(R45) Intro to Asset-Backed Securities

Question 1

Securitization

Answer 1

This process involves transferring ownership of assets from the original owners (Consumer Co) into a special legal entity (Consumer Asset Trust - SPV)

Question 2

Secured Assets

Answer 2

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.

Question 3

Special purpose entity

Answer 3

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.

Question 4

List the parties involved in securitization and their roles

Answer 4

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

Question 5

Credit tranching vs. Time Tranching (Typical structures of securitization)

Answer 5

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

Question 6

Characteristics of residential mortgage loans

Answer 6

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

Question 7

Recourse vs. non-recourse rights in a foreclosure

Answer 7

Recourse: lender gets all assets of the borrower (property and any other assets)
Non-recourse: lender only gets property

Question 8

Agency vs. Non-Agency RMBS

Answer 8

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)

Question 9

Two types of residential mortgage backed securities (RMBS)`

Answer 9

1) Mortgage pass-through securities

2) Collateralized mortgage obligations (CMO)

Question 10

Describe Collateralized Mortgage Obligation

Answer 10

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

Question 11

Mortgage pass through securities

Answer 11

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

Question 12

Conforming vs. non-conforming securities

Answer 12

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

Question 13

Prepayment rate

Answer 13

The speed at which prepayments are made; 0 PSA = no prepayments; 100 PSA = prepayments at the same speed at the benchmark

Question 14

Describe the two types of prepayment risk for securities

Answer 14

1. Contraction risk: Mortgage rates drop, while refinancing and prepayments increase (reinvest cash flows at lower rates)
2. Extension risk: mortgage rates increase, while refinancing and prepayments drop (don’t have cash flow to reinvest at higher rates)

Question 15

Why is contraction and extension bad?

Answer 15

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

Question 16

Sequential pay CMO

Answer 16

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.

Question 17

In a CMO, which tranche has contraction risk and which one has extension risk?

Answer 17

The first tranche has the most contraction risk while the last tranche has the most extension risk

Question 18

Planned amortization class (PAC)

Answer 18

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)

Question 19

Support Tranche

Answer 19

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.

Question 20

Prepayment risk

Answer 20

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.

Question 21

Extension risk

Answer 21

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.

Question 22

Contraction risk

Answer 22

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.

Question 23

Commercial Mortgage Backed Securities (CMBS)

Answer 23

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.

Question 24

Call (prepayment) protection includes

Answer 24

1. Prepayment lockout periods (2-5 years)
2. Defeasance
3. Prepayment penalty points
4. Yield maintenance charges

Question 25

Main difference between RMBS and CMBS

Answer 25

RMBS allows prepayments while CMBS does not

Question 26

Asset-backed securities

Answer 26

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.

Question 27

floating-rate tranches

Answer 27

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.

Question 28

Prime Loans

Answer 28

Mortgages with higher LTV ratios made to borrowers with higher credit quality

Question 29

Collateralized Debt Obligations

Answer 29

Generic term used to describe a security backed by a diversified pool of one or more debt obligations. Usually involves an asset (collateral) manager

Question 30

Collateral Manager

Answer 30

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.