk: when interest rates decline
- extension risk: when interest rates rise

Question 9

Prepayment risk can be reduced by distributing CF to different tranches with a process called…

Answer 9

structuring
collateralized mortgage obligation (CMO)
- some investors may want prepayment risk/or reduce it

Question 10

CMO tranches

Answer 10

• sequential-pay tranches
• planned amortization class (PAC) tranches
• support tranches
• floating-rate tranches

Question 11

Internal credit enhancements

Answer 11

• senior/subordinated structures
• cash reserve funds
• overcollateralization
• excess spread accounts

Question 12

External credit enhancements

Answer 12

• third party guarantee

Question 13

Two key risk ratios to assess the potential credit performance of a CMBS

Answer 13

• debt-to-service coverage ratio

- loan-to-value ratio

Question 14

debt-to-service coverage ratio

CMBS

Answer 14

= annual net operating income / debt service

NOI = rental income - cash operating expenses - non-cash replacement reserve

DSC > 1 means there is enough CF to service debt and lower credit risk

Question 15

non-mortgage ABS non-amortizing loans examples and amortizing examples

Answer 15

non-amortization
- credit card receivables

amortizing
- automobile loans

ABS must offer credit enhancement to be appealing to investors

Question 16

Credit enhancement examples for auto-loan backed securities

Answer 16

• senior subordinated structure: senior tranche is protected from lower classes
• there is no “lockout period” for auto loans
• reserve account; internal enhancement, used to protect bondholders from x% of losses of the issue
• over-collateralization; internal enhancement, the $ amount issued to investors does not quite total the $ amount of the “reference portfolio”
  - ie if the reference portfolio has a value of 100%, then the securities issued to investors may be ~98% of that value. so, the value of the assets > the value of the liabilities
  - 2% of the assets would need to default before the lowest tranche would be affected by defaults

Question 17

Characteristics of credit card receivable-backed securities

Answer 17

• the credit card receivables are pooled together to act as the collateral
• CF consists of: interest charges, fees and principal repayments
• investors in the pool are paid interest periodically; fixed or floating rates
• principal payments to investors are not made during the “lockout period”
  - during the lockout period, repayments are invested to issue new loans
• ## non-amortizing

Question 18

Collateralized debt obligations (CDO)

Answer 18

• as with an ABS, CDOs create an SPV
• in contrast to an ABS, a CDO requires a collateral manager to buy/sell debt obligations for and from the CDO’s portfolio of assets to generate sufficient CF to meet the obligations of the bondholders, and to generate a fair return for the equity holders
• the funds raised by the issuance of bonds are invested into assets by the collateral manager with the goal of earning a higher return on the assets than what is paid to the bondholders
  
  • the excess return spread is used to pay the equity holders
• CF to bondholders: interest, principal repayments, and sale of collateral assets (capital gains from active CDO manager)
• the CDO manager will enter into an interest rate swap with a counterparty in the amount equal to the senior tranche; to receive a fixed rate
• after the total interest received and total interest paid is net, the CDO manager gets their fee
• then the equity traunch receives the remaining CF
  - the equity return % is = the remaining CF/tranche par value