Fixed Income

Introduction to Asset-Backed Securities

- Anurag Mishra
• Securitization involves pooling debt obligations, such as loans or receivables, and
creating securities backed by pool of debt obligations called Asset-backed securities
(ABS). The cash flow of the debt obligations are used to make interest payments repayment
to the holders of the ABS.

• Securitization has several benefits. It allows investors direct access to liquid investment
and payment streams that would be unattainable if all the financing were performed
through banks. It enables banks to increase loan originations at economic scale greater
than if they used only their own in-house loan portfolios. Thus, securitization contributes to
lower costs of borrowing for entities raising funds, higher risk-adjusted returns to
investors, and greater efficiency and profitability for the banking sector.
• The parties to a securitization include the seller of the collateral (pool of loans),
the servicer of the loans, and the special purpose entity (SPE). It’s a bankruptcy
remote, which plays a pivotal role in the securitization.

• A common structure in a securitization is subordination, which leads to creation

of more than one bond class or tranche. Bond classes differ as to how they will
share any losses resulting from defaults of the borrowers whose loans are in
collateral. The credit ratings assigned to various bond classes depend on how
credit rating agencies evaluate the credit risks of collateral and any credit
enhancements.
• Different structures are encouraged to redistribute prepayment risk & credit risk
efficiently.
• Prepayment risk is uncertainty that actual cash flows will be different from
scheduled cash flows as set forth in loan agreements. Often, borrower choose to
pay principal early to take advantage of interest rate movements.
• SPE enhances credit rating of company which result in lower funding cost when
funds are raised through corporate bonds.
• Mortgage is a loan secured against collateral of specified real estate property.
 MBS

• Cash flow of mortgage includes; Interest, Scheduled Principal Payments, and Prepayments (any principal
repaid in excess of scheduled principal payment).
• Mortgage Designs should specify:-
1. The maturity of loan
2. How interest Rate is determined (Fixed vs FRN’s)
3. How Principal would be repaid (Amortizing, fully amortized or partially amortized with a balloon
payment)
4. Option of Prepayment for Borrower & if any prepayment penalties are imposed
5. Rights of the lender in a foreclosure (whether the loan is a recourse or non-recourse loans)
• In US, these 3 sectors for securities are backed by residential mortgages:-
1. Guaranteed by Federal Agency (Ginnie Mae) & have full faith and credit of US
Government

2. Guaranteed by GSE (eg., Fannie Mae & Freddie Mac) but not by US Government

3. Private entities that are not owned by Federal Agency or a GSE.

1st two types are Agency Residential MBS & 3rd Sector is Non-Agency RMBS
• To create a Mortgage pass-through security, one or more holders of mortgages
form a pool of mortgages & sell shares or Participation Certificate.
• Cash Flow of such security depends on cash flow of underlying pool of mortgages
and consists of monthly mortgage payments representing interests, Scheduled
repayment of Principal, and any Prepayments, net of servicing & other
administrative fees.
• Prepayment Rate can be measured by either Single Monthly Mortality Rate
(SMM) & its corresponding annualized rate, Conditional Prepayment Rate
(CPR).
• For MBS, Weighted Average life of MBS is widely used.
 Pre-Payment Risk
• Prepayment rates are determined by Public Securities Association (PSA) benchmark. If PSA
assumption would be greater than 100 PSA than prepayments are assumed to occur faster than
the benchmark and vice versa.

• Prepayment Risk :-
1. Contraction Risk – When Interest rate declines, security will have shorter maturity than was
anticipated at time of Purchase. {Refinance of loans due to lower Interest Rates}

2. Extension Risk – If interest rates will go up, fewer prepayments will occur than what was
anticipated at the time of purchase because homeowners are reluctant to give up benefits of a
contractual interest rate that will look low.
Collateralized Mortgage Obligation (CMO)
• Broadens appeal of Mortgage-backed Products.
• Creates more lucrative securities for asset/liability needs if institutional
investors.
• Manage Pre payment Risk by distributing various forms of Risk among
different classes of bondholders.
• Most common types of CMO tranches are sequential-pay tranches,
planned amortization class (PAC) tranches, support tranches, &
floating rate tranches.
• Non – Agency RMBS & CMO’s shares features as well as structuring techniques.
• Both of these include 2 complimentary mechanism ;-
1. Cash Flows are distributed by rules that dictate allocation of interest payments &
principal repayments to tranches with various degrees of priority or seniority.

2. There are rules for allocation of realized losses i.e., tranches.

 Commercial Mortgage-backed securities
(CMBS)
• Pool of commercial mortgages on income-inducing property.
• Key indicators of potential credit performance of CMBS are the debt-service-
coverage (DSC) ratio & the Loan-to-value ratio (LTV).
• DSC ratio is property’s annual net operating income divided by debt service.
• CMBS have considerable call protection, which allows it to trade in market more
like corporate bonds than like RMBS. This protection comes in two forms; at the
structural level & at the loan level. Creation of Sequential pay tranches is example
of call protection at the Structure level. At Loan level, four mechanism offer
investors call protection; pre payment lockouts, prepayment penalty points, yield
maintenance charges and defeasance.
 Asset Backed Securities
• Backed by wide range of asset types.
• Most popular non-mortgage ABS are Auto Loan ABS & Credit Card
receivable ABS.
• Collateral is amortizing for auto loan ABS and non amortizing for credit card
receivables ABS.
• As with Non Agency RMBS, these ABS must offer credit enhancement to be
appealing to investors.
 Collateralized Debt Obligation (CDO)
• Security backed by diversified pool of one or more debt obligations (e.g.,
corporate & emerging market bonds, leveraged bank loans, ABS, RMBS and
CMBS)
• Involves Creation of SPE.
• Requires lateral manager to buy & sell debt obligations for and from CDO’s
Portfolio of assets to generate sufficient cash flows to meet the obligations
of CDO Bondholders and to generate a fair return for Equity holders.
• Structure includes senior, mezzanine, and subordinated equity bond classes.