READING 45: INTRODUCTION TO ASSET-BACKED SECURITIES

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 (i.e., 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. 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.

Adjustable-rate mortgage

An adjustable-rate mortgage (ARM), also called a variable-rate mortgage, has an interest rate that can change over the life of the mortgage. An index-referenced mortgage has an interest rate that changes based on a market determined reference rate such as LIBOR or the one-year U.S. Treasury bill rate, although several other reference rates are used.

EXAM FOCUS

- Our primary focus is residential mortgage-backed securities (RMBS). - Candidates should understand the characteristics of mortgage pass-through securities and how and why collateralized mortgage obligations are created from them. - Be prepared to compare and contrast agency RMBS, nonagency RMBS, and commercial MBS. - Finally, candidates should know why collateralized debt obligations are created and how they differ from the other securitized debt securities covered.

NOTE

An excess spread account, sometimes called excess interest cash flow, is a form of internal credit enhancement that limits credit risk. It is an amount that can be retained and deposited into a reserve account and that can serve as a first line of protection against losses. An excess spread account does not limit prepayment risk, extension, or contraction.

Sequential risk graph

Contraction risk Extension risk Tranch A Higher Lower Tranch B ------- ------- Tranch C ------- ------- Tranch D Lower Higher

Credit card ABS

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 (i.e., nonamortizing), 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 holders 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.

Shifting interest mchanisim

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.

NOTE

In a mortgage pass-through security, the pass-through rate is less than the mortgage rate on the underlying pool of mortgages by an amount equal to the servicing (and other administrative) fees.

NOTE

In addition to a senior/subordinated (sequential pay) structure, many auto loan ABSs are structured with additional credit enhancement in the form of overcollateralization and a reserve account, often an excess spread account. The excess spread is an amount that can be retained and deposited into a reserve account that can serve as a first line of protection against losses.

NOTE

In credit card receivable ABSs, the only way the principal cash flows can be altered is by triggering the early amortization provision. Such provisions are included in the ABS structure to safeguard the credit quality of the issue.

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). As an example of this structure, we 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 2 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. Let's expand this example with some specific numbers to illustrate how sequential pay structures work.

Recourse loans

Other mortgage loans are recourse loans under which 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. Understandably, borrowers are more likely to default on nonrecourse loans than on recourse loans. In Europe, most residential mortgages are recourse loans. In the United States, they are recourse loans in some states and nonrecourse in others. in other in the words event of a default go after the borrower

Collateralized loan obligations

are supported by a portfolio of leveraged bank loans.

Structured finance CDOs

are those where the collateral is ABS, RMBS, other CDOs, and CMBS.

Synthetic CDOs

are those where the collateral is a portfolio of credit default swaps on structured securities. Credit default swaps are derivative securities that decrease (increase) in value as the credit quality of their reference securities increases (decreases).

Debt-to-service-coverage ratio DSC

is a 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 / debt service 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.

Collateralized debt obligation CDO

is a structured security issued by an SPE for which the collateral is a pool of debt obligations.

Convertible mortgage

is 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.

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.

Auto mobiles loans & credit card receivables

we explain the characteristics of two types, ABS backed by automobile loans and ABS backed by credit card receivables. These two have an important difference in that automobile loans are fully amortizing while credit card receivables are nonamortizing.

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.

Collateralized bond obligation CBO

When the collateral securities are corporate and emerging market debt

Non-agency RMBS

They need credit enhancement ( external ): 1- Corporate guarantee by seller 2- Bank letter of credit 3- Bond insurance

Compared to this traditional structure, with the bank serving the function of financial intermediary between borrowers and lenders, securitization can provide the following benefits (2)

- 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. - 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 horizon can invest in a portfolio of long- term mortgage loans rather than in only bank bonds, deposits, or equities. The investor can gain exposure to long-term mortgages without having the specialized resources and expertise necessary to provide loan origination and loan servicing functions. - Securitization provides diversification and risk reduction compared to purchasing individual loans (whole loans).

CMBS loan-level call protection

- Prepayment lockout: For a specific period of time (typically two to five years), the borrower is prohibited from prepaying the mortgage loan. - 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. - 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. - 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.

Compared to this traditional structure, with the bank serving the function of financial intermediary between borrowers and lenders, 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). - 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. - 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.

Hybrid mortgage vs rollover 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. Fixed interest rate then adjustable interest rate If the interest rate changes to a different fixed rate after the initial fixed-rate period it is called a rollover or renegotiable mortgage. Fixed interest rate then different fixed interest rate

Fixed-rate mortgage

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

Prepayment

A partial or full repayment of principal in excess of the scheduled principal repayments required by the mortgage is referred to as a prepayment. If a homeowner sells her home during the mortgage term (a common occurrence), repaying the remaining principal is required and is one type of prepayment. A homeowner who refinances her 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.

Residential mortgage loan

A residential mortgage loan is a 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. One key characteristic of a mortgage loan is its loan-to-value ratio (LTV), 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.

Mortgage-backed securities (MBS)

ABS are most commonly backed by automobile loans, credit card 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 the loans owned by the trust (SPE) are mortgages, we refer to the securities issued by the trust as mortgage-backed securities (MBS).

Agency RMBS

Agency RMBS are issued 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 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.

Agency RMBS interpretation

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 mortgage's 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.

NOTE

Agency residential mortgage-backed securities (RMBS) are issued by a government-sponsored enterprise (GSE), and their credit risk is reduced by a guarantee of the GSE. They must also satisfy specific underwriting standards established by various government agencies. The use of credit enhancements to reduce credit risk is a feature associated with non-agency RMBS.

Prepayment risk

An important characteristic of pass-through securities is their prepayment risk. Because the mortgage loans used as collateral for agency MBS have no prepayment penalty, the MBS themselves have significant prepayment risk. Recall that prepayments are principal repayments in excess of the scheduled principal repayments for amortizing loans. 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.

RMBS vs CMBS

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 nonrecourse loans, meaning the lender can 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 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.

Planned Amortization class 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 prepayments to the underlying MBS. The PAC tranches have both reduced contraction risk and reduced extension risk compared to the underlying MBS.

Auto loans ABS

Auto loan-backed securities are backed by loans for automobiles. Auto loans have maturities from 36 to 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 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, an excess interest spread, or overcollateralization, is also 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 refers to those made to borrowers with low credit ratings.

NOTE

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 an 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. A high PSA, such as 400, will reduce the average life of an MBS to only 4.5 years, compared to an average life of about 11 years for an MBS with a PSA of 100.

CDO interpretation (1)

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 the 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 purchase the debt securities in the CDO's collateral pool. To the extent the collateral manager meets 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 tranche.

Two important ratios to analyze CMBS

CMBS are structured as nonrecourse loans for that reason, the analysis of CMBS securities focuses on the credit risk of the property and not the credit risk of the borrower. The analysis of CMBS structures focuses on two key ratios to assess credit risk. 1- Debt-to-service-coverage ratio 2- Loan-to-value ratio

CMO (2)

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 a different claim against the 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 investors and investment managers.

Collateralized mortgage obligations

Collateralized mortgage obligations (CMO) are securities that are collateralized by RMBS. Each CMO has multiple bond classes (CMO tranches) that have different exposures to prepayment risk. The total prepayment risk of the underlying RMBS is not changed; the prepayment risk is simply reapportioned among the various CMO tranches.

Commercial mortgage-backed securities CMBS

Commercial mortgage-backed securities (CMBS) are backed by income-producing real estate, typically in the form of: - Apartments (multi-family). - Warehouses (industrial use property). - Shopping centers. - Office buildings. - Health care facilities. - Senior housing. - Hotel/resort properties.

CMBS Balloon payment risk

Commercial mortgages are typically amortized over a period longer than the loan term; for example, 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 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.

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 the initial PAC collar.

Loan-to-value ratio interpretation

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). Also, 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. In the United States, mortgages with higher LTV ratios, made to borrowers with good credit, are termed prime loans. Mortgages to borrowers of lower credit quality, or that have a lower-priority claim to the collateral in event of default, are termed subprime loans.

Agency RMBS requirements

In order to be included in agency MBS pools, loans must meet certain criteria, including: - a minimum percentage down payment - a maximum LTV ratio - maximum size - minimum documentation required - insurance purchased by the borrower. Loans that meet the standards for inclusion in agency MBS are called conforming loans. Loans that do not meet the standards are called nonconforming loans. Nonconforming mortgages can be securitized by private companies for nonagency RMBS.

CMO (1)

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.

Pass-through rates

Investors in mortgage pass-through securities receive the 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.

NOTE

Lower LTV -- lower probability of default -- greater recovery percentage

NOTE

Many commercial loans backing commercial mortgage-backed securities (CMBS) are balloon loans that require significant repayment of principal at maturity. The risk that the borrower will not be able to make the balloon payment is called balloon risk. The lender may decide to extend the loan over a period of time called the workout period. Because the term of the loan can be extended, balloon risk is a type of extension risk.

Single monthly morality rate & conditional prepayment rate

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.

Non agency RMBS

RMBS not issued by GNMA, Fannie Mae, or Freddie Mac are referred to as nonagency RMBS. They are not guaranteed by the government, so credit risk is an important consideration. The credit quality of a nonagency 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 nonagency 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.

Planned Amortization class CMO Interpretation

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, the 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.

Agency vs nonagency RMBS

Residential mortgage-backed securities (RMBS) in the United States are termed agency RMBS or nonagency RMBS, depending on the issuer of the securities.

NOTE

Securitization allows for the creation of tradable securities with greater liquidity than the original loans on a bank's balance sheet. Securitization results in lessening the roles of intermediaries, which increases disintermediation. Securitization is a process in which relatively simple debt obligations, such as loans, are repackaged into more complex structures.

Tranches

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 often referred to as tranches. With this structure, a particular risk of the 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.

NOTE

The coupon rate of a mortgage pass-through security is called the pass-through rate, whereas the mortgage rate on the underlying pool of mortgages is calculated as a weighted average coupon rate (WAC). The pass-through rate is lower than the WAC by an amount equal to the servicing fee and other administrative fees.

Prepayment penalty

Some loans have no penalty for prepayment of principal while others have a prepayment penalty. A 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).

Nonrecourse loans

Some mortgage loans are nonrecourse loans, which 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. in other in the words event of a default repossess the property only, cant go after the borrower

Waterfall structure

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 interest payments to the owners of the ABS. Often there are several classes, or tranches, of ABS issued by the trust, each with 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 is referred to as time tranching. 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.

CDO interpretation (2)

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 the collateral yield more closely match the funding costs in an environment of changing interest rates. The term arbitrage CDO is used for CDOs structured to earn 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.

Public Securities Association

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 the issue. 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.

CMBS Structure

The basic CMBS structure is created to meet the risk and return needs of the CMBS investor. As with residential MBS securities, rating organizations 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.

NOTE

The benefit of the return on collateral in excess of what is paid out to the bond classes accrues to the equity holders and to the CDO manager.

NOTE

The key to whether a CDO is viable is whether a structure can be created that offers a competitive return for the subordinated tranche (often referred to as the residual or equity tranche). Investors in a subordinated tranche typically use borrowed funds (the bond classes issued) to generate a return above the funding cost.

CMO structure

The primary CMO structures include sequential-pay tranches, planned amortization class tranches (PACs), support tranches, and floating-rate tranches.

Benefits of securitization

The primary benefits of the securitization of financial assets are: (1) a reduction in funding costs for firms selling the financial assets to the securitizing entity (2) an increase in the liquidity of the underlying financial assets.

Maturity

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

CMBS-level call protection

To create 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 the CMBS.

NOTE

Typical mortgage terms and structures differ across regions and countries. The key characteristics of mortgage loans include: - their maturity - the determination of interest charges - how the loan principal is amortized - the terms under which prepayments of loan principal are allowed - the rights of the lender in the event of default by the borrower.

NOTE

When the collateral manager fails pre-specified tests, a provision is triggered that requires the payoff of the principal to the senior class until the tests are satisfied. This reduction of the senior class effectively deleverages the CDO because the CDO's cheapest funding source is reduced.

Collateral manager

Unlike the ABS we have discussed, CDOs do not rely on interest payments from the collateral pool. CDOs have a collateral manager who buys and sells securities in the collateral pool in order to generate the cash to make the promised payments to investors.

NOTE

Using CMOs, securities can be created to closely satisfy the asset/liability needs of institutional investors. The creation of a CMO cannot eliminate prepayment risk; it can only distribute the various forms of this risk among various classes of bondholders. The collateral of CMOs are mortgage-related products, not the mortgages themselves.

NOTE

With all loan call protection programs, any prepayment penalties received are distributed to the CMBS investors in a manner determined by the structure of the CMBS issue.

Interest-only mortgage

With an 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.

Credit tranching

With 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.

Time tranching

With time tranching, the 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 the 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 tranching and time tranching are often included in the same structure.

Securitization risks limits interpretation

based on the book's example Note that the SPE is a separate legal entity from Fred and the buyers of the ABS have no claim on other assets of Fred, only on the loans sold to the SPE. If Fred had issued corporate bonds to raise the funds to make more auto loans, the bondholders would be subject to the financial risks of Fred. With the ABS structure, a decline in the financial position of Fred, 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 Fred, 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 Fred, in which case the cost to fund the loans using the ABS structure is lower than if Fred funded additional loans by issuing corporate bonds.

Parties involved in the securitization process and their roles

based on the book's example: - The seller or depositor (Fred) originates the auto loans and sells the portfolio of loans to Auto Loan Trust, the SPE. - The issuer/trust (Auto Loan Trust) is the SPE that buys the loans from the seller and issues ABS to investors. - The servicer (Fred) services the loans. - In this case, the seller and the servicer are the same entity (Fred Motor Company), but that is not always the case.

Loan-to-value ratio

compares the loan amount on the property to its current fair market or appraisal value. = Current mortgage amount / current 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.

Fully amortizing

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 large principal repayment component.