Study Session 15: Readying 54: Introduction to Asset-Backed Securities

Two key ratios to assess credit risk

1. Debt-to-service-coverage ratio (DSC) 2. Loan-to-value ratio LTV

Means of creating Loan-Level Call Protection

1. Prepayment Lockout- for a specific period of time (typically 2-5 years), the borrower is prohibited from prepaying the mortgage loan. 2. Defeasance- Should the borrower insist on making principal payments on the mortgage loan, the mortgage loan can be defeased. This is accomplished by using the prepaid principal to purchase a portfolio of government securities that is sufficient to make the remaining required payments on the CMBS. Given the high credit quality of government securities, defeased loans increase the credit quality of a CMBS loan pool. 3. Prepayment Penalty Points- A penalty fee expressed in points may be charged to borrowers who prepay mortgage principal. Each point is 1% of the principal amount prepaid. 4. Yield Maintenance Charges- The borrower is charged the amount of interest lost by the lender should the loan be prepaid. This make whole charge is designed to make lenders indifferent to prepayment, as cash flows are equivalent (at current market rates) whether the loan is prepaid or not.

Auto Loan ABS

Fully amortizing.backed by loans for automobiles. Auto loans have maturities from 36-72 months. Issuers include the financial subsidiaries of auto manufacturers, commercial banks, credit unions, finance companies, and other small financial institutions. The cash flow components of auto loan- backed securities include interest payments, scheduled principal payments, and prepayments. Auto loans prepay if the cars are sold, traded in, or repossessed. Prepayments also occur if the car is stolen or wrecked and the loan is paid off from insurance proceeds. Finally, the borrower may simply use excess cash to reduce or pay off the loan balance. Automobile loan ABS all have some sort of credit enhancement to make them more attractive to institutional investors. Many have a senior subordinated structure with a junior tranche that absorbs credit risk. One or more internal credit enhancement methods, a reserve account, or excess interest spread, or overcollaterlization is often present in these structures. Just as with mortgages, prime loans refer to those made to borrowers with higher credit ratings and sub-prime loans refer to those made to borrowers with low credit ratings.

Credit Tranching

The ABS tranches will have different exposures to the risk of default of the assets underlying the ABS. With this structure, also called a SENIOR/SUBORDINATED STRUCTURE, the subordinated tranches absorb credit losses as they occur (up to their principal values). The level of protection for the senior tranche increases with the proportion of subordinated bonds in the structure.

Interest- Only Mortgage

There is no principal repayment for either an initial period or the life of the loan. If no principal is paid for the life of the loan it is an interest-only lifetime mortgage and the balloon payment is the original loan principal amount. Other interest-only mortgages specify that payments are interest-only over some initial period, with partial or full amortization of principal after that.

Of ten there are several classes of ABS issued by the trust

each class has a different priority claims to the cash flows from the underlying loans and different specifications of the payments to be received if the cash flows from the loans are not sufficient to pay all the promised ABS cash flows. This flow of funds structure is called a waterfall structure because each class of ABS (tranche) is paid sequentially, to the extent possible, from the cash flows from the underlying loan portfolio.

Prepayment Penalty

is an additional payment that must be made if principal is prepaid during an initial period after loan origination or, for some mortgages, prepaid anytime during the life of the mortgage. A prepayment penalty benefits the lender by providing compensation when the loan is paid off early because market interest rates have decreased since the mortgage loan was made (i.e. loans are refinanced at a lower interest rate.)

Securitization

refers to a process by which financial assets (e.g. mortgages, accounts receivable, or automobile loans) are purchased by an entity that then issues securities supported by the cash flows from those financial assets. The primary benefits of securitization of financial assets are 1. A reduction in funding costs for firms selling the financial assets to the securitizing entity and 2. an increase in the liquidity of the underlying financial assets.

Maturity

term of mortgage loan is the time until the final loan payment is made. In U.S., mortgage loans typically have terms from 15-30 years, terms are longer 20-40 years in many European countries and as long as 50 in others. In Japan, mortgage loans may have terms of 100 years.

Securitization can provide the following benefits:

1. Securitization reduces intermediation costs, which results in lower funding costs for borrowers and higher risk-adjusted returns for lenders (investors). 2. With securitization, the investors' legal claim to the mortgages or other loans is stronger than it is with only a general claim against the bank's overall assets. 3. When a bank securitizes its loans, the securities are actively traded, which increases the liquidity of the bank's assets compared to holding the loans. 4. By securitizing loans, banks are able to lend more than if they could only fund loans with bank assets. When a loan portfolio is securitized, the bank receives the proceeds, which can then be used to make more loans. 5. Securitization has led to financial innovation that allows investors to invest in securities that better match their preferred risk, maturity, and return characteristics. As an example, an investor with a long investment horizion can in vest in a portfolio of long-term mortgage lonas rather than in only bank bonds, deposits, or equities. The investor can gain exposure ot long-term mortgages without having the specialized resources and expertise necessary to provide loan origination and loan servicing functions. 6. Securitization provides diversification and risk reduction compared to purchasing individual loans (whole loans).

Prepayment

A partial or full repayment of principal in excess of scheduled principal repayments required by the mortgage. If a homeowner sells the home during the mortgage term ( a common occurrence), repaying the remaining principal is required and is one type of prepayment. A homeowner who refinances the mortgage prepays the remaining principal amount using the proceeds of a new, lower interest rate loan. Some homeowners prepay by paying more than their scheduled payments in order to reduce the principal outstanding, reduce their interest charges, and eventually pay off their loans prior to maturity.

LOS 54I: Describe collateralized debt obligations, including their cash flows and risks:

A COLLATERALIZED DEBT OBLIGATION (CDO) is a structured security issued by an SPE for which the collateral is a pool of debt obligations. When the collateral securities are corporate and emerging market debt, they are called collateralized bond obligations (CBO). Collateralized Loan Obligations (CLO) are supported by a portfolio of leveraged bank loans. Unlike the ABS we have discussed, CDOs do not rely on interest payments from the collateral pool. CDOs have a COLLATERAL MANGER who buys and sells securities in the collateral pool in order to generate the cash to make the promised payments to investors. STRUCTURED FINANCE CDOs- those where the collateral is ABS, RMBS, and other CDOs and CMBS. SYNTHETIC CDOs- are those where the collateral is a portfolio of credit default swaps on structured securities- CREDIT DEFAULT SWAPS- derivative securities that decrease (increase) in value as the credit quality of their reference securities increases (decreases). CDOs issue three classes of bonds (tranches): senior bonds, mezzanine bonds, and subordinated bonds (sometimes called the equity or residual tranche). The subordinated tranche has characteristics more similar to those of equity investments than bond investments. In creating a CDO, the structure must be able to offer an attractive return on the subordinated tranche, after accounting for the required yields on the senior and mezzanine bond classes. An investment in equity or residual tranche can be viewed as a leveraged investment where borrowed funds ( raised from selling the senior and mezzanine tranches) are used to purchased the debt securities in the CDO's collateral pool. To the extent the collateral manager mets his goal of earning returns in excess of borrowing costs ( the promised return to CDO investors), these excess returns are paid to the CDO manager and the equity trance. The CDO structure typically is to issue a floating rate senior tranche that is 70-80% of the total and a smaller mezzanine tranche that pays a fixed rate of interest. If the securities in the collateral pool pay a fixed rate of interest, the collateral manager may enter into an interest rate swap that pays a floating rate of interest in exchange for a fixed rate of interest in order to make collateral yield more closely match the funding costs in an environment of changing interest rates. The term arbitrage CDO is used for CDOs structure to real returns from the spread between funding costs and portfolio returns. The collateral manager may use interest earned on portfolio securities, cash from maturing portfolio securities, and cash from the sale of portfolio securities to cover the promised payments to holders of the CDOs senior and mezzanine bonds.

Broken PAC

A PAC may have an initial collar given as 100-300 PSA. This means the PAC will make its scheduled payments to investors unless actual prepayment experience is outside these bounds (above 300 PSA or below 100 PSA). If the prepayment rate is outside of these bounds so payments to a PAC tranche are either sooner or later than promised, the PAC tranche is referred to as a broken PAC.

Hybrid Mortgage

A mortgage loan may have an interest rate that is fixed for some initial period, but adjusted after that. If the loan becomes an adjustable-rate mortgage after the initial fixed rate period it is called a hybrid mortgage.

Mortgage Pass-Through Securities

Agency RMBS are mortgage pass-through securities. Each mortgage pass-through security represents a claim on the cash flows from a pool of mortgages. Any number of mortgages may be used to form the pool, and any mortgage included in the pool is referred to as a SECURITIZED MORTGAGE. The mortgages in the pool typically have different maturities and different mortgage rates. The WEIGHTED AVERAGE MATURITY (WAM) of the pool is equal to the weighted average of the final maturities of all the mortgages in the pool, weighted by each mortgages outstanding principal balance as a proportion of the total outstanding principal value of all the mortgages in the pool. The WEIGHTED AVERAGE COUPON (WAC) of the pool is the weighted average of the interest rates of all the mortgages in the pool. The investment characteristics of mortgage pass-through securities are a function of their cash flow features and the strength of the guarantee provided.

Special Purpose Entity (SPE)

Allow loan originator to remove loan totals from balance sheet, and use proceeds to make more loans by selling to SPE. SPE which is set up for the specific purpose of buying loans and selling asset-backed securities (ABS), is referred to as the trust or issues. SPE then sells ABS to investors. The loan portfolio is the collateral supporting the ABS because the cash flows from the loans are the source of the funds to make the promised payments to investors. The SPE is a separate legal entity from the loan originator. Subsequent to the initial transaction, the principal and interest payments on the original loans are allocated to pay servicing fees to the servicer and principal and investment payments to the owners of the ABS.

Planned Amortization Class (PAC) CMO

Another CMO structure has one or more planned amortization class (PAC) tranches and SUPPORT TRANCHES. A PAC tranche is structured to make predictable payments, regardless of actual prepayment to the underlying MBS. The PAC tranches have both reduced contraction risk and reduced extension risk compared to the underlying MBS. Reducing the prepayment risk of the PAC tranches is achieved by increasing the prepayment risk of the CMO's support tranches. If principal repayments are more rapid than expected, support tranche receives the principal repayments in excess of those specifically allocated to the PAC tranches. Conversely, if the actual principal repayments are slower than expected, principal repayments to the support tranche are curtailed so the scheduled PAC payments can be made. The larger the support tranche(s) relative to the PAC tranches, the smaller the probability that the cash flows to the PAC tranches will differ from their scheduled payments. Support tranches have both more contraction risk and more extension risk than the underlying MBS and have a higher promised interest rate than the PAC tranche.

Debt-to-Service Coverage Ratio (DSC)

Basic cash flow coverage ratio of the amount of cash flow from a commercial property available to make debt service payments compared to the required debt service cost. Net Operating Income (NOI) is calculated after the deduction for real estate taxes but before any relevant income taxes. This ratio, which is typically between one and two, indicates greater protection to the lender when it is higher. Debt service coverage ratios below one indicate that the borrower is not generating sufficient cash flow to make the debt payments and is likely to default. Remember: the higher the better for this ratio from the perspective of the lender and the MBS investor.

Initial PAC Collar

For a given CMO structure there are limits to how fast or slow actual prepayment experience can be before the support tranches can no longer either provide or absorb prepayments in the amounts required to keep the PAC payments to their scheduled amounts. The upper and lower bounds on the actual prepayment rates for which the support tranches are sufficient to either provide or absorb actual prepayments in order to keep the PAC principal repayments on schedule are called initial PAC collar.

CMBS-Level Call Protection

CMBS loan pools are segregated into tranches with a specific sequence of repayment. Those tranches with a higher priority will have a higher credit rating than lower priority tranches because loan defaults will first affect the lower tranches. -A wide variety of features can be used to provide call protection to the more senior tranches of CMBS.

Servicer of Loan

Collects principal and interest payment on loan, sends out delinquency notices, and repossesses and disposes of the collateral item if customers do not make timely payments.

Balloon Payment/Risk

Commercial mortgagees are typically amortized over a period longer than the loan term. Ex Payments for a 20 year commercial mortgage may be determined based on a 30 year amortization schedule. At the end of the loan term, the loan will still have principal outstanding that needs to be paid; this amount is called a BALLOON PAYMENT. IF the borrower is unable to arrange refinancing to make this payment, the borrower is in default. This possibility is called balloon risk. The lender will be forced to extend the term of the loan during a workout period, during which the time the borrower will be charged a higher interest rate. Because balloon risk entails extending the term of the loan, it is also referred to as extension risk for CMBS.

Loan-to-Value Ratio (LTV)

Compares the loan amount on the property to its current fair market or appraisal value. The lower this ratio, the more protection the mortgage lender has in making the loan. Loan-to-value ratios determine the amount of collateral available, above the loan amount, to provide a cushion to the lender should the property be foreclosed on and sold. Remember: the lower the better for this ratio from the perspective of the lender and the MBS investor.

Basic CMBS Structure

Created to meet the risk and return needs of the CMBS investor. As with residential MBS securities, rating organization such as S&P and Moody's assess the credit risk of each CMBS issue and determine the appropriate credit rating. Each CMBS is segregated into tranches. Losses due to default are first absorbed by the tranche with the lowest priority. Sometimes this most-junior tranche is not rated and is then referred to as the equity tranche, residual tranche, or first-loss tranche. As with any fixed- rate security, call protection is valuable to the bondholder. In the case of MBS, call protection is equivalent to prepayment protection (i.e., restrictions on the early return of principal through prepayments). CMBS provide call protection in two ways: loan-level call protection provided by the terms of the individual mortgages and call protection provided by the CMBS structure.

Fully AmortizingLoan

Each payment includes both an interest payment and a repayment of some of the loan principal so there is no loan principal remaining after the last regular mortgage payment. When payments are fixed for the life of the loan, payments in the beginning of the loan term have a large interest component and a small principal repayment component, and payments at the end of the loan terms have a small interest component and a large principal repayment component.

First-Loss Tranche

First tranche to absorb any losses when payments do not flow in. Losses can go up to principal value.

Prepayment Risk

Important characteristic of pass-through securities. Because the mortgage loans used as collateral for the agency MBS have no prepayment penalty, the MBS themselves have significant prepayment risk. The risk that prepayments will be slower than expected is called extension risk and the risk that prepayments will be more rapid than expected is called contraction risk.

Prime Loans

In U.S. mortgages with higher LTV ratios, made to borrowers with good credit.

Agency RMBS

Issue by the Government National Mortgage Association (GNMA or Ginnie Mae), the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Mortgage Corporation (Freddie Mac). Ginnie Mae securities are guaranteed by the GNMA and are considered to be backed by the full faith and credit of the U.S. government. Fannie Mae and Freddie Mac are also guarantee the MBS they issue but are government-sponsored enterprises (GSE). While they are not considered to be backed by the full faith and credit of the U.S. government, these securities are considered to have very high credit quality.

Convertible Mortgage

one for which the initial interest rate terms, fixed or adjustable, can be changed at the option of the borrower, to adjustable or fixed, for the remaining loan period.

Residential mortgage Loan

Loan for which the collateral that underlies the loan is residential real estate. If the borrower defaults on the loan, the lender has a legal claim to the collateral property.

Originates Loan

Loans someone money for purchase with purchase item as collateral.

Non-Recourse Loans

Means the lender has no claim against the assets of the borrower except for the collateral property itself. When this is the case, if home values fall so the outstanding loan principal is greater than the home value, borrowers sometimes voluntarily return the property to the lender in what is called a strategic default.

Subprime Loans

Mortgages to borrowers of lower credit quality, or that have lower priority claim to the collateral in the event of default.

Credit Card Receivable ABS

Non-amortizing. Credit card receivable-backed securities are ABS backed by pools of credit card debt owed to banks, retailers, travel and entertainment companies and other credit card issuers. The cash flow to a pool of credit card receivables includes finance charges, annual fees, and principal repayments. Credit cards have periodic payment schedules, but because their balances are revolving (non amortizing), the principal amount is maintained for a period of time. Interest on credit card ABS is paid periodically, but no principal is paid to the ABS holder during the lockout period, which may last from 18 months to 10 years after the ABS are created. If the underlying credit card holders make principal payments during the lockout period, these payments are used to purchase additional credit card receivables, keeping the overall value of the receivables pool relatively constant. Once the lockout period ends, principal payments are passed through to security holders. Credit card ABS typically have an early (rapid) amortization provision that provides for earlier amortization of principal when it is necessary to preserve the credit quality of the securities. Interest rates on credit card ABS are sometimes fixed but often they are floating. Interest payments may be monthly, quarterly, or for longer periods.

Sequential Pay CMO

One way to reapportion the prepayment risk inherent in the underlying pass-through MBS is to separate the cash flows into tranches that are retired sequentially (i.e., create a SEQUENTIAL PAY CMO). Ex, consider a simple CMO with two tranches. Both tranches receive interest payments at a specified coupon rate, but all principal payments (both scheduled payments and prepayments) are paid to Tranche 1 ( the short tranche) until its principal is paid off. Principal payments then flow to Tranche two until its principal is paid off. Contraction and extension risk still exist with this structure, but they have been redistributed to some extent between the two tranches. The short tranche, which matures first offers investors relatively more protection against extension risk. The other tranche provides relatively more protection against contraction risk.

Amortization of Principal

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Foreclosure

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Interest Rates

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LOS 54B: Describe securitization, including the parties involved in the process and the roles they play:

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LOS 54C: Describe typical structures of securitizations, including credit tranching and time tranching:

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LOS 54D: Describe types and characteristics of residential mortgage loans that are typically securitized:

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LOS 54E: Describe types of characteristics of residential mortgage-backed securities, including mortgage pass-through securities and collateralized mortgage obligations, and explain the cash flows and risks for each type: LOS 54F: Define prepayment risk and describe the prepayment risk of mortgage-backed securities:

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LOS 54G: Describe characteristics and risks of commercial mortgage-backed securities:

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LOS 54H: Describe types and characteristics of non-mortgage asset-backed securities including cash flows and risks of each type:

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LOS54A: Explain benefits of securitization for economies and financial markets:

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Payment Provisions

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Residential Mortgage-backed Securities (RMBS) in the Unites States are termed agency RMBS or non-agency RMBS, depending on the issuer of the securities.

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Prepayment Risk Continued

Prepayments cause the timing and amount of cash flows from mortgage loans and MBS to be uncertain; rapid prepayment reduces the amount of principal outstanding on the loans supporting the MBS so the total interest paid over the life of the MBS is reduced. Because of this it is necessary to make specific assumptions about prepayment rates in order to value mortgage pass-through securities. The single monthly mortality rate (SMM) is the percentage by which prepayments reduce the month-end principal balance, compared to what it would have been with only scheduled principal payments (with no prepayments). The CONDITIONAL PREPAYMENT RATE (CPR) is an annualized measure of prepayments. Prepayment rates depend on the weighted average coupon rate of the loan pool, current interest rates, and prior prepayments of principal.

Waterfall Structure

Senior Tranches are protected from any credit losses until up to the principal amounts of subordinated tranches. Senior tranches will have highest credit rating and offer lowest yield of trance structure. Waterfall because in liquidation, each subordinated tranche would receive only the "overflow" from more senior tranches if they are repaid their principal value in full.

Non-Agency RMBS

RMBS not issued by GNMA, Fannie Mae, or Freddie Mac are referred to as non-agency RMBS. They are not guaranteed by the government, so credit risk is an important consideration. The credit quality of a non-agency MBS depends on the credit quality of the borrowers as well as the characteristics of the loans, such as their LTV ratios. To be investment grade, most non-agency RMBS include some sort of CREDIT ENHANCEMENT. The level of credit enhancement is directly proportional to the credit rating desired by the issuer. Rating agencies determine the exact amount of credit enhancement necessary for an issue to hold a specific rating. Credit tranching (subordination) is often used to enhance the credit quality of senior RMBS securities. A SHIFTING INTEREST MECHANISM is a method for addressing a decrease in the level of credit protection provided by junior tranches as prepayments or defaults occur in a senior/subordinated structure. If prepayments or credit losses decrease the credit enhancement of the senior securities, the shifting interest mechanism suspends payments to the subordinated securities for a period of time until the credit quality of the senior securities is restored.

SPE details

SPE is a separate legal entity from loan originator and the buyers of the ABS have no claim on any other assets of originator, only on the loans sold to SPE. If originator had issued corporate bonds to raise the funds to make more auto loans, the bondholders would be subject to the financial risks of originator.

Collateralized Mortgage Obligations (CMO)

Securities that are collateralized by RMBS. Each CMO has multiple bond classes (CMO trances) that have different exposures to prepayment risk. The total prepayment risk of the underlying RMBS is not changes; the prepayment risk is simply reapportioned among various CMO tranches. Institutional investors have different tolerances for prepayment risk. Some are primarily concerned with extension risk while others may want to minimize exposure to contraction risk. By partitioning and distributing the cash flows generated by RMBS into different risk packages to better match investor preferences, CMOs increase the potential market for securitized mortgages and perhaps reduce funding costs as a result. CMOs are securities backed by mortgage pass-through securities (i.e., they are securities secured by other securities). Interest and principal payments from the mortgage pass-through securities are allocated in a specific way to different bond classes called tranches, so that each tranche has different claims against cash flows of the mortgage pass-throughs. Each CMO tranche has a different mixture of contraction and extension risk. Hence, CMO securities can be more closely matched to the unique asset/liability needs of institutional investment managers. The primary CMO structures include sequential-pay tranches, planned amortization class tranches (PACs), support tranches, and floating-rate tranches.

Tranches/Tranching

Securitizations may involve a single class of ABS so the cash flows to the securities are the same for all security holders. They can also be structured with multiple classes of securities, each with a different claim to the cash flows of the underlying assets. The different classes are referred to as TRANCHES. With this structure, a particular risk of ABS securities is redistributed across the tranches. Some bear more of the risk and others bear less of the risk. The total risk is unchanged, simply reapportioned.

Prepayment Risk Continued 3

The Public Securities Association (PSA) prepayment benchmark assumes that the monthly prepayment rate for a mortgage pool increases as it ages (becomes seasoned). The PSA benchmark is expressed as a monthly series of CPRs. IF the prepayment rate (CPR) of an MBS is expected to be the same as the PSA standard benchmark CPR, we say the PSA is 100 (100% of the benchmark CPR). A pool of mortgages may have prepayment rates that are faster or slower than PSA 100, depending on the current level of interest rates and the coupon rate of issuance. A PSA of 50 means that prepayments are 50% of the PSA benchmark CPR. and a PSA of 130 means that prepayments are 130% of the PSA benchmark CPR. Based on an assumption about the prepayment rate for an MBS, we can calculate its weighted average life, or simply average life, which is the expected number of years until all the loan principal is repaid. Because of prepayments, the average life of a MBS will be less than its weighted average maturity. During periods of falling interest rates, the refinancing of mortgage loans will accelerate prepayments and reduce the average life of an MBS.

Recourse Loans

The lender has a claim against the borrower for the amount by which the sale of a repossessed collateral property falls short of the principal outstanding on the loan. Borrowers are more likely to default on non-recourse loans than on recourse loans.

Partially Amortizing

When loan payments include some repayment of principal, but there is a lump sum of principal that remains to be paid at the end of the loan period which is called a balloon payment.

More ABS and SPE basics

With ABS structure, a decline in the financial position of originator, its ability to make cash payments, or its bond rating do not affect the value of the claims of ABS owners to the cash flows from the trust collateral (loan portfolio) because it has been sold by originator, which is now simply the servicer(not the owner) of the loans. The credit rating of the ABS securities may be higher than the credit rating of bonds issued by originator, in which case the cost to fund the loans using the ABS structure is lower than if originator funded additional loans by issuing corporate bonds.

Commercial Mortgage-Backed Securities (CMBS)

backed by income producing real estate, typically in the form of: apartments, warehouses, shopping centers, office buildings, health care facilities, senior housing, hotel/resort properties. An important difference between residential and commercial MBS is the obligations of the borrowers of the underlying loans. Residential MBS loans are repaid by homeowners; commercial MBS loans are repaid by real estate investors who, in turn, rely on tenants and customers to provide the cash flow to repay the mortgage loan. CMBS mortgages are structured as non-recourse loans, meaning the lender an only look to the collateral as a means to repay a delinquent loan if the cash flows from the property are insufficient. In contrast, a residential mortgage lender with a recourse can go back to the borrower personally in an attempt to collect any excess of the loan amount above the net proceeds from foreclosing on and selling the property. For these reasons the analysis of CMBS securities focuses on the credit risk of the property and not the risk of the borrower.

Rollover or Renegotiable Mortgage

if the interest rate changes to a different fixed rate after the initial fixed rate period.

Time Tranching

first sequential tranche receives all principal repayments from the underlying assets up to the principal value of the tranche. The second tranche would then receive all principal repayments from underlying assets until the principal value of this tranche is paid off. There may be other tranches with sequential claims to remaining principal repayments. Both credit ranching and time tranching are often included in the same structure. All recieve interest, but principal is not repaid to lower tranches until senior tranches are repaid.

Adjustable-Rate Mortgage (ARM)/Variable-Rate Mortgage

has an interest rate that can change over the life of the mortgage.

Index-Referenced Mortgage

has an interest rate that changes based on a market determined reference rate such as Libor or the on-year U.S. Treasury bill rate, although several other reference rates are used.

Fixed-Rate Mortgage

has an interest rate that is unchanged over the life of the mortgage.

Loan-to-Value (LTV)

key characteristic of a mortgage loan. The percentage of the value of the collateral real estate that is loaned to the borrower. The lower the LTV, the higher the borrower's equity in the property. For a lender loans with lower LTVs are less risky because the borrower has more to lose in the event of default (so is less likely to default). If the property value is high compared to the loan amount, the lender is more likely to recover the amount loaned if the borrower defaults and the lender repossesses and sells the property.

Key characteristics of mortgage loans include:

maturity, determination of interest charges, how the loan principal is amortized, the terms under which prepayments of loan principal are allowed, and the rights of the lender in the event of default by the borrower.

In order to be included in agency MBS pools, the loans must meet certain criteria including:

minimum percentage down payment, a maximum LTV ratio, maximum size, minimum documentation required, and insurance purchased by the borrower. Loans that meet the standards for inclusion in the agency MBS are called conforming loans. Loans that do not meet the standards are called non-conforming loans. Non-conforming mortgages can be securitized by private companies for non-agency RMBS.

Investors in mortgage pass-through securities receive:

monthly cash flows generated by the underlying pool of mortgages, less any servicing and guarantee/insurance fees. The fees account for the fact that pass-through rates (i.e., the coupon rate on the MBS, also called its net interest or net coupon) are less than the mortgage rate of the underlying mortgages in the pool. The timing of the cash flows to pass-through security holders does not exactly coincide with the cash flows generated by the pool. This is due to the delay between the time the mortgage service provider receives the mortgage payments and the time the cash flows are passed through to the security holders.

ABS details

most commonly backed by auto loans, credit cared receivables, home equity loans, manufactured housing loans, student loans, Small Business Administration (SBA) loans, corporate loans, corporate bonds, emerging market bonds, and structured financial products. When loans owned by the trust (SPE) are mortgages, we refer to the securities issued by the trust as mortgage-backed securities (MBS).