LM 6: Fixed Income Securitization: Asset-Backed & Mortgage-Backed Securities Flashcards
What is securitization?
process of creating streams of cash flows from an underlying pool of assets.
What is the difference between asset-backed securities and covered bonds?
asset-backed securities: investor receives interest and principal payments but also takes on the risk of the underlying asset
covered bonds (senior debt obligations): the issuer takes on the risk and the investor has dual recourse against both the issuer and assets in the segregated pool
What are 2 distinct characteristics that make covered bonds different than securitizations (ABS)?
- The assets in the segregated pool remain on the issuer’s balance sheet.
- Cash flows go directly from the issuer to investors without passing through an intermediary.
What are pass-through securities?
assets transferred from their owner to a legally distinct entity that the cash flow from these assets “pass-through” before they are received by investors
What is the pass through rate for mortgage pass through securities?
The pass-through rate earned by investors is the interest rate on the underlying mortgages after fees have been deducted.
fees like collecting payments, maintaining records, providing tax information, etc.
What are tranches (aka subordination) and credit tranches?
tranches: bonds with multiple classes
credit tranches: bonds with multiple tranches separated by credit risk. eg. MBS with AAA bonds and then B bonds, etc.
What are the 3 benefits of securitization? MII
- more funds available to borrowers at a lower cost
- improves liquidity
- improves efficiency of overall financial system
Describe the 3 risks associated with securitization.
- contraction risk (cash flows received sooner than expected)
- extension risk (cash flows received later than expected)
- credit risk (possibility of default)
What are the 7 steps to securitization process?
- The manufacturer sells equipment to its customers on credit
- The manufacturer establishes a special purpose vehicle (SPV) as a separate legal entity
- The SPV purchases loans from the manufacturer, which now has $200 million in cash
- The SPV creates securities backed by the loans purchased from the manufacturer
- Investors purchase securities from the SPV
- Loan payments from customers are received by the SPV
- The SPV distributes cash flows to investors
What are the 3 parties to securitization? SIS
- seller
- issuer
- servicer
Describe the role of the 3 parties to securitization?
- The seller (or depositor) originates the assets that are used as collateral
- The issuer is the legally distinct SPV that issues the asset-backed securities to investors
- The servicer collects payments on the underlying loans
What is the lawyers role in securitization?
lawyers draft the sale agreements and prospectus.
What is the investment bank’s role in securitization?
Investment banks underwrite the securities.
What is the financial guarantor’s role in securitization?
financial guarantors guarantee the performance of the underlying assets.
What is the rating agencies’ role in securitization?
Rating agencies assess the credit risk.
What is the trustee’s role in securitization?
Trustees safeguard the assets and transfer funds.
What does bankruptcy remote for a special purpose entity mean?
when a bank securitizes its pool of loans and the assets have been transferred to the SPE the bank no longer owns the assets, therefore, investors’ risk is no longer with the bank it is with the ones unable to repay the loans
What is over-collateralization?
when the value of collateral is greater than value of the bond
What are the 3 redemption regimes covered bonds use if payments do not occur according to original schedule?
- hard-bullet covered bond
- soft-bullet covered bond
- conditional pass-through covered bond
Describe the 3 redemption regimes covered bonds use if payments do not occur according to original schedule?
- hard-bullet covered bond trigger a bond default and accelerate the bond payments
- soft-bullet covered bond delay the bond default and payment acceleration until a new final maturity date
- conditional pass-through covered bond convert to pass-through securities after the original maturity date
What are 2 forms of credit enhancement?
- internal credit enhancements
- external credit enhancements
What are the 3 types of external credit enhancements? CLF
- cash collateral accounts
- letter of credit
- financial guarantees from banks or insurers
What are the 3 types of internal credit enhancements? OEC
- over-collateralization
- excess spread
- credit tranching
What are excess spread credit enhancements?
when the ABS coupon rate is lower than the underlying loans, the excess cash will be used to build up cash reserve
What is credit tranching?
when a bond is divided into tranches where cash flows are paid in a waterfall structure from highest seniority to lowest seniority. highest seniority gets the lowest yield and the lowest seniority gets the highest yield for taking on more risk.
What is the difference between an amortizing loan and a non-amortizing loan?
amortizing loans: include both interest and principal payments
non-amortizing loan: don’t have scheduled principal payments
What is a revolving (lockout) period in terms of non amortizing loans?
the repaid principal is reinvested into an equivalent amount of new loans, replenishing the collateral pool
What kind of cash flows do investors of credit card ABS earn?
they earn only interest charges and fee payments, principal repayments are reinvested
What are rapid (early) amortization provisions?
a mechanism used to accelerate principal repayment prior to maturity on an accelerated schedule
What is a collateralized debt obligation (CDO)?
broad term for securities that are backed by diversified pool of debt obligations
Describe the 4 types of CDO’s. CCSS
- 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
What does a collateral manager do?
collateral manager issues debt and uses the proceeds to purchase a portfolio of assets that provide cash flows for CDO bondholders.
What is dual recourse?
if an issuer is in default, allow claims on both the issuer and the assets in the bonds’ collateral
What is time tranching?
Like credit tranching except instead of seniority of tranches, it’s with maturity
ABS/MBS is segregated into different classes/tranches with different expected maturities.
What is a residential mortgage loan?
mortgage loan is simply a loan with real estate as collateral
What does first lien mean on mortgage loans for lenders?
lender has the first lien, meaning that they can take ownership of the property and sell it if the borrower is unable to make payments and defaults on their obligations
What is foreclosure?
the process of the lender taking ownership of the property and selling it
What is LTV or loan-to-value ratio and how is it calculated?
loan-to-value ratio (LTV) is the ratio of the mortgage amount to the property’s purchase price.
Borrowers with lower LTV ratios are less likely to default
What is debt to debt-to-income ratio (DTI) and how is it calculated?
measures a borrower’s credit quality or ability to pay its mortgage obligations
DTI = monthly mortgage payment / borrowers monthly pre-tax income
What is the difference between prime loans and subprime loans?
Prime loan borrowers have high credit quality, good credit history, and enough income to cover the loan payments
Subprime loans either have borrowers with low credit quality, or the loan is not the first lien on the property
What are non-agency RMBS?
Mortgages that do not meet the criteria for agency RMBS, may be pooled into privately issued pass-through securities called non-agency RMBS
What is the difference between collateralized mortgage obligations (CMO) and mortgage pass through securities?
CMOs redistribute cash flows among multiple tranches with various levels of exposure to prepayment risk and credit risk.
Describe the 2 types of agency RMBS.
- agency RMBS by a government agency is backed by the government and guarantees performance
- agency RMBS by government-sponsored enterprise (GSE) guarantees payments but not performance
What is prepayment risk?
the risk involved with the premature return of principal on fixed-income security which causes reinvestment risk for the lender
What is reinvestment risk?
possibility that an investor will be unable to reinvest cash flows received from an investment at a rate comparable to their current rate of return.
What is underwater mortgage mean?
mortgage is described as being “underwater” if the value of the property is less than the amount of outstanding principal (i.e., the LTV ratio is greater than 1
If you owe more than what it’s worth
What is the difference between a recourse loan and a non-recourse loan?
recourse loan allows a lender to pursue additional assets when a borrower defaults on a loan if the debt’s balance surpasses the collateral’s value.
non-recourse loan permits the lender to seize only the collateral specified in the loan agreement, even if its value does not cover the entire debt.
What is weighted average maturity?
average time until a portfolio’s securities mature
What is a weighted average coupon (WAC)?
rate of return on a pool of mortgages
What is sequential pay CMO structure?
each class (or tranche) is retired sequentially, which allows investors to choose the class that corresponds to their desired maturity
each tranche receives the same coupon rate, but all scheduled principal payments and prepayments are directed to one tranche until its full par value is repaid. After that, principal payments are directed to the next tranche. This is done until all tranches are completely paid off.
What is Z tranche?
Z tranche is the lowest ranked tranche that only receives payments once all the other tranches have been retired.
The lowest-ranked tranche that’s not entitled to any copayments until more senior tranches have been paid off.
What is a principal-only (PO) tranche?
tranche receives only the principal repayments (including prepayments) from the underlying pool of mortgages.
What is an interest-only (IO) tranche?
tranche receives only the interest payments from the underlying pool of mortgages.
What is a floating rate tranche?
investors take a floating rate on tranche, then an inverse rate is created to offset the rate at the fixed rate price
What are residual tranches?
tranches that receive only the cash flows that remain after obligations of all other tranches have been met
What is a planned amortization class (PAC) tranche?
PAC bondholders are given priority to receive principal prepayments over all other collateralized mortgage obligation (CMO) tranches
What is a call protection for CMBS and what are the 2 types of call protection?
offer protection against mortgage being paid ahead of schedule
- structural call protection
- loan level call protection
What is structural call protection?
sequential payments based on each tranche’s credit rating.
The highest-rated tranches are repaid before those with lower ratings and default losses are absorbed by the lowest-rated tranches.
What are the 4 mechanisms of a loan level call protection?
- prepayment lockouts
- prepayment penalty points
- yield maintenance charges
- defeasance.
What is defeasance?
provisions that require the borrower to purchase a portfolio of government securities that replicate the future cash flows that the lender would receive in the absence of prepayments
What is balloon risk?
risk that the borrower will fail to make the principal payment (balloon payment) of a commercial mortgage.
What is the debt to service coverage ratio formula and use?
measures a firm’s available cash flow to pay current debt obligations. higher is better, indicates lower credit risk
DSC = Net annual operating income (NOI) / debt service
What is the formula for net annual operating income and debt service?
net annual operating income = (rental income - cash operating expense) - replacement reserves
debt service = annual interest payments + annual principal repayment
What are commercial mortgage back securities (CMBS)?
Commercial mortgage-backed securities (CMBS) redistribute cash flows from a pool of mortgages on commercial properties (e.g., apartment buildings, offices, warehouses)
What are 4 ways commercial mortgage back securities protect or help with prepayment risk? LPYD
- Lockout periods
- Prepayment penalty points
- Yield maintenance charges that make lenders whole if the borrower chooses to refinance
- Defeasing future cash flows: a borrower setting aside sufficient funds, often in cash and bonds, to cover his or her associated debts.
How many bond classes are there in covered bonds vs asset-backed securities?
ABS uses credit tranching and has many
covered bond only has one bond class
What are the three different CLO tranches from safe to riskiest?
- Senior tranches
- Mezzanine tranches
- Equity tranches
