Part 15. Intro of Asset-Backed Securities

Question 1

Securitisation

Answer 1

This refers to a process by which financial assets (e.g. mortgages, accounts receivable, or automobile loans), are purchased by an entity that the issues securities supported by cash flows from financial assets.

Question 2

Benefits of securitisation of financial assets:

Answer 2

1. A reduction in funding costs for firms selling the financial assets to securitising entity.
2. An increase in the liquidity of underlying financial assets.

Question 3

Benefits of securitisation as a whole:

Answer 3

• Reduces intermediation costs, results in lower funding costs for borrowers and higher risk-adjusted returns for lenders (investors).
• The investors legal claim to mortgages or other loans is stronger than with only a general claim against the banks overall assets.
• When bank securitises loans, the securities are actively traded which increases the liquidity of banks assets compared to holding loans.
• By securitising loans, means banks are able to lend more than if they could only fund loans with bank assets, when loan portfolio is securitised, the bank receives proceeds, which can then be used to make more loans.
• This has led to financial innovation that allows investors to invest in securities better match their preferred risk, maturity and return characteristics.

e. g. an investor with long investment horizon can invest in portfolio of LT mortgage loans than only bank bonds, deposits or equities.
- Gain exposure to LT mortgages without having specialised resources and expertise necessary to provide loan origination and loan servicing functions.

• Provides diversification and risk reduction compared to purchasing individual loans (whole loans).

Question 4

Time tranching

Answer 4

• There are several classes/tranches of ABS issued by the trust, each with different priority claims to cash flows from underlying loans and different specifications of payments to be received if cash flows from loans are not sufficient to pay all promised ABS cash flows.

Question 5

Examples of ABS backed by:

Answer 5

• Automobile loans
• Credit card receivables
• Home equity loans
• Manufactured housing loans
• Student loans
• Small business Admin loans (SBA)
• Corporate loans
• Corporate bonds
• Emerging market bonds
• Structured financial products

Question 6

Credit tranching

Answer 6

• The ABS tranches will have different exposures to risk of default of assets underlying ABS.

Question 7

Senior/subordinated structure

Answer 7

• The subordinated tranches absorb credit losses as they occur (up to principle values), with level of protection for senior tranche increases with the proportion of subordinated bonds in structure.

Question 8

Residential mortgage loan

Answer 8

This is a loan for which collateral underlies the loan is residential real estate, if borrower defaults on loan, the lender has legal claim to the collateral property.

key characteristic:

• loan-to-value ratio (LTV) - the percentage of value of collateral real estate that is loaned to borrower, the lower LTV, the higher borrowers equity in property.

for lenders:

• loans with lower LTVs are less risky as borrower has more to lose in event of default.
• if property value is high compared to loan amount, lender is more likely to recover amount loaned if borrower defaults and lender repossesses and sells property.
• US - mortgages with higher LTV ratios made to borrowers with good credit = prime loans
• US - mortgages to borrowers of lower credit quality or lower priority claim to collateral in event of default = subprime loans.

Question 9

Key characteristics of mortgage loans:

Answer 9

• Maturity
• Determination of interest charges
• How the loan principal is amortised
• Terms under which prepayment of loan principal are allowed
• Rights of lender in event of default by borrower

Question 10

Maturity

Answer 10

= the term of a mortgage loan is time until final loan payment is made.

Question 11

Fixed-rate mortgage

Answer 11

This has an interest rate that is unchanged over the life of the mortgage.

Question 12

Variable rate mortgage

Answer 12

This has an interest rate that can change over the life of a mortgage.

Question 13

Index referenced mortgage

Answer 13

This has interest rate that changes based on market determined reference rate such as LIBOR or 1 year US T-Bill rate, although several other reference rates are used.

Question 14

Hybrid vs renegotiable mortgage

Answer 14

Hybrid mortgage = if loan becomes adjustable-rate mortgage after initial fixed rate period.

Renegotiable mortgage = if interest rate changes to different fixed rate after initial fixed rate period.

Question 15

Convertible mortgage

Answer 15

This is one for which initial interest rate terms, fixed or adjustable can be changed at the option of the borrower, to adjustable or fixed for remaining loan period.

Question 16

Full amortising loan

Answer 16

This means each payment includes both interest payment and repayment of some of loan principal so the is no loan principal remaining after last regular mortgage payment.

Payments fixed for the life of loan, payments in beginning of loan term have large interest component and small principal repayment component and vice versa.

Question 17

Partially amortising loan

Answer 17

• When loan payments include some repayment of principal, but there is a lump sum of principal that remains to be paid at end of loan period — balloon payment.

Question 18

Interest only mortgage

Answer 18

• There is no principal repayment for either an initial period or life of the loan, if no principal is paid for life of loan it is an interest only lifetime mortgage, and balloon payment is original loan principal amount.
• Other specify payments are interest only over some initial period with partial or full amortisation of principal after that.

Question 19

Prepayment

Answer 19

A partial or full repayment of principal in excess of scheduled principal repayments required by the mortgage.

types:

1. if homeowner sells home during mortgage term, repaying remaining principal is required.
2. a homeowner who refinances her mortgage prepays remaining principal amount using proceeds of new, lower IR loan.
3. some prepay by paying more than their scheduled payments in order to reduce the principal outstanding, reduced their interest charges and eventually pay off loans prior to maturity.

Question 20

Prepayment penalty

Answer 20

• some loans have no penalty for prepayment of principle while others do.
• This is an additional payment that must be made if principal is prepaid during initial period after loan origination or some mortgages prepaid anytime during life of mortgage.
• This benefits lender by providing compensation when loan is paid off early as market interest rates have decreases since mortgage loan was made (i.e. loans are refinanced at lower IR).

Question 21

Nonrecourse loans

Answer 21

This means lender has no claim against the assets of borrower except for the collateral property itself.

If the case, if home values fall so outstanding loan principal > home value, borrowers sometime voluntarily return property to lender = strategic default.

Question 22

Recourse loans

Answer 22

• The lender has a claim against borrower for amount by which the sale of a repossessed collateral of property falls short of principal outstanding on loan.
• Borrowers are likely to default on nonrecourse than recourse loans

Question 23

Mortgage pass through securities

Answer 23

• each mortgage pass through security represents claim on cash flows from pool of mortgages.
• any no. of mortgages may be used to form pool, and any mortgage included in pool = securitised mortgage.
• mortgages in pool typically have different maturities and mortgage rates.
• its characteristics are a function of their cash flow features and strength of guarantee provided.

Question 24

Weighted average maturity

Answer 24

• This pool is equal to weighted average of final maturities of all mortgages in pool, weighted by each mortgages outstanding principal balance as proportion of total outstanding principal value of all mortgages in pool.

Question 25

Weighted average coupon

Answer 25

• This pool is weighted average of interest rates of all mortgages in pool.

Question 26

Criteria to be part of Agency MBS pools:

Answer 26

• Minimum percentage down payment
• Maximum LTV ratio
• Maximum size
• Minimum documentation required
• Insurance purchased by borrower

Question 27

Loan types

Answer 27

Conforming loans = loans that meet standards for inclusion in agency MBS.

Nonconforming loans = loans that do not meet standards.

Nonagency RMBS = nonconforming mortgages can be securitised by private companies.

Question 28

Function of mortgage pass through securities:

Answer 28

• investors receive monthly cash flows generated by underlying pool of mortgages, less any servicing and guarantee/insurance fees.
• fees account for the fact that pass-through rates (i.e. coupon rate on MBS call net interest/net coupon) < mortgage rate of underlying mortgages in pool.
• timing of cash flows to pass through security holders does not exactly coincide with cash flows generated by pool, due to delay between time the mortgage service provider receives mortgage payments, and time cash flows are passed through security holders.

Question 29

Prepayment risk

Answer 29

• exists within MBS, as mortgage loans used as collateral for agency MBS have no prepayment penalty.

extension risk = risk prepayments will be slower than expected.

contraction risk = risk prepayments will be more rapid than expected.

Question 30

Single monthly mortality rate (SMM)

Answer 30

• the percentage by which prepayments reduce month-end principal balance, compared to what it would have been with only scheduled principal payments (with no prepayments).
• this is due to uncertainty if prepayments cause timing and amount of cash flows from mortgages and MBS.
• rapid prepayment reduces amount of principal outstanding on loans supporting MBS, so total interest paid over life of MBS is reduced, so necessary to make specific assumptions about prepayments rates to value mortgage pass-through securities.

Question 31

Conditional prepayment rate

Answer 31

• The annualised measure of prepayments, where rates depend on weighted average coupon rate of the loan pool, current interest rates and prior prepayments of principal.

Question 32

PSA prepayment benchmark

Answer 32

• This assumes monthly prepayment rate for mortgage pool increases as it ages, expressed as a monthly series of CPRs.
• if CPR of MBS is expected to be the same as PSA standard benchmark CPR, we say PSA is 100 (100% of benchmark CPR).
• a pool of mortgages may have prepayment rates faster or slower than PSA 100, depending on current level of interest rates and coupon rate of issue.
• PSA 50 = prepayments are 50% of PSA benchmark CPR.
• PSA 130 = prepayments are 130% of PSA benchmark CPR.

Question 33

Assumption about prepayment rate MBS:

Answer 33

• we can calculate its weighted average life, the expected no. of years until all the loan principal is repaid.
• since prepayments, the average life of MBS < weighted average maturity, where during periods of falling interest rates, refinancing of mortgage loans will accelerate prepayments and reduce average life of MBS.
• high PSA = e.g. 400 will reduce average life of MBS to only 4.5 years, but PSA of 100 will have average life of about 11 years.

Question 34

Collateralised mortgage obligations (CMO)

Answer 34

This is securities that are collateralised by RMBS, where each CMO has multiple bond classes (CMO tranches) that have different exposures to prepayment risk.

• by partitioning and distributing cash flows generated by RMBS into different risk packages to better match investor preferences, CMO increases potential market for securitised mortgages, and maybe reduce funding costs.

Question 35

Characteristics of CMOs:

Answer 35

• These are securities backed by mortgage pass through securities.
• interest and principal payments from MPTS allocated in specific way to different bond classes = tranches, so each tranche has different claim against cash flow of MPT.
• CMO tanche has different mix of contraction and extension risk, so can be more closely matched to unique asset/liability needs of investors/managers.

Question 36

Primary CMO structures:

Answer 36

• Sequential-pay tranches
• Planned amortisation class tranches (PACSs)
• Support tranches
• Floating rate tranches

Question 37

Sequential pay CMO:

Answer 37

• Consider a simple CMO with two tranches, both receive interest payments at specified coupon rate, but all principal payments (scheduled and prepayments) are paid to Tranche 1 (short tranche) until principal is paid off.
• Principal payments then flow to Tranche 2 until principal is paid off.
• contraction and extension risk still exist with this structure, but redistributed between 2 tranches.
• short tranche – matures first, offers investors relatively more protection against extension risk.
• tranche 2 — provides relatively more protection against contraction risk.

Question 38

Planned amortisation class (PAC):

Answer 38

• This tranches is structured to make predictable payments, regardless of actual prepayments to underlying MBS.
• These have both reduced contraction risk and extension risk compared to the underlying MBS.
• reducing prepayment risk is achieved by increasing prepayment risk of CMO’s support tranches.
• principal repayment = more rapid than expected, the support tranche receives principal repayments in excess specifically allocated to PAC tranches.
• actual principal repayment are slower than expected, principal repayments to support tranche are curtailed to schedule PAC payments can be made.
• larger support tranche relative to PAC tranches, the smaller probability cash flows to PAC tranches will differ from scheduled payments.
• support tranches have more contraction risk, and extension risk than underlying MBS, and higher promised IR than PAC tranche.

Question 39

Initial PAC collar

Answer 39

• the upper and lower bounds on actual prepayment rates for which support tranches are sufficient to either provide or absorb actual prepayments to keep PAC principal repayments on schedule.
  e. g. PAC may have an initial collar given as 100 - 300 PSA, meaning PAC will make scheduled payments to investors unless actual prepayment experience is outside bounds.

Question 40

Broken PAC

Answer 40

• if prepayment rate is outside of these bounds so payments to PAC tranche are either sooner or later than promised.

Question 41

Nonagency RMBS

Answer 41

• RMBS not issued by GNMA, Fannie Mae or Freddie Mac.
• Not guaranteed by gov. so credit risk is important consideration.
• Credit quality of MBS depends on credit quality of borrowers, as well as characteristics of loans such as LTV ratios.
• to be investment grade, most include credit enhancement, where level is directly proportional to credit rating desired by issuer.
• rating agencies determine exact amount of credit enhancement necessary for issue to hold specific rating.
• credit tranching (subordination) is often used to enhance the credit quality of senior RMBS securities.

Question 42

Shifting interest mechanism

Answer 42

• A method for addressing decrease in level of credit protection provided by junior tranches as prepayments or defaults occur in senior/subordinated structure.
• if prepayments or credit losses decrease credit enhancement of senior securities, the shifting interest mechanism suspends payments to subordinated securities for period of time, until credit quality of senior securities is restored.

Question 43

Commercial MBS

Answer 43

These are backed by income-producing real estate, in form of:

• apartments (multi family)
• warehouses (industrial use property)
• shopping centres
• office buildings
• health care facilities
• senior housing
• hotel/resort properties

Question 44

Difference between commercial and residential MBS:

Answer 44

• the obligations of borrowers of underlying loans.
• residential MBS loans repaid by homeowners; commercial MBS loans are repaid by real estate investors who rely on tenants and customers to provide cash flow to repay mortgage loan.
• CMBS mortgages structured as nonrecourse, so lender can only look to collateral to repay delinquent loan if cash flow of property is insufficient.
• Residential mortgage lender with recourse can go back to borrower personally in attempt to collect any excess loan amount above net proceeds from foreclosing on and selling property.
• CMBS focuses on credit risk of property not borrower.

Question 45

CMBS structures 2 key ratios to access credit risk:

Answer 45

1. Debt to service coverage ratio= a basic cash flow coverage ratio of amount of cash flow from commercial property available to make debt service payments compared to required debt service cost.
2. Loan value ratio = compares loan amount on property to its current fair market or appraisal value.

Question 46

CMBS structure

Answer 46

= this is created to meet risk and return needs of the CMBS investor.

• residential MBS; S&P and Moody’s access credit risk of each CMBS issue and determine appropriate credit rating.
• each CMBS is segregated to tranches, with losses due to default first absorbed by tranche with lowest priority.
• any fixed rate security, call protection is valuable to bondholder, for MBS equivalent is prepayment protection.

Question 47

CMBS provide call protection in 2 ways:

Answer 47

1. Loan level-call protection - provided by terms of individual mortgages.
2. Call protection provided by CMBS structure

Question 48

Means of creating loan-level call protection:

Answer 48

1. prepayment lockout - for specific period of time (2-5 years), the borrower is prohibited from prepaying the mortgage loan.
2. defeasance - on mortgage loan, by using prepaid principal to purchase a portfolio of government securities sufficient to make remaining required payments on CMBS.
   - given high credit quality of gov. securities, defeased loans increase credit quality of CMBS loan pool.
3. prepayment penalty points - penalty fee in point may be charged to borrowers who prepay mortgage principal, each point is 1% of principal amount paid.
4. yield maintenance charges - borrower is charged amount of interest lost by lender should loan be prepaid, this make whole charge is designed to make lenders indifferent to prepayment, as cash flows are equivalent whether loan prepaid or not.

Question 49

To create CMBS call protection:

Answer 49

• CMBS loan pools are segregated into tranches with specific sequence of repayment.
• Tranches with higher priority will have higher credit rating than lower priority tranches as defaults will first affect lower tranches.
• A wide variety of features can be used to provide call protection to most senior tranches of CMBS.

Question 50

Balloon payment

Answer 50

• at end of loan term, the loan will have principal outstanding that needs to be paid, whereby commercial mortgages typically amortised over longer period than loan term, typically 20 year determined based on 30 year amortisation schedule.

balloon risk = if borrower unable to arrange refinancing to make payment the borrower is default.

extension risk for CMBS = lender forced to extend term of loan due to balloon risk during workout period, during which time borrower will be charged higher IR.

Question 51

Collateralised debt obligation

Answer 51

A structured security issued by SPE for which collateral is a pool of debt obligation.

collateralised bond obligation = when collateral securities are corporate and emerging market debt.

collateralised loan obligation = supported by portfolio of leverage bank loans.

• not rely on interest payments from collateral pool.
• they have a collateral manager who buys and sells securities in collateral pool to generate cash to make the promised payments to investors.

Question 52

Structured finance CDOs

Answer 52

These are those where collateral is ABS, RMBS, other CDOs and CMBS.

Question 53

Synthetic CDOs

Answer 53

These are those where collateral is a portfolio of credit default swaps on structured securities.

Question 54

CDO characteristics

Answer 54

• issue 3 classes of bonds (tranches): senior bonds, mezzanine bonds and subordinated bonds (similar to equity investments).
• must be able to offer attractive return on subordinated tranche, after accounting for required yields on senior and mezzanine bond classes.
• typically to issue floating rate senior tranche 70-80% of total and smaller mezzanine tranche pays fixed rate of interest.
• if securities in collateral pool pay fixed rate of interest, the collateral manager may enter into interest rate swap pays floating rate of interest in exchange for fixed rate of interest to make collateral yield closely match funding costs in environment of changing IR.
• arbitrage CDO = CDOs structured to earn returns from the spread between funding costs and portfolio returns.
• CM uses interest earnt on portfolio securities, cash from maturing portfolio securities, and cash from sale of portfolio securities to cover promised payments of holders of CDOs senior and mezzanine bonds.