INTRODUCTION TO ASSET BACKED SECURITIES

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ASSET BACKED SECURITIES
(ABS)

Mortgage Backed securities Collateralized Debt Obligations

(MBS)
Non MBS (CDO)

RMBS CMBS Amortizing Non Amortizing

Agency RMBS Non Agency RMBS

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LOS a Benefits of securitization
1. Securitization results in disintermediation. The wall between
ultimate investor and originating borrower is reduced.
2. Borrowers are able to borrow at low cost.
3. Investor are able to borrow at low cost.
4. Bank can improve profitability by increasing volume
(increasing loan origination)
5. Increase the liquidity of the banks assets.
6. Securitization has led to financial innovation that allows investor to
invest in securities that better match their preferred risk, maturity
and return characteristics.
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LOS b Describe securitization process including the parties involved

Note: In the entire process there are law firms, Underwriter, Rating agencies, Guarantor, (external credit enhancement)
E.g. Monoline Insurance Company
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LOS C Typical structure of securitization including credit & time tranching
➢In “Tranches” structure – some tranches bear more risk while others bear
less
➢Credit tranching (senior/subordinate structure)- losses are first absorbed by
the tranche with lowest priority
➢Time tranching – first tranche receives all principal repayments from
underlying assets up to the principle value of the tranche
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LOS d Residential mortgage Loans
𝐿𝑜𝑎𝑛 𝑎𝑚𝑜𝑢𝑛𝑡
Loan-to-value ratio (LTV) = x 100
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑜𝑙𝑙𝑎𝑡𝑒𝑟𝑎𝑙 𝑟𝑒𝑎𝑙 𝑒𝑠𝑡𝑎𝑡𝑒
If ↑ LTV, then borrower’s equity ↓
For Lenders,
+ Loans with low LTVs is less riskier (because borrower loses
more in case of default)
+ If the property value is high compared to the loan amount,
lender is more likely to recover the amount loaned if
borrower defaults
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Prime loans- Mortgages with high LTV ratios, made to borrowers of high credit
quality
Subprime loans- Mortgage to borrowers of lower credit quality
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Characteristics of residential mortgage loans:
Maturity – typically 15-30 years
Amortization- Fully amortizing, partially amortizing or interest -only
Prepayment provisions- Some loans have prepayment penalty
Foreclosure- Non-recourse and recourse loans
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Interest rate
• Fixed Interest rate- interest rate that is unchanged over the life of
the asset
• Adjustable rate (Variable rate) Mortgage
→ Index reference adjustable rate mortgage
→ Reviewable adjustable rate mortgage
Renegotiable mortgage- initially fixed later revised (but fixed)
Hybrid mortgage- initially fixed later floating
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
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LOS e Describe types and characteristics of residential mortgage- backed securities, including mortgage pass-
through securities and collateralized mortgage obligation and explain the cash flow and risk for each type.

RMBS (Depending on issuer)

Agency RMBS Non Agency RMBS

▪ Issued by private
Issued by Federal
Issued by Government companies
Sponsored Entities
Institutional
(GSE’S) ▪ High credit risk
▪ Backed by full ▪ Some credit risk ▪ Non-confirming
faith & credit of ▪ Fannie Mae, mortgages
US Govt. Freddie Mac
▪ Ginnie Mae
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Mortgage Pass through securities:

▪ Simplest type of RMBS
▪ Single type of MBS is issued to all securities holder (No Tranching)
▪ Every body has same claim
▪ Equal credit & prepayment risk
▪ Gross Interest minus servicing & other fees+ Net Interest
(known as pass through rate) is distributed to all securities holder
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Collateralized mortgage obligations (CMOs)
This are issued with mortgage pass through securities as mortgage
CMO
Pool of
Mortgage SPV PTS CMO

CMO

They are structured with tranches Attempt to replace credit/ Prepayment

risk. 2 varieties of Tranching
1. Sequential Pay CMO
Imagine a word with 2 types of investors
Type 1- Love Contraction risk & hate extension risk
Type 2- Love extension risk & hate contraction risk
▪ Sequential pay CMO is designed to suit both
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Interest CMO1
Mortgage
Pool CMO2
Principal +
Pre payment CMO3

2 Another Variety has planned amortization class (PAC) tranches & support
tranches.
A PAC tranche is structured to make predictable payment, regardless of
actual payment PAC tranches have reduced both Contraction & extension
risk.
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LOS f Define prepayment risk and describe the prepayment risk of mortgage – backed
securities
▪ Prepayment risk- Uncertainty about timing of the principal CFs from the ABS
▪ Contraction risk –Risk that loan principal will be paid more rapidly than expected (when
interest rates decrease)
▪ Extension risk- Risk that loan principal will be repaid more slowly than expected (when
interest rates increase)
▪ Prepayment measurement –
1 Single monthly mortality rate (SMM) is % by which prepayment reduce the month end
principal balance
2 Conditional prepayment rate (CPR) –is an annualized measure of prepayment
▪ Public securities Association (PSA) – prepayment benchmark
If prepayment rate of an MBS is expected to be the same as PSA standard benchmark CPR
we say PSA is 100%
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Commercial mortgage backed securities (CMBS)
→ This securities are backed by pool of non- recourse commercial mortgage
loans on Income producing property
→ Hence a deep analysis of the property, its rent generation ability has to be
undertaken by the lender
→ Typical parameter evaluated are
▪ Loan to value ratio (lower the better)
𝑁𝑂𝐼
▪ Debt service coverage ratio =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡+𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙
→ Two distinguish features of CMBS as compared to RMBS
Call protection (protection against prepayment risk)can be at
1) loan level &
2) Structural level- Tranching
→ Structural level- Prepayment tranching as discussed earlier (Sequential /PAC)
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LOAN LEVEL

Prepayment Prepayment Yield Maintenance /

lockout Penalties (fines) Whole loans charge Defeasance
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LOS h Non mortgage ABS
Amortizing loan
▪ Auto loan receivables
▪ Pre-determined schedule so
prepayment risk arise
▪ Principal amount keep reducing
from beginning
Non-Amortizing loan
▪ Credit card receivables
▪ No predetermined schedule so no
prepayment risk
▪ There is lockout/revolving period
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