Reading 45: Introduction to Asset-Backed Securities Flashcards
Identify the payment rules for planned amortization classes (PAC).
For payment of monthly coupon interest: Disburse monthly coupon interest to each tranche on the basis of the amount of principal outstanding for the tranche at the beginning of the month.
For disbursement of principal payments: Disburse principal payments to the PAC tranche based on its schedule of principal repayments. The PAC tranche has priority with respect to current and future principal payments to satisfy the schedule.
Explain the absolute priority rule.
It refers to the principle that in case of default, senior secured creditors are repaid before subordinated creditors receive anything, and all creditors are repaid before equity holders receive anything. It generally holds in liquidations, but not in a reorganization, where it is possible for the actual outcome regarding distributions to various classes of bondholders and equity holders to be markedly different from the terms stated in the debt agreement.
Give the formula used to calculate the single monthly mortality (SMM) rate and its corresponding annualized rate, the conditional prepayment rate (CPR).
SMMt = Prepayment in month t / (Beginning mortgage balance for month t ‒ Scheduled principal payment in month t)
CPR=1−(1−SMM)12
Explain the senior/subordinate structure.
This type of structure has senior bond classes and subordinate bond classes (also known as non-senior/junior bond classes). The structure basically provides credit tranching as the subordinate bond classes provide credit protection to the senior classes. More formally, credit tranching occurs when credit risk (or risk of loss from default) is redistributed among the various classes of ABS.
Differentiate between recourse loans and nonrecourse loans.
In a recourse loan, the lender has a claim against the borrower if the proceeds from sale of the property fall short of the mortgage balance outstanding.
In a nonrecourse loan, the lender does not have such a claim against the borrower if the proceeds from sale of the property fall short of the mortgage balance outstanding.
List the circumstances under which prepayments result from auto loan receivable-backed securities.
Sales and trade-ins requiring full payoff of the loan.
Repossession and subsequent resale of the automobile.
Proceeds from insurance claims arising from loss or destruction of the vehicle.
Cash payments to save interest costs.
Refinancing of the loan at lower interest rates.
Explain the revolving period for credit card receivable-backed securities.
Any principal repayments from the pool of receivables are used to purchase additional receivables to maintain the size of the pool. During this period, the cash flow passed on to security holders consists only of (1) finance charges and (2) fees collected from the pool of receivables. Principal repayments are passed on to security holders only once the principal-amortizing period sets in.
Name the 5 primary specifications of mortgage design.
- Maturity
- Interest rate denomination
- Amortization schedule
- Prepayments and prepayment penalties
- Rights of the lender in a foreclosure
Note: a mortgage is a borrowing that is secured by some form of real estate.
Explain the 2 measures commonly used to evaluate the potential credit performance of a commercial property.
- The debt-service coverage (DSC) ratio is used to evaluate the adequacy of income generated from the property to service the loan. It is calculated as net operating income (NOI) divided by debt service. NOI is calculated as rental income minus cash operating expenses and a noncash replacement reserve that reflects depreciation of the property over time.
- The loan-to-value ratio equals the loan amount divided by the appraised value of the property.
Define collateralized mortgage obligations (CMOs).
They redistribute the cash flows from mortgage pass-through securities into packages/classes/tranches with different risk exposures to prepayment risk. The risk/return characteristics and exposures to prepayment risk of the various CMO tranches are different from those of the underlying mortgage pass-through securities, which makes them attractive as investments to different types of investors.
Identify what may be included in a collateralized debt obligation (CDO) that is backed by a diversified pool of securities.
Corporate bonds and emerging market bonds (collateralized bond obligations or CBOs).
ABS, RMBS, and CMBS (structured finance CDOs).
Leveraged bank loans (collateralized loan obligations or CLOs).
Credit default swaps and other structured securities (synthetic CDOs).
Identify the benefits of securitization for investors.
It allows investors to have a stronger legal claim on the collateral pool of assets.
Investors can pick and choose the types of securities they want to invest in (in terms of interest rate and credit risk).
Large investors, who may be able to purchase real estate loans, automobile loans, or credit card loans directly, would prefer to invest in asset-backed bonds since they would not be required to originate, monitor, and collect payments from the underlying loans themselves (the securitization process takes care of all this).
Define planned amortization class (PAC) tranches.
PAC bonds were introduced in the bond market to improve upon sequential-pay structures (that entail significant variation in average lives depending on realized prepayment patterns) and to offer investors greater protection from prepayment risk (both contraction and extension risk). PAC bonds bring increased predictability of cash flows, as they specify a repayment schedule that will be satisfied as long as actual prepayments realized from the collateral fall within a predefined band.
Describe the major difference between an ABS and a CDO.
In an ABS the cash flows from the collateral pool are used to pay off bondholders without the active management of collateral. In a CDO, the manager buys and sells debt obligations (assets) to (1) generate the cash flow required to repay bondholders and to (2) earn a competitive return for the equity tranche.
Describe overcollateralization.
This refers to a situation where the value of the collateral exceeds the par value of the securities issued by the SPV. The amount of overcollateralization (excess collateral) can be used to absorb future losses.
