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CFA Level II Alts & Fixed Income > Reading 49 - Asset Backed Sector of the Bond Market > Flashcards

Reading 49 - Asset Backed Sector of the Bond Market Flashcards

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1
Q

What is an Asset-backed security (ABS)?

A

Securities created from the pooling of non-mortgage asset (e.g. auto loans, credit card receivables, and corporate bonds)

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2
Q

What is prepayment tranching (aka time tranching)?

A

When ABSs are structured to distribute prepayment risk

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3
Q

What is the most common form of credit enhancement for ABSs?

A

Credit tranching, which is a senior-subordinated structure in which the subordinated bonds absorb all losses first up to their par value.

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4
Q

What is an amortizing asset?

A

An example of is a residential mortgage.

Are loans for which the borrower makes periodic scheduled payments that include both principal and interest.

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5
Q

What are non-amortizing assets?

A

A revolving credit card loan is an example.

Are loans that do not have a scheduled payment amount. Instead, a mimimum payment, which is applied against accrued income, is required.

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6
Q

Does the composition of the loans change over time for non-amortizing assets?

A

Yes.

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7
Q

What are the two types Credit enhancements regarding ABSs?

A
  1. External Credit Enhancements
  2. Internal Credit Enhancements
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8
Q

What are External Credit Enhancements?

A

Are financial guarantees from third parties that support the performance of the bond.

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9
Q

What are the 3 main External Credit Enhancements?

A
  1. Corporate Guarantees - the sellers of the securities agrees to guarantee a portion of the offer.
  2. Letter of Credit - a bank letter of credit provides a guarantee against loss up to a certain level.
  3. Bond Insurance - Provides protection against loss through the purchase of insurance against nonperformance.
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10
Q

What are the 3 main types of Internal Credit Enhancement?

A
  1. Reserve funds
  2. Overcollateralization
  3. Senior/Subordinated debt
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11
Q

What are the two types of reserve funds ?

A
  1. Cash reserve funds - are cash deposits that come from issuance proceeds. This excess cash provides for the establishment of a reserve account to pay for future losses.
  2. Excess servicing spread funds - are reserve funds in the form of excess spread or cash after paying for servicing and other expenses.
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12
Q

Describe overcollateralization…

A

occurs when the ABS is issued with a face values less than the value of the underlying collateral.

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13
Q

Describe how having senior/subordinated structure is a Internal Credit Enhancement?

A

There is a senior tranche and junior tranche. The junior tranche absorbs the first losses.

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14
Q

What is the mechanism that addresses the change in the level of credit protection provided by junior tranches as prepayments occurs in a senior/subordinated structure

A

Shifting Interest Mechanism

**The shifting interest mechanism reduces the credit risk of the senior tranches, but the trade-off is greater prepayment risk for the senior tranches.

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15
Q

Describe a Home Equity Loan (HEL)…

A

The main type, a closed end HEL is just like a standard fixed rate, fully amortizing mortgage.

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16
Q

What is the base case prepayment assumption for a HEL?

A

The assumption that is made regarding the initial speed of prepayments and time until the issue is expected to become seasoned.

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17
Q

What is the prospectus prepayment curve (PPC) of a HEL?

A

The benchmark speed stated in the prospectus.

Is specific to the issuer..

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18
Q

What are HEL floaters?

A

HEL-backed securities that are collateralized with variable rate HELs.

19
Q

HEL structures frequently include non-accelerating senior tranched and planned amortization class (PAC) tranches. What are the primary characteristics of these tranches?

A
  1. Non-accelerating senior tranches- receives principal payments on the basis of a predetermined schedule.
  2. PAC tranche - PAC bondholders have priority over all other classes in receiving principal payments when prepayment speed is within a collar.
20
Q

Why are prepayments for Manaufactured Housing-Backed Securities less significant than other ABSs?

A

b/c the underlying loans are not as sensitive to financing

21
Q

What are the reasons why Manufactured Housing-Backed securities are less sensitive to refinancing?

A
  • Loan balances are usually small, reducing the extent of savings from refinancing
  • The depreciation of mobile homes during the earlier yrs may be greater than the reduction of the loan principal.
  • Borrowers are likely to have relatively low credit ratings, which makes it difficult for them to refinance.
22
Q

What is the payment structure for manufactured housing-backed loans?

A

The same a nonagency MBS and HEL-backed securities

Each isssue is divided into different classes, each with a different claim against the cash flow components.

23
Q

Why is refinancing low for Auto Loan ABS?

A
  1. Loan balances are usually small
  2. automobile’s value may depreciate faster than the loan balance in the early years.
24
Q

What is the Absolute prepayment speed (ABS) and how it is calculated?

A

is the measure of prepayments associated with securities backed by auto loans.

It is calculated as the monthly prepayent expressed as a % of the value of the initial collateral.

ABS will be used in connected with SMM…

25
Q

What is the FFELP program?

A

The U.S. government guarantees loans made by private lenders to students.

Gov’t guarantees up to 98% of loan principal and accrued interest

26
Q

What is a SLABS?

A

Student loan a**sset-**backed securities.

27
Q

What are student loans called in they are not part of the FFELP program?

A

alternative loans

28
Q

Cash flows associated with SLABS occur during three periods, name and describe what these 3 periods are:

A
  1. The deferment period - when the borrowers makes no payments and the loan accrues no interest.
  2. The grace period - when the borrowers makes no payments, but interest does accrue.
  3. The loan repayment period - when the borrower makes principal and interest payments based on a reference rate plus a margin.
29
Q

What are the two ways prepayments occur for SLABS?

A
  1. Because of student defaults (inflows from the gov’t guarantee process)
  2. Loan consolidation
30
Q

What is an SBA backed security?

A

loans made by private lenders to small businesses.

The private lenders must be approved by the SBA for their loans to be eligible for the guarantee.

Guarantees back by the full faith and credit of the U.S. Govt

31
Q

What are the 3 cash flows an SBA-backed security investor receives?

A
  1. Interest based on the coupon rate set at the beginning of the reset period
  2. The principal repayment that is based on the amortization schedule developed at the time of the loan origination
  3. Prepayments received by the lender that are applied to the outstanding loan.
32
Q

What are the 3 performance measures when assesing the performance of a credit card receivable portfolio?

A
  • Net Portfolio Yield
  • Delinquencies
  • Monthly repayment rate (MPR)
33
Q

Define the Net portfolio yield used for assessing the performance of a credit card receivable portfolio and what is the warning signal that a portfolio may be in trouble?

A

Definition:

Gross portfolio yield minus charge offs

Warning Signal:

If the weighted average coupon promised to the ABS tranches is greater than the net portfolio yield, there is a risk that tranches will not get paid off as promised.

34
Q

Define Delinquencies used for assessing the performance of a credit card receivable portfolio and what is the warning signal that a portfolio may be in trouble?

A

Definition:

Percentage of past due receivables

Warning Signal:

High delinquencies signal potential future charge offs and lower net portfolio yield

35
Q

Define the Monthly Repayment Rate (MPR) that is used for assessing the performance of a credit card receivable portfolio and what is the warning signal that a portfolio may be in trouble?

A

Definition:

Monthly payments (interest,fees, principal) as a % of outstanding receivables at the previous month end

Warning Signal:

Low MPR signal:

  1. increased extension risk of the ABS tranches and ,
  2. insufficient cash flow to pay off tranches
36
Q

What is a collateralized debt obligation (CDO)?

A

An ABS that is collateralized by a poll of debt obligations

37
Q

What are some examples of types of debt obligations that can be found in a CDO?

A
  • Corporate bonds with ratings below investment grade
  • MBS & ABS
  • Bond issues in emerging markets
  • Corporate loans advanced by commercial banks
  • Special situation loans and distressed debt
38
Q

What is the structure of a CDO?

A
  • One or more senior tranches
  • Several levels of mezzanine tranches
  • A subordinated tranche (aka Equity tranche), to provide prepayment and credit protection for other tranches
39
Q

What is a Cash Flow CDO?

A

Its objective is for the portfolio manager to generate sufficient cash flow (from interest and principal payments) to repay the senior mezzanine tranches.

40
Q

What are the 3 phases of cash flows for Cash CDOs and describe each phase….

A
  1. Ramp up phase - lasts 1-2 months, the PM puts together a portfolio financial with the help of the sale of different tranches to investors
  2. Reinvestment phase - after the portfolio has been assembled, the PM monitors its performance & reinvests prepayments and cash flows from calls and loan default recoveries
  3. Pay down phase - may last from 3-5 yrs, principal payments are made to junior and senior tranches holders. This is the winding down of the CDO.
41
Q

What is a Synthetic CDO?

A

bondholders take on the economic risks of the underlying assets but do not take legal ownership of them,

This is accomplished by linking certain contingent payments to a reference asset (ie bond index)

  • It gets divided into senior and junior sections
  • debt obligations are only issued to fund the junior section
  • Junior section absorbs losses up to a certain level before the senrio section is forced fto absorb any losses.
  • Proceeds from the junior section are invested by the PM in high quality debt securities
42
Q

What are the advantages to creating a Synthetic CDO instead of a cash structure for an arbitrage CDO?

A
  1. Senior section doesn’t require funding
  2. The ramp-up period is shorter
  3. It is cheaper to acquire exposure to the reference asset through the credit default swap instead of buying the asset directly.
43
Q

What are the two motivations for creating a CDO and describe them?

A
  1. CDO’s can be arbitrage-driven, in which the motivation is to generate an arbitrage return on the spread between return on the collateral and the funding costs.
  2. CDOs can be balance-sheet driven, in which the motivation is to remove assets from the balance sheet.
44
Q

The measure of prepayments associated with securities backed by auto loans is called:

A

The measure of prepayments associated with securities backed by auto loans is called absolute prepayment speed.

CFA Level II Alts & Fixed Income (7 decks)

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