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CFA Level II Fixed Income > New - Reading 46 - Introduction to Asset-Backed Securities > Flashcards

New - Reading 46 - Introduction to Asset-Backed Securities Flashcards

1
Q

Describe the Securitization process?

A

Involves moving assets from the owner of the assets into a special legal entity

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2
Q

What is a Mortgage Backed Security (MBS) ?

A

securities backed by high quality real estate mortgages

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3
Q

What are some of the benefits of Securitization?

A
  1. Lowers or removes the wall between ultimate investors and originating borrowers
  2. Allows the ultimate investors to achieve better legal claim on underlying mortgages and to tailor interest rate and credit risks to suit their needs
  3. Banks improve their profitability by doing more loan origination
  4. Allows for the creation of tradable securities with better liquidity than the original loans on the bank’s balance sheet
  5. Enables innovations of investment products, which allow investors to access asset classes which match their risk, return and maturity profiles
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4
Q

Why is the structure adopted in a securitization transaction referred to as the “Waterfall”?

A

B/c the cascading flow of payments between bond classes

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5
Q

What is Prepayment Risk ?

A

the uncertainty that the cash flows will be different from the scheduled cash flows as set forth in the loan agreement.

This primarily occurs from the borrowers ability to alter payments, usually to take advantage of lower interest rates

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6
Q

What is the creation of different bond classes called when it is done for prepayment risk reasons?

A

Time Tranching

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7
Q

What is Subordination?

A

A common structure in securitization, which leads to the creation of more than one bond class or tranche. 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.

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8
Q

What is Credit Tranching?

A

a set of bond classes that is created to allow investors a choice in the amount of credit risk they prefer to bear

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9
Q

What is the absolute priority rule ?

A

the principle that senior creditors are paid in full before subordinated creditors are paid anything

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10
Q

How do you calculate the loan-to-value ?

A

= Mortgage Amount / Appraised value of the property

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11
Q

What are the 5 specifications that can be found in a mortgage design?

A
  1. The Maturity of the Loan
  2. How the interest rate is determined
  3. How the principal is to be repaid
  4. Whether the borrower has any option to prepay, if if so, what are the penalties to do so
  5. The rights of a lender in a foreclosure
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12
Q

What are the basic ways that the mortgage rate can be specified?

A
  1. Fixed Rate
  2. Adjustable or variable rate
  3. Initial Period fixed rate
  4. Convertible
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13
Q

Describe what a **Prepayment Option **is?

A

Contractual provision that entitles the borrower to prepay all or part of the outstanding mortgage principal prior to the scheduled due date the principal must be repaid. Also called early repayment option.

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14
Q

What are a recourse loan and a non-recourse loan?

A
  • Recourse loan - the lender has a claim against the borrower for the shortfall between the amount of the mortgage balance outstanding and the sale proceeds
  • Non-recourse loan - then lender _does not _ have a claim, so the lender can look only to the property to recover the outstanding mortgage balance
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15
Q

What are the 3 sectors that the residential mortgage loan securities can be divided into?

A
  1. those guaranteed by a federal agency
  2. those guaranteed by either of the the two GSEs
  3. those issued by private entities and that are not guaranteed by a federal agency or GSE
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16
Q

What is a mortgage pass-through security?

A

A security created when one or more holders of mortgages form a pool of mortgages and sell shares or participation certificates in the pool.

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17
Q

What is the amount of the monthly cash flow for a mortgage pass-through security?

A

Is less than the monthly cash flow of the underlying pool of mortgages by an amount equal to servicing and other fees

= Monthly cash flow from pool of mortgages

  • Servicing Fees
  • Other Fees
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18
Q

What is a **pass-through rate **?

A

The coupon rate of a mortgage pass-through security.

19
Q

What the 2 key prepayment rate measures?

A
  1. Single Month Mortality (SMM) **A monthly measure**
  2. Conditional Prepayment Rate (CPR) **A annualized measure**
20
Q

How do you calculate the Single Month Mortality Rate (SMM) ?

A
21
Q

What does a 6% CPR mean?

A

That approximately 6% of the outstanding mortgage balance at the beginning of the year is expected to prepaid by the end of the year

22
Q

What is the CPR?

A

Conditional Prepayment Risk

An annualized SMM

23
Q

Why is a Weighted Average Life figure calculated for MBSs?

A

gives investors an indication of how long they can expect to hold the MBS before it is paid off

**This is b/c principal repayments are paid

24
Q

What are the two components of prepayment risk?

A
  1. _Contraction Risk _ - the risk that when interest rates decline, the security will have a shorter maturity than was originally anticipated
  2. _Extension Risk _ - the risk that when interest rates rise, fewer prepayments will occur b/c homeowners are reluctant to give up the benefits of a contractual interest rate that now looks low compared to the current market
25
Q

What is a Collateralized Mortgage Obligation?

A

A security created through the securitization of a pool of mortgage-related products (mortgage pass-through securities or pools of loans).

26
Q

What are the benefits of Planned Amortization Class (PAC) found in CMOs?

A

b/c they offer greater predictability of the cash flows as long as the prepayment rate is within a specified band over the collateral’s life

27
Q

What is the advantage of being a PAC Bondholder?

A

They have priority over all other tranches in the CMO structure in receiving principal payments from the collateral

28
Q

What is the role that Support Tranches play with a CMO?

A

they defer principal payments to the PAC tranches if the collateral payments are slow.

Support tranches do not receive any principal until the PAC tranches receive their scheduled principal repayment

***Exposed investors to the greatest level of prepayment risk***

29
Q

Non-agency RMBS are very similar to agency CMOs, but what 2 additional mechanisms must be done when reviewing Non-agency RMBS?

A
  1. Cash flows are distributed by rules, such as a waterfall,that dictate the allocation of interest payments and principal repayments to tranches with various degrees of priority/seniority
  2. There are rules for the allocaion of realized losses
30
Q

What are the 3 types of Internal Credit Enhancement?

A
  1. Senior/Subordinated Structures- The subordinated class provide credit support for the senior bond class
  2. Reserve Funds-
    1. A cash reserve fund - a deposit of cash to the SPV from the proceeds of the sale of the loan pool
    2. Excess spread account - involves the allocation into an account of any amounts resulting from monthly funds remaining after paying out interest and servicing and other fees
  3. Overcollateralization - when the value of the collateral exceeds the amount of par value of the outstanding bond classes issued by the SPV
31
Q

What is the main External Credit Enhancement found for Non-Agency RMBS?

A

Third party guarantee, usually provided by an insurance company

32
Q

What are the two measures that have been key indicators of potential credit performance with the CMBS market?

A
  1. Loan to value ratio
  2. Debt Service Coverage Ratio
33
Q

How do you calculate the Debt Service Coverage Ratio?

A

= Annual NOI / debt service

34
Q

What are two characteristics that RMBS strctures have that CMBS structures do not?

A
  1. The prescence of call protection
  2. A Balloon Maturity Provision
35
Q

What are the 4 mechanisms that offer call protection to RMBS investors?

A
  1. Prepayment Lockouts- a contractual agreement that prohibits any prepayment during a specified time period
  2. Prepayment Penalty Points - Predetermined penalties that a borrower who wants to refinance must do to repay… 1 point is equal to 1% of the outstanding balance
  3. Yield Maintenance Charges - a “make whole charge”, a penalty paid by the borrower which makes refinancing soleley to get a lower rate uneconomical
  4. Defeasance - Borrower provides sufficient funds for the servicer to invest in a portfolio of gov’t securities to replicate the cash flows the servicer otherwise would have received
36
Q

What is a Balloon Maturity Provision within a CMBC structure?

A
  • Requires a substantial principal repayment at maturity of the loan
  • If borrower fails to make the balloon payment they are in default
  • A type of extension risk
37
Q

What is a Collateralized Debt Obligation (CDO) ?

A

Generic term used to describe a security backed by a diversified pool of one or more debt obligations.

38
Q

What is a CDO?

A
  • involves the creation of an SPV but is not asset backed
  • The basic economics of the CDO is that the funds are raised by the sale of the bond classes and the CDO manager invests those funds in assets.
  • The CDO manager seeks to earn a rate of return higher than the aggregate cost of the bond classes.
  • The benefit of the return in excess of what is paid out to the bond classes accrues to the equity holders and to the CDO manager.
  • In other words, this is a leveraged transaction in which the equity investors are using borrowed funds (the bond classes issued) to generate a return above the funding cost.
39
Q

What do you calculate the Conditional Prepayment Rate (CPR)?

A
40
Q

What is a Reviewable Arm?

A

when the new mortgage rate at the reset date is based on the lender’s discretion

41
Q

What is a Bullet Mortgage?

A

When there are no scheduled principal repayments over the entire life of the loan

42
Q

What is a Conforming Mortgage?

A

when a loan satisfies the underwriting standards to be included as collateral for an agency RMBS

43
Q

What type of convexity does an RMBS have when interest rates are declining?

A

Negative Convexity

44
Q

Describe a Sequential Pay Tranche….

A

All principal payments are distributed to the first tranche until the principal balance is 0. After the first tranche is fully paid, principal payments are distributed to the second tranche until the balance is zero… and so forth

CFA Level II Fixed Income (5 decks)

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