(R45) Intro to Asset-Backed Securities Flashcards
Securitization
This process involves transferring ownership of assets from the original owners (Consumer Co) into a special legal entity (Consumer Asset Trust - SPV)
Secured Assets
Assets that are typically used to create asset-backed bonds; for example when bank securitizes a pool of loans, the loans are said to be securitized.
Special purpose entity
A non-operating entity created to carry out a specified purpose, such as leasing assets or securitizing receivables; can be a corporation, partnership, trusts, limited liability, or partnership formed to facilitate a specific type of business activity.
List the parties involved in securitization and their roles
Seller: originator of the loans (sell loans to SPV)
Issuer/trust: SPV (they sell ABS to investors)
Customer buys product via loan from a company, who then sells the loans to SPV, who then sells ABS to investors
Credit tranching vs. Time Tranching (Typical structures of securitization)
Credit tranching: credit losses are first absorbed by the tranche with the lowest priority, and after that by any other suboridinated tranches, in order (used when there are difference bond classes) Time tranching refers to security classes that receive the principal payments from underlying securities sequentially as each prior tranche is repaid in full (used when all bonds are part of the same bond class for example A rated).
Time tranching redistributes prepayment risk while credit tranching redistributes credit risk
Characteristics of residential mortgage loans
Maturity: 15 to 30 years
Payments to the lender include: principal, interest, and prepayments
Interest rate determination: Fixed rate or adjustable rate mortgages
Lockout periods: protects against prepayment risk
Recourse vs. non-recourse rights in a foreclosure
Recourse: lender gets all assets of the borrower (property and any other assets)
Non-recourse: lender only gets property
Agency vs. Non-Agency RMBS
Agency: securities backed by residential mortgage loans and guaranteed by a federal agency or government sponsored agency (Ginnie Mae, Fannie Mae, or Freddie Mae) - No credit risk, but prepayment risk
Non-Agency: securities issued by private entities that are not guaranteed by a federal agency or GSA (credit and prepayment risk)
Two types of residential mortgage backed securities (RMBS)`
1) Mortgage pass-through securities
2) Collateralized mortgage obligations (CMO)
Describe Collateralized Mortgage Obligation
Security created through securitization of a pool of mortgage related products. Used to create a security with different maturities and different yields. This distributes prepayment risk. Structured with time tranches
Mortgage pass through securities
Security created when one or more holders of mortgages form a pool of mortgages and sell shares in the pool; monthly payments include principal, interest, prepayments and penalties
Conforming vs. non-conforming securities
A mortgage is conforming if it meets the following criteria: size, docs required, max LTV ratio, insured. If it doesn’t meet any one of the criteria then its non-conforming
Prepayment rate
The speed at which prepayments are made; 0 PSA = no prepayments; 100 PSA = prepayments at the same speed at the benchmark
Describe the two types of prepayment risk for securities
- Contraction risk: Mortgage rates drop, while refinancing and prepayments increase (reinvest cash flows at lower rates)
- Extension risk: mortgage rates increase, while refinancing and prepayments drop (don’t have cash flow to reinvest at higher rates)
Why is contraction and extension bad?
Contraction: You have to reinvest when mortgage rates are dropping because borrowers are increasing their prepayments
Extension: You don’t have the cash flow to invest at the higher mortgage rates because borrowers are prepaying less
Sequential pay CMO
All scheduled principal payments and prepayments are paid to each tranche in sequence until that tranche is paid off (bond class 1 gets paid first). The first tranche is to be paid principal and has the most contraction risk and the last tranche to be paid principal has the most extension risk.
In a CMO, which tranche has contraction risk and which one has extension risk?
The first tranche has the most contraction risk while the last tranche has the most extension risk
Planned amortization class (PAC)
A planned amortization class (PAC) CMO has PAC tranches that receive predictable cash flows as long as the prepayment rate remains within a predetermined range (offers both contraction and extension risk due to a lower and upper PSA)
Support Tranche
A class or tranche in a CMO that protects the PAC tranche from prepayment risk. Support tranches get any money that is over the principal payment.
Prepayment risk
The uncertainty that the timing of the actual cash flows will be different from the scheduled cash flows as set forth in the loan agreements due to the borrowers ability to alter payments, usually to take advantage of interest rate movements.
Extension risk
The risk that when interest rates rise, fewer prepayments will occur because homeowners are reluctant to give up the benefits of a contractual interest rate that now looks low. As a result, the security becomes longer in maturity than anticipated at the time of purchase.
Contraction risk
The risk that when interest rates decline, the security will have a shorter maturity than was anticipated at the time of purchase because borrowers refinance at the new, lower interest rates.
Commercial Mortgage Backed Securities (CMBS)
Pools of commercial mortgages backed by mortgages on income-producing real estate properties. Because commercial mortgages are non-recourse loans, analysis of CMBS focuses on credit risk of the properties. CMBS are structured in tranches with credit losses absorbed by the lowest priority tranches in sequence.
Call (prepayment) protection includes
- Prepayment lockout periods (2-5 years)
- Defeasance
- Prepayment penalty points
- Yield maintenance charges
Main difference between RMBS and CMBS
RMBS allows prepayments while CMBS does not
Asset-backed securities
A type of bond issued by a legal entity called a special purpose entity (SPE) on a collection of assets that the SPE owns. Also, securities backed by receivables and auto loans other than mortgages.
floating-rate tranches
Type of tranch for Collateralized mortgage obligations where collateral pays a fixed rate. The CMO still get a fixed $ interest amount but principle amount is split into a floating and inverse floating portion.
Prime Loans
Mortgages with higher LTV ratios made to borrowers with higher credit quality
Collateralized Debt Obligations
Generic term used to describe a security backed by a diversified pool of one or more debt obligations. Usually involves an asset (collateral) manager
Collateral Manager
Buys and sells debt obligations for and from the CDO’s portfolio of assets (the collateral) to generate sufficient cash flows to meet the obligations to the CDO bondholders.
