Fixed Income

Introduction to Asset-Backed Securities

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Graphs, charts, tables, examples, and figures are copyright 2014, CFA Institute. Reproduced and
republished with permission from CFA Institute. All rights reserved.
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 Contents
1. Introduction
2. Benefits of Securitization for Economies and Financial Markets
3. The Securitization Process
4. Residential Mortgage Loans
5. Residential Mortgage-Backed Securities
6. Commercial Mortgage-Backed Securities
7. Non-Mortgage Asset-Backed Securities
8. Collateralized Debt Obligations

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 1. Introduction
The securitization process involves pooling relatively straight-forward debt obligations, such as loans or bonds, and
using the cash flows from the pool of debt obligations to pay off the bond created in the securitization process.

• Securtization

• Asset-Backed Securities

• Mortgage-Backed Securities

• Securitized Assets

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2. Benefits of Securitization for Economies and Financial
Markets
• Securtization enables investors to get direct access to liquid investments and
payment streams that would be otherwise unattainable

• Securitzation enables banks to increase loan origination, monitoring, and

collections
 Lower costs of borrowing for entities raising fund
 Higher risk-adjusted returns to investors
 Greater efficiency and profitability for the banking sector

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 3. The Securitization Process

1. An Example of a Securitization Transaction

2. Parties and Their Role to a Securitization Transaction

3. Bonds Issued

4. Key Role of the Special Purpose Vehicle

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3.1. An Example of a Securitization Transaction

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3.2. Parties and Their Role to a Securitization Transaction

• SPV
 Also called the trust

• Seller of pool of securities

 Also called the depositor

• Servicer

• Other parties

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 Example 2: A Securitization by Harley-Davidson
Harley-Davidson, Inc. manufactures and markets motorcycles. The following information is taken from a filing with
the US Securities and Exchange Commission for a securitization related to the purchase of Harley-Davidson
motorcycles:
• Issuer: Harley-Davidson Motorcycle Trust 2005-2
• US$487,000,000 3.79% Harley-Davidson Motorcycle Contract Backed Notes, Class A-1
• US $251,180,000 4.07% Harley-Davidson Motorcycle Contract Backed Notes, Class A-2
• US$ 36,820,000 4.27% Harley-Davidson Motorcycle Contract Backed Notes, Class B
• Seller and Servicer: Harley-Davidson Credit Corp.
• Contracts: The assets underlying the notes are fixed-rate, simple interest, conditional sales contracts,
promissory notes, and security agreements relating to the purchase of new or used motorcycles.
With this information, identify the collateral and the parties to this securitization.

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 3.3. Bonds Issued
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. Prepayment risk is the
uncertainty that the actual cash flows will be different from the scheduled cash flows as set forth in the
loan agreements because borrowers may alter payments to take advantage of interest rate
movements.
MET issued the following four bond classes,
with a total par value of US$200 million:
Time tranching
• A1 (US$80 million)
• A2 (US$60 million)
Subordination and credit tranching • A3 (US$40 million)
• A4 (US$20 million)

Bond Class Par Value ($ millions)

A (senior) 180
B (subordinated) 14
C (subordinated) 6
Total 200

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 Example 3: Bond Classes and Tranching
Return to the Harley-Davidson securitization described in Example 2. How many bond classes are there
in the securitization transaction? If the A-1 Notes are senior to the A-2 Notes, which are, in turn, senior
to the B Notes, does the transaction have time and/or credit tranching?

• US$487,000,000 3.79% Harley-Davidson Motorcycle Contract Backed Notes, Class A-1

• US $251,180,000 4.07% Harley-Davidson Motorcycle Contract Backed Notes, Class A-2
• US$ 36,820,000 4.27% Harley-Davidson Motorcycle Contract Backed Notes, Class B
• Contracts: The assets underlying the notes are fixed-rate, simple interest, conditional sales contracts,
promissory notes, and security agreements relating to the purchase of new or used motorcycles.

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 3.4. Key Role of the Special Purpose Vehicle
Because of the SPV, the securitization of a company’s assets may include some bond classes that have
better credit ratings than the company itself or its corporate bonds. Thus, in the aggregate, the
company’s funding cost is often lower when raising funds through securitization than by issuing
corporate bonds.

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 Example 4: The Special Purpose Vehicle and Bankruptcy
Agnelli Industries, a manufacturer of industrial machine tools based in Bergamo, Italy, has €400 million of receivables
on its balance sheet that it would like to securitize. The receivables represent payments Agnelli expects to receive for
machine tools it has sold to various customers in Europe. Agnelli’s corporate bonds have a credit rating below
investment grade. Agnelli securitizes the receivables by selling them to the Agnelli Trust (the special purpose vehicle),
which then issues the following bonds that all have a maturity of five years:

Bond Class Par Value (€ millions) The Class A bonds in the securitization have an investment-
grade credit rating.
A (senior) 280
1. How can a class of an asset-backed bond have an
B (subordinated) 60 investment-grade rating when Agnelli’s corporate bonds
C (subordinated) 60 do not?
2. Assume that two years after the issuance of the asset-
Total 400
backed bonds, Agnelli Industries files for bankruptcy.
What is the effect of the bankruptcy on the holders of
the asset-backed bonds?

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 4. Residential Mortgage Loans
A mortgage loan is a loan secured by the collateral of some specified real estate property which 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 (any principal repaid in
excess of the scheduled principal). The ratio of the property’s purchase price to the amount of the
mortgage is called the loan-to-value ratio.

• Maturity

• Interest Rate Determination

• Amortization Schedule

• Prepayments and Prepayment Penalties

• Rights of the Lender in a Foreclosure (recourse and non-recourse mortgage loans)

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 5. Residential Mortgage-Backed Securities
Three sectors for securities backed by residential mortgages:
(1) those guaranteed by a federal agency (Ginnie Mae) whose securities
are backed by the full faith and credit of the US government Agency
(2) those guaranteed by either of the two GSEs (Fannie Mae and Freddie
Mac) but not by the US government
(3) those issued by private entities that are not guaranteed by a federal Non-Agency
agency or a GSE.

• Mortgage Pass-Through Securities

• Collateralized Mortgage Obligations

• Non-agency Residential Mortgage-Backed Securities

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 5.1. Mortgage Pass-Through Securities
A mortgage pass-through security is created when one or more holders of mortgages form a pool of
mortgages and sell shares or participation certificates in the pool.

Cash Flow Characteristics

• Interest, scheduled repayment, prepayments
• Pass-through rate
• Weighted average coupon (WAC)
• Weighted average maturity (WAM)

Conforming and Non-Conforming Loans

Measures of Pre-Payment Rate

Cash Flow Construction
Weighted Average Life
Contraction Risk and Extension Risk

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 Measures of Pre-Payment Rate
Single month mortality (SMM) measures prepayments in a month

SMM = Prepayment for month ÷ (Beginning mortgage balance for month – Scheduled principal repayment for month)

The conditional prepayment rate (CPR) is an annualized version of SMM

A CPR of 6%, for example, means that approximately 6% of the outstanding mortgage balance at the beginning of the year
is expected to be prepaid by the end of the year.

The 100 PSA prepayment benchmark is expressed as a monthly series of CPRs.

A PSA assumption greater than 100 PSA means that prepayments are assumed to be faster than the benchmark. In
contrast, a PSA assumption lower than 100 PSA means that prepayments are assumed to be slower than the benchmark.

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 Cash Flow Construction
Exhibit 2. Monthly Cash Flow to Bondholders for a US$800 Million Mortgage Pass-Through Security
with a WAC of 6.0%, and a WAM of 357 Months and a 5.5% Pass-Through Rate, Assuming 165 PSA.

Beginning of Scheduled Total

Mortgage Net Interest
Month Month Mortgage SMM Principal Prepayment Principal Cash Flow
Payment Payment
Balance Repayment Repayment

1 800,000,000 0.00111 4,810,844 3,666,667 810,844 884,472 1,695,316 5,361,982

2 798,304,684 0.00139 4,805,520 3,658,896 813,996 1,104,931 1,918,927 5,577,823

SMM = Prepayment for month ÷ (Beginning mortgage balance for month – Scheduled principal repayment for month)

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 WAL, Contraction Risk, Extension Risk
The weighted average life (average life) gives investors an indication of how long investors can expect
to hold the MBS before it is paid off.

PSA assumption 100 125 165 250 400 600

Average life (years) 11.2 10.1 8.6 6.4 4.5 3.2

Contraction risk is the risk that when interest rates decline, the security will have a shorter maturity
than was anticipated at the time of purchase because homeowners refinance at now-available lower
interest rates.

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

Example 6: What type of prepayment risk would an investor be exposed to at prepayment rates faster
than 165 PSA, and what would be the consequences for the investor?

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 5.2. Collateralized Mortgage Obligations
The creation of a collateralized mortgage obligation (CMO) can help manage prepayment risk by
distributing the various forms of prepayment risk among different classes of bondholders. For CMOs
the collateral is usually a pool of mortgage pass-through securities.

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 CMO’s major financial innovation is that the securities
can be created to closely satisfy the asset/liability needs of institutional investors, thereby broadening
the appeal of mortgage-backed products.

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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 Sequential-Pay Structure with Four Tranches
Par Amount Coupon PSA Collateral Tranche A Tranche B Tranche C Tranche D
Tranche
(US$) Rate (%) 100 11.2 4.7 10.4 15.1 24.0
A 389,000,000 5.5 125 10.1 4.1 8.9 13.2 22.4
B 72,000,000 5.5 165 8.6 3.4 7.3 10.9 19.8
C 193,000,000 5.5 250 6.4 2.7 5.3 7.9 15.2
D 146,000,000 5.5 400 4.5 2.0 3.8 5.3 10.3
Total 800,000,000 600 3.2 1.6 2.8 3.8 7.0

For payment of monthly coupon interest: Disburse monthly coupon interest to each tranche on the basis of the
amount of principal outstanding for each tranche at the beginning of the month.

For disbursement of principal payments: Disburse principal payments to Tranche A until it is completely paid off.
After Tranche A is completely paid off, disburse principal payments to Tranche B until it is completely paid off.
After Tranche B is completely paid off, disburse principal payments to Tranche C until it is completely paid off.
After Tranche C is completely paid off, disburse principal payments to Tranche D until it is completely paid off.

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 Planned Amortization Class (PAC) and Support Tranches
PAC tranches offer greater predictability as long as the prepayment rate is within a specified band.
PACs offer protection against both extension risk and contraction risk.

Greater certainty comes at the expense of the non-PAC tranches (called support tranches).

PSA Life of PAC Life of Support The support tranches defer principal payments to the PAC
tranches if the collateral prepayments are slow; support
50 10.2 24.9
tranches do not receive any principal until the PAC tranches
75 8.6 22.7 receive their scheduled principal repayment.
100 7.7 20.0
Support tranches absorb any principal repayments in excess of
165 7.7 10.7
the scheduled principal repayments that are made. This rule
250 7.7 3.3 reduces the contraction risk of the PAC tranches.
400 5.5 1.9
If the support tranches are paid off quickly because of faster-
600 4.0 1.4
than-expected prepayments, they no longer provide any
protection for the PAC tranches.

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Example 7: Mortgage Pass-Through Securities Compared with CMOs
In a portfolio management meeting, you hear one of your colleagues make the following statement:
“Mortgage pass-through securities are not as complicated as collateralized mortgage obligations, which
divide the cash flows into different bond classes. The agency CMOs are far more risky than the pass-
throughs.” How would you respond?

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 Floating-Rate Tranches
Often, there is a demand for tranches that have a floating rate. Although the collateral pays a fixed rate,
it is possible to create a tranche with a floating rate. This is done by constructing a floater and an
inverse floater combination from any of the fixed-rate tranches in a CMO structure. Because the
floating-rate tranche pays a higher rate when interest rates go up and the inverse floater pays a lower
rate when interest rates go up, they offset each other. Thus, a fixed-rate tranche can be used to satisfy
the demand for a floating-rate tranche.

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 Example 8: Selecting a Suitable Tranche
Which tranche in a CMO structure is most suitable for the following investors?
1. An investor who is most concerned about contraction risk
2. An investor who would like the investment to have a predictable and stable average life
3. An investor who expects that interest rates will fall
4. An investor who is willing to accept significant prepayment risk if compensated with a relatively
high expected return

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 5.3. Non-agency Residential Mortgage-Backed Securities
Non-agency RMBS are not backed by the government or by a GSE; hence credit risk is a major concern

Non-agency RMBS typically include two complementary mechanisms:

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

In order to obtain favorable credit rating, non-agency RMBS and non-mortgage ABS often require one
or more credit enhancements
• Internal credit enhancements: senior/subordinated structures, reserve funds, overcollateralization
• External credit enhancements: financial guarantee by a third party such as a monoline insurance
company

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 6. Commercial Mortgage-Backed Securities
• Commercial mortgage-backed securities (CMBS) are securities backed by a pool of commercial
mortgage loans on income-producing property.

• Generally commercial mortgage loans are non-recourse loans; hence, credit analysis involves
studying the cash flow from the underlying properties

• Two key indicators of the potential credit performance: 1) debt-to-service-coverage ratio and 2) the
loan-to-value ratio

• A credit-rating agency determines the level of credit enhancement necessary to achieve a desired
credit rating. For example, if specific DSC and LTV ratios are needed and those ratios cannot be met
at the loan level, subordination is used to achieve the desired credit rating.

• Losses arising from loan defaults are charged against the principal balance of the lowest priority
CMBS tranche outstanding. This tranche may not be rated by credit-rating agencies; in this case, this
unrated tranche is called the “first-loss piece,” “residual tranche,” or “equity tranche.”

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 Call Protection and Balloon Risk
CMBS have considerable call protection
Call protection comes in two forms: at the structure level and at the loan level
Example of call protection at the structure level : sequential-pay tranches
At the loan level, four mechanisms offer investors call protection
1. prepayment lockouts
2. prepayment penalty points
3. yield maintenance charges
4. defeasance

Many commercial loans backing CMBS transactions are balloon loans

The risk that a borrower will not be able to make the balloon payment because either the borrower
cannot arrange for refinancing or cannot sell the property to generate sufficient funds to pay off the
balloon balance is called “balloon risk”
Balloon risk is a type of extension risk

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 Example 10: A Commercial Mortgage-Backed Security
Initial The collateral for this CMBS is a pool of 72 fixed-rate mortgage loans secured by first liens (first
Pass- claims) on various types of commercial, multifamily, and manufactured housing community
Classes Initial Principal properties. What is the meaning of the following statement in the offering?
Through
Rate “If you acquire Class B certificates, then your rights to receive distributions of amounts collected or
advanced on or in respect of the mortgage loans will be subordinated to those of the holders of the
A-1 $75,176,000 0.754% Class A-1, Class A-2, Class A-3, Class A-4, Class A-AB, Class X-A, and Class A-S certificates. If you
A-2 $290,426,000 1.987% acquire Class C certificates, then your rights to receive distributions of amounts collected or
advanced on or in respect of the mortgage loans will be subordinated to those of the holders of the
A-3 $150,000,000 2.815% Class B certificates and all other classes of offered certificates.”
A-4 $236,220,000 3.093%
The offering states the following provisions. What do these three provisions mean?
A-AB $92,911,000 2.690% “Prepayment Penalty Description” or “Prepayment Provision” means the number of payments from
X-A $948,816,000 1.937% the first due date through and including the maturity date for which a Mortgage Loan is, as
applicable, (i) locked out from prepayment, (ii) provides for payment of a prepayment premium or
A-S $104,083,000 3.422% yield maintenance charge in connection with a prepayment, (iii) permits defeasance.
B $75,423,000 3.732%
Explain the following risk stated in the offering: “the risk that it may be more difficult for the
C $42,236,000 borrower to refinance these loans or to sell the related mortgaged property for purposes of making
any balloon payment on the entire balance of such loans and the related additional debt at
maturity.”

The information in the offering states the NOI and DSC ratio. What are these measures and what is
their purpose?
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 7. Non-Mortgage Asset-Backed Securities

ABS are backed by a wide range of asset types.

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

The collateral is non-amortizing for credit card receivable-backed securities.

ABS must offer credit enhancement to be appealing to investors.

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 7.1. Auto Loan Receivable-Backed Securities
• Cash flows consist of interest payment, scheduled principal repayments and any prepayments

• Prepayments result from sales and trade-ins requiring full payoff of the loan, repossession and
subsequent resale of vehicles, insurance proceeds received upon loss or destruction of vehicles,
payoffs of the loan with cash to save on the interest cost, and refinancing of the loans at a lower
interest rate

• All auto loan-backed securities have some form of credit enhancement

 Senior/subordinated so the senior tranches have credit enhancement
 Reserve account, overcollateralization, and excess interest on the receivables

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 Main Points from Example 11
1. A subprime loan is one granted to borrowers with lower credit quality. Like any subprime loans,
subprime automobile loans are contracts made to borrowers who have experienced prior credit
difficulties or who cannot otherwise document strong credit.

2. The purpose of a reserve account is to provide credit enhancement. More specifically, the reserve
account is a form of internal credit enhancement that will protect the bondholders against losses
up to X% of the par value of the entire issue.

3. Overcollateralization means that the aggregate principal balance of the automobile loan contracts
exceeds the principal balance of the notes. It represents another form of internal credit
enhancement. Overcollateralization can be used to absorb losses from the collateral.

4. The bond class that absorbs the losses first is the Class E Notes.

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 7.2. Credit Card Receivable-Backed Securities
• Credit card receivables are used as collateral for the issuance of credit card receivable-backed
securities.
• For a pool of credit card receivables, the cash flows consist of finance charges collected, fees, and
principal repayments. Finance charges collected represent the periodic interest the credit card
borrower is charged on the unpaid balance after the grace period. Fees include late payment fees
and any annual membership fees.
• Interest is paid to security holders periodically (e.g., monthly, quarterly, or semiannually). The
interest rate may be fixed or floating.
• Credit card receivable-backed securities are non-amortizing loans. They 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.
• Certain provisions in credit card receivable-backed securities require early amortization of the
principal if certain events occur. Such provisions are referred to as “early amortization” or “rapid
amortization” provisions and are included to safeguard the credit quality of the issue. The only way
the principal cash flows can be altered is by the triggering of the early amortization provision.

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 8. 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 (e.g., corporate and emerging market bonds,
leveraged bank loans, ABS, RMBS, CMBS or CDO).

• Like an ABS, a CDO involves the creation of an SPV. But in contrast to an ABS where the funds
necessary to pay the bond classes come from a pool of loans that must be serviced, 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.

• The structure of a CDO includes senior, mezzanine, and subordinated/equity bond classes.

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 CDO Example
Consider the following US$100 million CDO. The collateral consists of bonds with par value of $100
million paying a fixed rate of 11%.

Tranche Par Value (US$) Coupon Rate CDO manager enters into a $80
million swap paying a fixed rate of 8%
Senior 80,000,000 Libor + 70 bps
and receiving Libor.
Mezzanine 10,000,000 9%
Subordinated/equity 10,000,000 —

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 CDOs: Risks and Motivations
In the case of defaults in the collateral, there is a risk that the manager will fail to earn a return sufficient to
pay off the investors in the senior and mezzanine tranches. Investors in the subordinated/equity tranche risk
the loss of their entire investment.

Example 13: Motivation for Creating a CDO. An arbitrage collateralized debt obligation relies on securitization
but is different from a traditional asset-backed security in terms of its motivation. Explain why.

Solution:
As with an ABS, the creation of an arbitrage CDO involves the creation of an SPV and the pooling of debt
obligations. The purpose and management of an arbitrage CDO, however, are different from those of an ABS.
With an ABS, the cash flows from the collateral are used to pay off the holders of the bond classes without the
active management of the collateral—that is, without a manager altering the composition of the debt obligations
in the pool that is backing the securitization. In contrast, in an arbitrage CDO, a CDO manager buys and sells debt
obligations with the dual purpose of not only paying off the holders of the bond classes but also generating an
attractive/competitive return for the subordinated/equity tranche and for the manager.

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 Summary
• Securitization Process and Parties Involved
• Benefits of Securtization
• Residential Mortgage-Backed Securities
 Agency
 Non-Agency
• Commercial
• Collateralized Mortgage-Backed Obligations (CMOs)
• Non-Mortgage Asset Backed Securities
• Collateralized Debt Obligations

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 Conclusion
• Read the summary

• Review learning objectives

• Examples

• Practice problems

• Practice questions from other sources

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