Intro to Asset-Backed securities Flashcards
Benefits of securitization
- to banks
- allows banks to increase loan origination, monitoring, and collections
- reduces need of intermediaries
- increased efficiency and profitability
- active trading in secondary markets
Benefits of securitization
- to borrowers
- lowers the cost of borrowing for homeowners
Time tranching
*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
subordination/credit tranching
similar to time tranching
- losses are first absorbed by lowest tranche
a firm can _____ its funding cost through securitization rather than issuing corp bonds
can lower its funding cost
LTV from a mortgage loan lense
= 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
Non-agency RMBS v Agency
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
Prepayment risk
prepayment risk cannot be eliminated but can be redistributed
has two components
- contraction risk: when interest rates decline
- extension risk: when interest rates rise
Prepayment risk can be reduced by distributing CF to different tranches with a process called…
structuring
collateralized mortgage obligation (CMO)
- some investors may want prepayment risk/or reduce it
CMO tranches
- sequential-pay tranches
- planned amortization class (PAC) tranches
- support tranches
- floating-rate tranches
Internal credit enhancements
- senior/subordinated structures
- cash reserve funds
- overcollateralization
- excess spread accounts
External credit enhancements
- third party guarantee
Two key risk ratios to assess the potential credit performance of a CMBS
- debt-to-service coverage ratio
- loan-to-value ratio
debt-to-service coverage ratio
CMBS
= 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
non-mortgage ABS non-amortizing loans examples and amortizing examples
non-amortization
- credit card receivables
amortizing
- automobile loans
ABS must offer credit enhancement to be appealing to investors
Credit enhancement examples for auto-loan backed securities
- 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
Characteristics of credit card receivable-backed securities
- 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
Collateralized debt obligations (CDO)
- 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
