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Debt Capital Markets > Topic 4 > Flashcards

Topic 4 Flashcards

1
Q

What is a mortgage

A

Mortgage = debt instrument where borrower gives lender a lien on real property as securement for payment of a loan

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2
Q

Mortgage: Lender makes a loan based on:

A
  1. Credit of borrower
  2. Collateral (LTV)
  3. Poss issuance
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3
Q

US Agencies / Mortgage Mkt

A
  1. Govt National Mortgage Association (Ginnie Mae,m explicit guaranteed, public federal agency)
  2. Federal National Mortgage Assoc (Fannie Mae (Line of credit to US Treasury, public owned)
  3. Federal Home Loan Mortgage Assoc (Freddie Mac (Line of credit to US treasury, public owned)
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4
Q

Mortgage Pass through Security

A
  1. Agencies create pass through securities by securitising residential mortgages
  2. Create pools of mortgages underwritten by private sector & provide credit enhancement to these pools
  3. resulting pass through securities represent a pro rata share of underlying pool of individual mortgages and receive a proportionate amount of pool’s flows (ie pmts by borrowers (- fees) pass through.
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5
Q

Weighted average coupon

A

interest rate of each individual mortgage weighted by its outstanding balance

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6
Q

Cusp coupons

A

Bonds trading very close to par (typically with coupons 100bps below or 50 bps above current coupon)
Relatively small changes in rates -> prepayment speed can change significantly

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7
Q

Amortising mortgages

A
  1. most common

2. no bullet payment, rather they pay back principal over the life of the mortgage

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8
Q

Prepayment options

A
  1. embedded payment option: each borrower has option to accelerate payment
  2. Prepayment occurs because: buyer sells home, buyer refinances, borrower defaults
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9
Q

Constant Prepayment Rate

A
  1. expresses prepayments in an annualised basis as a percentage of principal outstandings\
  2. eg CPR = 5%: borrowers repayed 5% of outstanding principal in addition to scheduled mortgage payments
  3. CPR: mortality, divorce rate, labour mobility, interest rates, bonuses, inheritance
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10
Q

Public Securities Assoc standard =

A

PSA standard = another prepayment measure
Assumes CPR ramps up gradually from 0% to 6% pver 30 mths then levels at 6%
eg 200% PSA over 30 mths means CPR ramps up to 12% instead of 6%.

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11
Q

Prepayment risk

A

Risk to lender as borrower refinances at lower rates

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12
Q

Risks of mortgage pass throughs

A
  1. interest rate risk (when yields rise, pasthrough prices fall)
  2. convex / volatility risk due to pre payment
  3. spread risk
  4. credit risk
  5. model risk
  6. interest rate risk
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13
Q

Measuring interest rate sensitivity

A
  1. option adjusted duration (incorporates impact of embedded options)
  2. weighted average life (av time to receive principal back)
  3. WAM (av maturity)
  4. convexity: for normal bond, convexity is positive for investor. HOWEVER, for bond with prepayment risk the opposite is true.
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14
Q

Credit enhancement

A
  1. mechanism that provides bondholders with protection from losses on the underlying pool]
  2. subordination (senior, junior tranches)
  3. excess interest (revenue remaining after all pmts to bonds are made. Net av coupon of asset pool minus weighted av note rate plus trx expenses)
  4. over collateralisation (greater level of assets vs rated notes issued)
  5. external third party provider in the form of financial guarantee (monoline wrapper)
  6. provision of reserve account
  7. external equity
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15
Q

Adjustable Rate Mortgage (ARM)

A
  • predetermined adjustments of interest rate at specific intervals
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16
Q

Collateralised mortgage obligation

A
  • principal payments paid in sequential order eg once 1st tranche is paid down, payment commence on next tranche
17
Q

CMOs who participates

A
  1. Originator (bigger size is better, sell mtg at higher than cost, hold mtg in investment portfolio, commercial bank/mortgage brokers, orig fee, app fee, processing fee
  2. Mortgage Servicer (collect pmts, usually banks / mortgage brokers
  3. Mortgage Insurer (register insurance bought by lender to protect against borrow default. Usually LTV > 80% -> cost bourne by borrower
18
Q

Mitigate credit risk

A
  • originate good loans
  • insurance
  • over collateralisation
  • cash reserve
  • subordination
19
Q

Mitigate liquidity risk

A
  • creation of secondary market
  • rating
  • standardised features
  • wide distribution
20
Q

Clean up clause

A

When principal is 10% of original outstanding issuer has right to call remaining security

21
Q

Why securitise

A
  • recycling of capital
  • turning over balance sheet
  • banks may retain bottom tranche
  • cheap form of funding and diversified funding
22
Q

Collateralised Loan Obligation

A
  • Manager buys pools of leverage loans (loans made to sub IG cos, high default rate, high recovery rate, tight covenants
23
Q

CDS

A
  1. agreement between 2 parties to exchange credit risk of issuer, also known as reference entity
  2. Buyer pays periodic fee & profits if reference entity has a credit event
  3. Payment calc: multiply notional by mkt price of CDS (annualised basis)
  4. Define which credit (note, not which bond, but which issuer)
  5. Notional amt
  6. Spread
  7. Maturity: expiry normally 20 March,. June, Sep, Dec; 5 year contract usually most liquid
24
Q

CDS Credit Events (Note for EXAM)

A
  1. bankruptcy (incl insolvency & apt of admin.liquidators)
  2. Failure to pay
  3. Restructuring (change in agreement betw ref entity and holders of an obligation)
  4. Repudiation / moratorium (govt entity repudiates or imposes moratorium for failure to pay
  5. Obligation acceleration
25
Q

CDS: Settlement

A
  1. Physical: deliver the seller with bonds of face value equal to notional. Can deliver any bond that is pari passu to specified bond in contract (eg senior, sub)
    (a) notify of credit event).
    (b) default + 30 days: notice of physical settlement
    (c) default + 33 days, delivery of bonds
  2. Cash settlement: seller pays buyer notional minus price assigned to recovery rate. RR is not fixed, determined only after credit event
26
Q

Importance of credit derivatives

A
  1. efficient way to take credit risk
  2. efficient way to short credit
  3. tailor credit investments and hedged
  4. link between structurally separate markets
  5. provide liquidity in times of turbulence in credit markets
  6. credit derivatives are confidential
27
Q

CDS trading strategies

A
  1. Decompose risk of bond (risk free rate, funding risk (swap spread), credit risk)
  2. Basis trading
    a) Negative basis: CDS spread is lower than bond spread
    b) Positive basis (CDS spread is higher than bond spread)
28
Q

Reasons behind CDS positive and negative basis

A

Positive basis:
- imperfections in repo markets (cost comparisons for borrowing bonds), segmented markets (eg regulation causes segregation betw bond & CDS mkt), cheapest to deliver option, bond covenants

negative basis
- excess protection selling, eg structured credit issuers, borrowing costs, bond new issuance, risk of non deliverables)

29
Q

CDX

tranches

A
  1. reference portfolio
  2. subordination (level of losses portfolio can suffer before notional is eroded
  3. tranche width (amt of leverage and exposure to portfolio losses)
  4. Upper & lower attachment points (lower attachment point determines amt of subordination; distance between upper and lower attachment points is the tranche width.
  5. Maturity: length of time over which protection contract is valid
30
Q

Synthetic tranche

A 
Underlying of the CDO is CDS rather than cash bonds
Synthetic CDO (as opposed to cash CDO) can also be referred to as collateralised swap obligation (CSO)
31
Q

Why are synthetic tranches traded

A
  1. default protection (hedge via equity tranches may be cheaper than hedging via CDX
  2. Leverage (eg as losses approach the tranche attachment point, tranche loss will be higher than portfolio loss
  3. Equity tranche is highest / risk return therefore commands spread and is the most leveraged

Debt Capital Markets (7 decks)

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