Reading 54 LOS's

Question 1

LOS 54a: Explain benefits of securitization for economies and financial markets

Answer 1

Before the advent of securitization, financing for mortgages was done by financial institutions and the only way investors could participate was to buy into the whole institutions assets (they couldn’t directly invest in mortgages per say). Securitizatoin solved these problems along with :

• it removes the layer between borrowers and lenders, reducing the costs to borrowers and increasing the returns to lenders (as the financial institutions role has become less)
• It allows investors to have a stronger legal claim on the collateral pool of assets
• Investors can pick and choose the types of securities they want to invest in
• Financial intermediaries are able to originate more loans than they would if they were only able to issue loans they could finance themselves
• The increase in total supply of loanable funds benefits organizations who are looking to borrow
• Since securitized bonds are sold in the public market, they are more liquid
• Securitization encourages innovation in invesment products, which can offer investors access to assets that match their risk, return, and maturity profiles

Question 2

LOS 54b: Describe the securization process, including the parties to the process, the roles they play, and the legal structures involved

Answer 2

The idea is that a company has some sort of asset that provides a cash flow. To raise money without issuing new debt or securities, the company can securitize these assets with their cash flows. To do this, the company will create a special purpose vehicle (SPV) or special purpose entity (SPE). The company will sell the assets to the SPV, which gives the SPV legal ownership of the assets. The SPV will issue asset backed securities (ABS) to raise funds to pay for the assets. The ABS will be backed by the cash flows from the asset.

In addition to the company and the SPV, other parties involved are:

• Attorneys prepare legal documents including:
  
  • the pruchase agreement between the seller and the SPV
  • a documents that describes the structure’s waterfall (who gets paid first in case of bankruptcy)
  • the servicing agreement
• An indepedent accounting firm verifies the accuracy of all numerical information in the prospectus and issue a comfort letter for securitization
• the trustee holds the assets in a trust, holds the payments due to bondholders until they are paid, and provides remittance reports
• the underwriter markets the securities to investors and handles the logistics of the transaction
• rating agencies determine the level of credit enhancement required for each bond class to obtain the credit rating desired by the issuer

Key Role of the SPV

In order for securitization to serve its purpose, the SPV must be a bankruptcy remote entity, that is its obligations remain secure even if the parent company goes bankrupt.

The idea is that the parent company may not have a good credit rating, and therefore has to pay higher yields if it were to issue debt. Instead of issuing debt, it can sell the assets to the SPV, which will securitize them and sell ABSs. These ABSs can sell with a higher rating than the parent company, because they now are a complete seperate entity. The credit rating for the ABSs is based solely on the cash generating ability of the assets, and has nothing to do with the parent company.

Another reason the SPV will be able to raise capital for less than the parent, has to do with the absolute priority rule. We know that when a company defaults and goes through liquidation, that the senior tranches should be paid before the junior and before equities. We also know that this tends to rarely go this way, as during liquidation negotiations, compromises are made. When it comes to securitization via a bankruptcy-remote SPV, rules regarding how credit losses are absorbed are actually adhered to.

Question 3

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

Answer 3

Residential mortgage loans

• A mortgage loan is a borrowing that is secured by some form of real estate
• if the borrower fails to make payments, the lender can seize the asset and sell it to make up for losses
• typically the loan is less than the purchase price of the house- the difference being the down payment
• Ratio of the purchase price to the amount of the mortgage loan is known as the loan-to-value ratio (LTV)
  
  • The lower the LTV, the higher the borrower’s equity, the less likely they are to default, and the more protection the lender has

Interest Rates on Mortgages

• Fixed-rate the mortgage rate is fixed over the term of the loan
• Adjustable-rate mortgage (ARM) or variable-rate mortgage- the mortgage rate is reset periodically (daily, weekly, monthly, annually) to some reference rate or index. There are normally caps on maximum interest rate changes and on max interest at any point.
• Initital period fixed rate- the mortgage is initially fixed until a certain period where the rate is adjusted to either 1) a new fixed-rate ( called rollover or renegotiable mortgage) or 2) a variable rate (called a hybrid mortgage)
• Convertible- The mortgage rate is initially fixed or adjustable, with the borrower having an option to convert the mortgage into a fixed rate or adjustable rate for the life of the mortgage

Ammortization Schedule

Most mortgages around the world are structured as ammortizing loans, where the principal is paid off over time. They can be either fully ammortizing or partially ammortizing, in which case there is a balloon payment at the end.

Prepayments and Prepayment Penalties

A mortgage loan may allow the borrower to pay some or all of the principal at any point during the loan, known as a prepayment option. Some loans will make the borrower pay some sort of penalty for prepayment to make up for the lost interest. Since borrowers can accelerate payments, lenders are faced with prepayment risk.

Rights of the Lender in a Foreclosure

In the US loans are stuctured as nonrecourse loans, where as in Europe they are recourse.

• recourse loan, the lender has a claim against the borrower if the proceeds from sale of the property fall short of the mortgage balance outstanding
• nonrecourse loan, the lender does not have such a claim against the borrower if the proceeds from sale of the property fall short of the mortgage balance outstanding

Question 4

LOS 54d: Describe types and characteristics of residential mortgage-backed securities, and explain the cash flows and credit risk for each type

Answer 4

In the United States, residential mortgage-backed securities are divided into 2 sectors:

• Agency RMBS which are issued by 1) federal agencies (Ginnie Mae) and 2) quasi-government entities (Freddie Mac and Fannie Mae- government sponsored enterprised or GSEs)
  
  • There is no credit risk for agency RMBS issued by Ginnie Mae as they are backed by the full faith and credit of the US gov
  • There are minimal credit risk for agency RMBS issued by Freddie or Fannie as they are guranteed by themselves
  • Note that loans issued by GSEs must satifsy specific underwriting standrads established by various government agencies to qualify for the collateral pool backing agency
• Nonagency MBS which are issued by private entities
  
  • they typically come with credit enhancements to reduce risk

Mortgage Pass-Through Securities are created when shares or participation certificates in a pool of mortgage loans are sold to investors

Cash Flow Characteristics

Nonagency MBS has cash flow collected from the collateral pool including scheduled principle and interest payments, along with prepayments. Agency RMBS have payments made by borrowers pass-through the government agencing who collects servicing and guranteeing fees. Therefore the pass through rate is lower than the mortgage rate.

Note mortgage loans that are securitized to create pass-through securities do not all carry the same mortgage and maturity rate. Therefore a weighted average coupon rate (WAC) and weighted average maturity (WAM) are calculated to describe the pool of mortgages

Conforming vs Nonconforming Loans

Agency RMBS must be comforming to 1) the maximum loan to value ratio (LTV) 2) the loan documentation required, 3) whether insurance is required, and 4) the maximum loan amount. A nonconforming loan is issued by a nonagency RMBS

Meaures of Prepayment Rate

Since the mortgage loans that are securitized to create pass-through securities entail prepayment risks, market participants refer to a prepayment rate in terms of monthly measure know as the single monthly mortality rate (SMM) or its corresponding annualized rate, the conditional prepayment rate (CPR):

• SMM = Prepayment in month t / ( Beginning mortgage balance for month t , - Scheduled principal payment in month t)

In the US, prepayment rates over the term of mortgage securities are described in terms of a prepayment pattern or benchmark introduced by the Public Securities Association (PSA):

• if t < 30, then CPR = 6% x (t/30)
• if t >= 30, then CPR = 6%
• t = number of months that have passed since mortgage origination

Slower or faster prepayment speeds are described in terms of percentages of 100PSA. Example a 75 PSA would move at three quarters the speed of normalPSA.

Weighted Average Life

When evaluating the interest rate risk of an MBS, using its legal maturity is inappropriate, as it does not account for prepayments. Therefore market participants use average life (the weighted average time it will take for all the principal payments to be received) as a measure of the interest rate risk of a MBS

Contraction and Extension Risk

Prepayment encompasses both of these risks

• Contraction Risk occurs when interest rates fall. When they fall, it becomes feasible for the mortgage issuer/borrower to prepay, making the upside potential for the pass-through limited. To make things worse, refinancing activity typically increases, further reducing the average life
• Extension Risk occurs when interest rates rise. The price of the pass-through (just like any bond) will decline. Refinancing and prepayments will slow down, as the pass-through rate is cheaper than whats available in the market.
  *

Question 5

LOS 54e: Explain the motivation for creating securitized structures with multiple tranches (ex collateralized mortgage obligations) and the characteristics and risks of securitized structures

Answer 5

Collateralized Mortgage Obligations

Mortgage pass-through securities (whose cash flows vary) are undesireable for institutional invesotrs who are interested in matching their cash flows with the maturities of their liabilities. CMOs redistribute the cash flows from mortgage pass-through securities into packages/classes/tranches with different risk exposures to prepayment risk. The major varieites of CMO structures are described below:

Sequential- Pay tranches

In this CMO structure each tranche of bonds is retired sequentially in a predetermined order, with senior debt getting thier principal paid first and then so on. Each tranche is paid coupon interest each month as its stated rate based on the principal outstanding. So while subordinate tranches wait to get their prinicpal paid off, they experience coupon payments for longer.

Planned Amortization Class Tranches (PAC)

PAC bonds were introduced in the bond market to improve upon sequential-pay structures and offer investors greater protection from prepayment risk. PAC bonds bring increased predictability of cash flows as they specify a repayment schedule that will be satisfied as long as actual prepayments realized from the collateral fall within a predefined band known as the initial PAC collar or initial PAC band (this band is bound by both an upper and lower PSA rate, say a 300PSA and a 75PSA). The greater certainty in payments for the PAC tranche comes at the expense of greater uncertainty for the support or companion tranche, who provide two-sided protection (protection against extension and contraction risk).

Nonagency Residential Mortgage-Backed Securities

RMBS are not guranteed by the government or a GSE, which makes evaluation of credit risk an important consideration when investing. Market participants identify 2 types of mortgage loans in the pool as prime (high-credit borrowers with substantial equity in property) and as sub-prime ( bad credit, with already loans out on property). When it comes to forecasting cash flows on nonagency MBS, investors must make assumptions regarding 1) the default rate for the collateral and 2) the recovery rate. In order to obtain favorable credit ratings, nonagency RMBS are credit enhanced.

Internal Credit Enhancements

• Reserve Funds
  
  • Cash reserve funds - cash can be used to pay for potential future losses
  • Excess spread accounts - the excess spread is kept in reserve to pay for future losses
• Overcollateralization- a securitization backed with $350 of assets, that only has a par value of $325, is overcollateralized by $25 million
• Senior/subordinate structure - Provided credit tranching as the subordinate bond classes provide credit protection to the senior classes. To protect investors in the senior bond classes, a shifting interest mechanism is added to the structure. This mechanism locks out subordinated classes from receiving payments for a period of time, ensuring credit protection enjoyed by the senior tranches doesn’t fade over time.

Question 6

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

Answer 6

CMBS are backed by a pool of commercial mortgage loans on income-generating properties. 2 Measures are commonly used to evaluate the potential credit performance of a commercial property:

1. The debt-service coverage ratio (DSC) is used to evaluate the adequacy of income generated from the property to service the loan. It is calculated as net operating income (NOI) divided by debt service. A ratio of greater than 1 means that cash flow from the property covers debt servicing costs adequately. THe higher the ratio, the lower the credit risk
2. the loan to value (LTV) equals the loan amount divided by the appraised value of the property. The lower the ratio, the lower the credit risk.

Basic CMBS Structure

• A credit rating agency determines the level of credit enhancement required for the issuer to attain the credit rating desired
• Different bond classes are created, with each class having different priority on cash flows ( highest rated tranched gets repaid first, lowest rated tranche absorbs losses first)
• Interest payments are made to all tranches

2 Characteristics that are usually specific to CMBS are described:

1. Typically CMBS investors have significant call protection that can come at the loan level or the structural level
   
   1. At the loan level can come in the following forms
   • Prepayment lockouts, which prohibit any prepayments during a specified period of time
   • Defeasance which occurs when the borrower, instead of prepaying the loan, provides funds to the servicer to invest in a portfolio of Treasuries whose cash flows replicate those of the loan assuming no repayments. Upon completion of the defeasance period, these securities are liquidated to pay off the loans
   • prepayment penalties are levied upon borrowers if they wish to refinance their loans
   • Yield maintenance charges are intended to compensate the lender for interest lost due to prepayments
   1. Call protection at the structure level comes from credit tranching
2. Most commercial loans that back CMBS have balloon maturity provisions, which exposes investors to balloon risk ( the borrower will not be able to pay the amount of funds due at maturity). To make up for this, there is normally a workout period where the borrower and lender negotiate ways to pay the balance.

Question 7

LOS 54g: Desribe types and characteristics of nonmortgage asset-backed securities, including the cash flows and credit risk of each type

Answer 7

Nonmortgage asset-backed securities can be classified as either amortizing or nonamortizing assets

• Amortizing loans have periodic cash flows that include interest payments, principal repayments, and prepayments. Example include automobile loans
• Nonamortizing loans only require a monthly minimum payment with no schedules principal payment. Since there is no scheduled principal amount, the concept of prepayment does not apply to nonamortizing assets. Examples include credit card receivables

The type of collateral has a significant effect on the structure of the securitization

• When amortizing assets are securitized, the total face value declines over time due to schedules repayments and prepayments
• Securitizations of nonamortizing loans usually take the form of a revolving structure
  
  • During an initial lockout or revolving period all principal repayments are reinvested in additional loans with a principal amount equal to the total principal amount received.
  • During the principal amortization period principal repayments are distributed to security holders

Now a description of the securitization of both an amortizing and non amortizing loan

• Auto loan Receivable-Backed Securties( Amortizing)- cash flows for auto-backed securities consist of regularly scheduled monthly interest and principal payments and prepayments. Generally speaking, auto loan-backed securities comes with some form of credit enhancement, usually tranching.
• Credit Card Receivable-Backed Securities (Nonamortizing)- here the card holder agrees to repay the amount borrowed. These receivables for the credit card company are used as collateral for the credit card receivbales-backed securities.
  
  • The cash flow from a pool of credit card receivables is 1) finance charges, 2) fees, and 3) principal repayment. Interest payments are made to security holders periodically
  • Since they are nonamortizing, there is a revolving period in which any principal repayments from the pool are used to purchase additional receivables to maintain the size of the pool. Principal payments are then passed on to the security holders during the principal-amortizing period.

Question 8

LOS 54h: Describe collateralized debt obligations (CDO), including their cash flows and credit risk

Answer 8

A CDO is a security that is backed by a diversified pool of securities that may include:

• Corporate bonds and emerging market bonds
• ABS, RMBS, CMBS
• Leveraged Bank Loans
• credit default swaps

Structure of a CDO Transaction.

• Like an ABS, a CDO also involved the creation of a SPV
• a CDO manager is responsible for managing the collateral portfolio of assets
• The funds used to purchase the collateral assets are raised from the issuance of bonds to investors
• Restrictive covenants are placed on the manager to ensure the credit ratings assigned to the varios tranches at issuance are maintained during the term of the CDO
• Cash flows from the underlying portfolio of assets include 1) coupon interest payments 2) proceeds from maturing assets and 3) proceeds from sale of assets
• Issuing a CDO is like undertaking a leveraged transaction where the idea is to use borrowed funds to generate a return that exceeds the funding cost

The major difference between an ABS and a CDO is that in an ABS the cash flow from the collateral pool are used to pay off the bond holders without the active management of collateral. In a CDO, the manager buys and sells debt obligations to 1) generate the cash flow required to pay bond holders and 2) to earn a competitive return for the equity tranche