INTRODUCTION TO ASSET-BACKED SECURITIES

CHAPTER 7
• In the Text Book Chapter 1 to 5 and Chapter 7 are to be covered for
Fixed Income Curriculum.

• For examination purpose also cover these chapters thoroughly

• Rest of the chapters are to be treated as additional readings

TABLE OF CONTENTS
01 INTRODUCTION
02 BENEFITS OF SECURITIZATION FOR ECONOMIES AND
FINANCIAL MARKETS
03 THE SECURITIZATION PROCESS
04 RESIDENTIAL MORTGAGE LOANS
05 RESIDENTIAL MORTGAGE-BACKED SECURITIES
06 COMMERCIAL MORTGAGE-BACKED SECURITIES
07 NON-MORTGAGE ASSET-BACKED SECURITIES
08 COLLATERALIZED DEBT OBLIGATIONS
09 SUMMARY

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 1. INTRODUCTION
• This topic examines fixed-income instruments created
through a process known as securitization. This process
involves moving assets from the owner of the assets into a
special legal entity.
• In addition to bonds issued by governments and
companies, the fixed-income market includes securities
that are backed, or collateralized, by a pool (collection) of
assets, such as loans and receivables, and are referred to
generically as asset-backed securities (ABS).

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 1. INTRODUCTION
• Assets that are typically used to create asset-backed
bonds are called “securitized assets” and include the
following, among others:

Residential mortgage Commercial Automobile

loans mortgage loans loans

Student loans Bank loans Credit card debt

• A mortgage-backed security (MBS) is, by definition, an

asset-backed security, but a distinction is often made
between MBS and ABS backed by non-mortgage assets.

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 2. BENEFITS OF SECURITIZATION FOR
ECONOMIES AND FINANCIAL MARKETS
• The securitization of pools of loans into multiple securities
provides an economy with a number of benefits:
• Allows investors to get a direct exposure to a portfolio of
mortgages or other receivables without having a bank as an
intermediary

• Allows banks to increase the amount of funds available to lend

and increase fee income

• Allows the creation of tradable securities with better liquidity

than the original loans on the bank’s balance sheet

• Enables innovations in investment products

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 3. THE SECURITIZATION PROCESS
Insurance 1. Financial Institution (FI)
Mortgage credit creates mortgages on
insurance balance sheet.
Premium Loans
Cash from sale of loans
2. Special purchase
vehicle (SPV) purchases
Insurance mortgages from FI and
Liquidity facility: places these on its balance
Cash flow sheet.
timing insurance Premium 3. SPV creates securities.
Securities
Cash from sale of securities

4. Investors purchase
securities.

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 MAIN PARTIES IN THE
SECURITIZATION PROCESS
The main two parties in securitization
Originator • Originally owns the assets and sells
(seller of the collateral) them to the issuer (SPV)

Special purpose • Creates a security backed by the

vehicle (SPV) assets and sells them to investors

The third parties in securitization

• Independent accountants,
Servicer (different from lawyers/attorneys, trustees,
the seller) underwriters, rating agencies, and
guarantors

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 BONDS ISSUED IN THE
SECURITIZATION PROCESS
• A simple transaction may involve the sale of only one bond
class.
• More complicated, multiple class bond structures can be
created:
In such a structure, rules will be established for the distribution of
interest and principal to the bond classes. Some bond classes
may receive payments earlier than others. Time tranching

In a subordination (senior/subordinated) structure, the bond

classes differ as to how they will share any losses resulting from
defaults of the borrowers whose loans are in the pool of loans.
Credit tranching

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 4. RESIDENTIAL MORTGAGE LOANS

A mortgage loan, or Typically, the amount

simply mortgage, is The mortgage gives of the loan advanced
a loan secured by the lender the right to purchase the
the collateral of to foreclose on the property is less than
some specified real loan if the borrower the property’s
estate property that defaults (i.e., allows purchase price.
obliges the borrower the lender to take • The loan-to-value
to make a possession of the ratio is less than
predetermined mortgaged property 100%.
series of payments and then sell it).
to the lender.

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FIVE SPECIFICATIONS OF MORTGAGE DESIGN

Mortgage designs vary around the world, in terms of the

following:
1) The maturity of the loan
2) How the interest rate is determined

3) How the principal is to be repaid (i.e., the

amortization schedule)

4) Whether the borrower has the option to prepay and,

in this case, whether any prepayment penalties might
be imposed

5) The rights of the lender in a foreclosure

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 5. RESIDENTIAL MORTGAGE-BACKED
SECURITIES
In the United States, residential mortgage-backed securities
(RMBS) are divided into three sectors:

Those guaranteed by a federal agency

Those guaranteed by a government-sponsored

agencies (GSE)

Those issued by a private entity and that are not

guaranteed by a federal agency or a GSE (known as
non-agency RMBS)

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 MORTGAGE PASS-THROUGH SECURITIES
• A mortgage pass-through security is a security created when
one or more holders of mortgages form a pool of mortgages and
sell shares or participation certificates in the pool.
• The cash flow of a mortgage pass-through security depends on
the cash flow of the underlying pool of mortgages.

Monthly
mortgage Scheduled
Any
Cash flow payments repayment
prepayments
representing of principal
interest

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 MORTGAGE PASS-THROUGH SECURITIES
• A mortgage pass-through security’s coupon rate is called
the “pass-through rate.”

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 fees.

• Not all of the mortgages in a pool have the same mortgage

rate and maturity.

For each mortgage pass-through security, a weighted

average coupon (WAC) rate and a weighted average
maturity (WAM) are determined.

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 MEASURES OF THE PREPAYMENT RATE
• The two key prepayment rate measures

Its corresponding
Single monthly mortality
and annualized rate, the
(SMM) rate, a monthly
conditional prepayment
measure
rate (CPR)

Prepayment for month

SMM =
Beg. mortgage balance (m) – Principal repayment (m)

• Forecasting the future prepayment rate is key. The Public

Securities Association (PSA) is a common benchmark.
Prepayment rates are stated as a percentage of a PSA
benchmark.

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 CONDITIONAL PREPAYMENT RATE
• In the standard PSA model, known as 100 PSA,
the CPR starts at 0.2% for the first month and then
increases at a constant rate of 0.2% per month to
equal 6% at the 30th month.
- After the 30th month, the CPR stays at a constant 6%.
- Thus, for any month t, the CPR is

 t 
CPR  0.06 , if t  30
 30 
CPR  0.06, if t  30
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 AVERAGE LIFE OF A MORTGAGE
• The average life of a mortgage in a pool is the
average time for a single mortgage in the pool to
be paid off, either by prepayment or by making
scheduled payments until maturity.
Example. For a pool of 30-year mortgages:
Prepayment Schedule Average Mortgage Life

100 PSA 11.2 years

165 PSA 8.6 years
250 PSA 6.4 years
400 PSA 4.5 years

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 COMPONENTS OF PREPAYMENT RISK
• The prepayment risk is the uncertainty of future cash
flows because of prepayments. It has two components:
• the risk that when interest rates decline,
the security will have a shorter maturity
Contraction risk than was anticipated at the time of
purchase because homeowners
refinance at now-available lower interest
rates

• the risk that when interest rates rise,

fewer prepayments will occur because
Extension risk homeowners are reluctant to give up the
benefits of a contractual interest rate that
now looks low

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COLLATERALIZED MORTGAGE OBLIGATIONS
Collateralized mortgage obligations (CMOs) are bond
classes created by redirecting the interest and principal
from a pool of pass-throughs or whole loans.

The creation of a CMO cannot eliminate prepayment risk;

it can only transfer the various forms of this risk among
different classes of bonds called “tranches.”

A wide range of CMO structures exists.

From a fixed-rate CMO tranche, a floating-rate tranche

and an inverse floating-rate tranche can be created.

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 TRANCHES
• Sequential-pay CMOs are structures where each class of bond
(the tranches) is retired sequentially.

First, distribute all principal payments to Tranche 1

until the principal balance for Tranche 1 is zero.

After Tranche 1 is paid off, do the same for

Tranche 2, and so on.

• Planned amortization class (PAC) tranches offer greater predictability

of cash flows as long as the prepayment rate is within a specified band
over the collateral’s life.
- The key to the prepayment protection for the PAC tranches is the
support tranches.

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 NON-AGENCY RESIDENTIAL MORTGAGE-
BACKED SECURITIES
• Non-agency RMBS share many features and structuring
techniques with agency CMOs. However, two
complementary mechanisms are usually required in
structuring non-agency RMBS.

1 The cash flows are distributed by rules, such as the

waterfall, that dictate the allocation of interest
payments and principal repayments to tranches
with various degrees of priority/seniority.

2 There are rules for the allocation of realized losses,

which specify that subordinated bond classes have
lower payment priority than senior classes.

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 6. COMMERCIAL MORTGAGE-BACKED
SECURITIES
• Commercial mortgage-backed securities (CMBS) are
backed by a pool of commercial mortgage loans on
income-producing property.
• Commercial mortgage loans are non-recourse loans, and
as a result, the lender can only look to the income-
producing property backing the loan for interest and
principal repayment.
Two measures of credit performance of CMBS:
Debt-to-service coverage ratio,
which is the property’s net
Loan-to-value ratio
operating income (NOI) divided
by the debt service

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 COMMERCIAL MORTGAGE-BACKED
SECURITIES
CMBS typically offer investors significant call
protection.

The degree of call protection available to a

CMBS investor is a function of (1) call
protection available at the loan level and (2)
call protection afforded from the actual CMBS
structure.

At the commercial loan level, call protection

can be in the form of a prepayment lockout, a
defeasance, prepayment penalty points, or
yield maintenance charges.

• Many commercial loans backing CMBS transactions are

balloon loans that require substantial principal payment at
maturity of the loan.
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 7. NON-MORTGAGE ASSET-BACKED
SECURITIES
• The collateral for an asset-backed security can be either:

Amortizing assets Non-amortizing assets

(e.g., auto loans, personal and or (e.g., credit card receivables)
commercial loans)
For non-amortizing assets,
prepayments by borrowers do not
In amortizing structures, the apply since there is no schedule
principal received from the of principal repayments.
scheduled repayment and any
prepayments are distributed to In non-amortizing structures,
the bond classes on the basis of typically there is a lockout period,
the waterfall. a period where principal
repayments are reinvested in new
assets.

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 AUTO LOAN-BACKED SECURITIES
Auto loan- The cash flows for auto loan-backed
backed securities consist of regularly scheduled
securities monthly loan payments (interest payment
and scheduled principal repayments) and
any prepayments.

All auto loan-backed securities have some

form of credit enhancement—often a senior/
subordinated so the senior tranches have
credit enhancement because of the presence
of subordinated tranches.

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 CREDIT CARD
RECEIVABLE-BACKED SECURITIES
Credit card For a pool of credit card receivables, the cash
receivable- flows consist of finance charges collected, fees,
backed and principal repayments.
securities

Interest—fixed or floating—is paid to security

holders periodically.

Credit card receivable-backed securities have

lockout periods during which the cash flow that
is paid out to security holders is based only on
finance charges collected and fees. When the
lockout period is over, the principal is no longer
reinvested but paid to investors.

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 8. COLLATERALIZED DEBT OBLIGATIONS
• A collateralized debt obligation (CDO) is a security backed by
a diversified pool of one or more of the following types of debt
obligations:

Corporate and emerging market bonds (CBOs)

Structured financial products, such as mortgage-backed

and asset-backed securities (structured finance CDOs)

Bank loans (collateralized loan obligations, or CLOs)

Credit default swaps (synthetic CDOs)

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 COLLATERALIZED DEBT OBLIGATIONS
• In a CDO, there is an asset manager responsible for managing
the portfolio of assets.
The tranches in a CDO
• Senior tranche
rated
• Mezzanine tranche
• Subordinate/equity tranche unrated

The proceeds to meet the obligations to the CDO tranches

(interest and principal repayment) can come from the following:
Coupon interest payments of the underlying assets
Maturing assets in the underlying pools

Sale of assets in the underlying pool

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 CALCULATING A COLLATERALIZED
DEBT OBLIGATION
Example. Consider the following US$100 million CDO:

Tranche Par Value (US$) Coupon Rate

Senior 80,000,000 LIBOR + 70 bps
Mezzanine 10,000,000 10-year US Treasury
rate + 200 bps
Subordinated/equity 10,000,000

• Assume the collateral consists of bonds that all mature in 10

years. The coupon rate is the 10-year US Treasury rate + 400
bps.
• The asset manager enters into an interest rate swap with a
notional amount of US$80 million. The asset manager agrees to
1) pay a fixed rate each year equal to the 10-year Treasury rate
+ 100 bps and 2) receive LIBOR.

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 CALCULATING A COLLATERALIZED
DEBT OBLIGATION
Example (continued).
• 10-year Treasury rate: 7%
• Interest from collateral: (7% + 4%) × $100 million = $11 million
• Interest to senior tranche: $80 million × (LIBOR + 70 bps)
• Interest to mezzanine tranche: $10 million × (7% + 2%) = $0.9 million
• Interest from swap counterparty: $80 million × LIBOR
• Interest to swap counterparty: 8% × $80 million = $6.4 million
• Net interest: $3.14 million

Now, suppose asset management fees are $640,000. Calculate cash

flow to subordinate/equity tranche and annual return.
• Cash flow: $3.14 million – $0.64 million = $2.5 million
• Return: $2.5 million/$10 million = 25% (assumes no defaults, no call)

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 9. SUMMARY
Benefits of securitization
• It allows investors direct access to liquid investments and
payment streams that would be unattainable if all the
financing were performed through banks.
• It enables banks to increase loan origination, monitoring, and
collections at economic scales greater than if they used only
their own in-house loan portfolios.

Securitization process
• The parties to a securitization include the special purpose
vehicle (SPV, also called the “trust”) that is the issuer of the
securities and the seller of the pool of loans (also called the
“depositor”).
• A common structure in a securitization is subordination,
which leads to the creation of more than one bond class or
tranche.

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 SUMMARY
Mortgage loans
• A mortgage loan is a loan secured by the collateral of some
specified real estate property that obliges the borrower to
make a predetermined series of payments to the lender.
• The cash flow of a mortgage includes (1) interest, (2)
scheduled principal payments, and (3) prepayments.

Mortgage-backed securities
• There are two MBS sectors: (i) agency residential mortgage-
backed securities (RMBS), including those guaranteed by
the government or government-sponsored agencies, and (ii)
non-agency RMBS.
• The payments that are received from the collateral are
distributed to pay interest and repay principal to the security
holders as well as to pay servicing and other fees.

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 SUMMARY

Motivation for creating securitized structures with

multiple tranches (CMOs)
• The motivation for the creation of different types of structures
is to redistribute prepayment risk and credit risk efficiently
among different bond classes in the securitization.
• The cash flow of a mortgage pass-through security depends
on the cash flow of the underlying pool of mortgages and
consists of monthly mortgage payments representing
interest, the scheduled repayment of principal, and any
prepayments, net of servicing and other fees.
• The most common types of CMO tranches are sequential-
pay tranches, planned amortization class (PAC) tranches,
support tranches, and floating-rate tranches.

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 SUMMARY

Commercial mortgage-backed securities

• Commercial mortgage-backed securities (CMBS) are
securities backed by a pool of commercial mortgage loans
on income-producing property.
• Two key indicators of the potential credit performance of
CMBS are the debt-to-service coverage ratio and the loan-
to-value ratio.
• CMBS have considerable call protection, which allows
CMBS to trade in the market more like corporate bonds than
like RMBS.

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 SUMMARY
Non-mortgage asset-backed securities
• The most popular non-mortgage ABS are auto loan
receivable-backed securities and credit card receivable-
backed securities.
• The collateral is amortizing for auto loan-backed securities
and non-amortizing for credit card receivable-backed
securities.
Collateralized debt obligations
• A collateralized debt obligation (CDO) is a generic term used
to describe a security backed by a diversified pool of one or
more debt obligations.
• A CDO requires a collateral manager to buy and sell debt
obligations for and from the CDO’s portfolio of assets to
generate sufficient cash flows to meet the obligations of the
CDO bondholders and to generate a fair return for the equity
holders.

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