CONTENTS

FIXED INCOME PRODUCTS AND 1 Introduction

MARKETS 2 Benefits of Securitization for Economies and Financial Markets

3 How Securitization Works
4
4. Introduction to Asset-
Residential Mortgage Loans
5 Residential Mortgage-Backed Securities
Backed Securities 6 Commercial Mortgage-Backed Securities
7 Non-Mortgage Asset-Backed Securities
8 Collateralized Debt Obligations
José Azevedo Pereira
9 Summary

José A. de Azevedo Pereira Fixed Income Products and Markets 2

1. INTRODUCTION INTRODUCTION
• This topic examines fixed-income instruments created through a process known • Assets that are typically used to create asset-backed bonds are called “securitized
as securitization. This process involves transferring the ownership of assets from assets” and include the following, among others:
the original owner into a special legal entity.
• The special legal entity issues securities backed by these assets whose cash flows Residential mortgage Commercial mortgage
Automobile loans
loans loans
are used to pay principal and interest are referred to as asset-backed securities
(ABS).
Student loans Bank loans Credit card debt
• The pool of assets from which the ABS cash flows are generated is called the
collateral. • 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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 3. HOW SECURITIZATION WORKS
2. BENEFITS OF SECURITIZATION FOR
ECONOMIES AND FINANCIAL MARKETS Mediquip
Originator
1.Sale of medical
equipment
Insurance
Customers
financed by loans
• 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 3. Cash
2. Sale of 6. Periodic
or other receivables without having a bank as an intermediary payment for cash payments
loans
loans
• Allows banks to increase the amount of funds available to lend and Medical Equipment Trust
increase fee income Special Purpose Entity (SPE)

• Allows the creation of tradable securities with better liquidity than 4. Issuance 5. Cash 7. Periodic
the original loans on the bank’s balance sheet and sale of payment for Cash
ABS ABS payments
• Benefits investors by creating access to securities matching their
risk, return and maturity profiles via financial innovation
Investors
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SECURITIZATION PARTIES AND THEIR

ROLES STRUCTURE
The three main parties to a securitization are: OF A SECURITIZATION
Originator ABS transactions may involve the sale of only one bond or class, or use more
• Originally owns the assets and sells them
to the issuer (SPE) complex multiple class bond structures:
(seller of the collateral) In a subordination (senior/subordinated) structure, the
Credit tranching bond classes differ as to how they will share any losses
resulting from defaults of the borrowers whose loans
Special purpose entity • Purchases the collateral and uses it to
(SPE) issue ABS to investors are in the pool of loans.

• This may be the original seller or a third In such a structure, rules will be established for the
Servicer of the collateral
party distribution of interest and principal to the bond
Time tranching
Other involves parties include independent accountants, classes. Some bond classes may receive payments
attorneys, trustees, underwriters, rating agencies and earlier than others and therefore face prepayment risk.
financial guarantors.

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 4. RESIDENTIAL MORTGAGE LOANS Five specifications of MORTGAGE design
Mortgage designs vary around the world in terms of:
A mortgage loan, or Typically, the amount
The mortgage gives of the loan advanced 1) The maturity of the loan
simply mortgage, is a
the lender the right to to purchase the
loan secured by the 2) How the interest rate is determined
foreclose on the loan property is less than
collateral of some
if the borrower the property’s
specified real estate 3) How the principal is to be repaid (i.e., the amortization
defaults (i.e., allows purchase price.
property that obliges schedule)
the lender to take
the borrower to make • The loan-to-value
possession of the
a predetermined ratio is less than 4) Whether the borrower has the option to prepay and, in
mortgaged property 100%.
series of payments to this case, whether any prepayment penalties might be
and then sell it).
the lender. imposed
5) The rights of the lender in a foreclosure

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5. RESIDENTIAL MORTGAGE-BACKED
MORTGAGE pass-through SECURITIES
SECURITIES
In the United States, residential mortgage-backed securities (RMBS) are divided • A mortgage pass-through security is a security created when one or more holders of
into three sectors: mortgages form a pool of mortgages and sell shares or participation certificates in the
pool.
Those guaranteed by a federal agency • The cash flows of a mortgage pass-through security depend on the cash flows of the
underlying pool of mortgages.

Those guaranteed by a government-sponsored agency

(GSE) Monthly
mortgage Scheduled
Any
Cash flows payments repayment
prepayments
representing of principal
Those issued by a private entity and are not guaranteed by interest
a federal agency or a GSE (known as non-agency RMBS)

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 MORTGAGE pass-through SECURITIES prepayment risk COMPONENTS
Prepayment risk is the uncertainty of future cash flows because
A mortgage pass-through security’s coupon rate is called the pass-through rate. of prepayment speed. It has two components:

The pass-through rate is less than the mortgage rate on the • Risk that if interest rates decline, the
underlying pool of mortgages by an amount equal to the security will have a shorter maturity than
1. Contraction risk previously anticipated as homeowners may
servicing and other fees.
refinance at now-available lower interest
Not all of the mortgages in a pool have the same mortgage rate and maturity. rates

• Risk that if interest rates rise, fewer

For each mortgage pass-through security, a weighted average prepayments occur as homeowners are
2. Extension risk reluctant to give up the benefits of a
coupon (WAC) rate and a weighted average maturity (WAM)
are determined. contractual interest rate that looks low

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Measures of the prepayment rate Conditional prepayment rate

• The two key prepayment rate measures

2. Its corresponding
In the standard PSA model, known as 100 PSA, the CPR starts at 0.2%
1. Single monthly mortality for the first month and then increases at a constant rate of 0.2% per
annualized rate, the
(SMM) rate, a monthly
measure
conditional prepayment rate month to equal 6% at the 30th month.
(CPR)
• After the 30th month, the CPR stays at a constant 6%.
• Thus, for any month t, the CPR is:

 t 
• Forecasting the future prepayment rate is key. The Public CPR = 0 . 06  , if t ≤ 30
Securities Association (PSA) is a common benchmark.  30 
Prepayment rates are stated as a percentage of a PSA
benchmark. CPR = 0 . 06 , if t > 30

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 Average life of a mortgage Collateralized mortgage obligations
Collateralized mortgage obligations (CMOs) are bond classes
created by redirecting the interest and principal from a pool of
The average life of a mortgage in a pool is the average time for a single pass-throughs or whole loans.
mortgage in the pool to be paid off, either by prepayment or by making
The creation of a CMO cannot eliminate prepayment risk; it can
scheduled payments until maturity. only transfer the various forms of this risk among different
classes of bonds called “tranches.”
Example: For a pool of 30-year mortgages:
A wide range of CMO structures exists.
Prepayment Schedule Average Mortgage Life

100 PSA 11.2 years

165 PSA 8.6 years From a fixed-rate CMO tranche, a floating-rate tranche and an
inverse floating-rate tranche can be created.
250 PSA 6.4 years
400 PSA 4.5 years

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Non-agency RESIDENTIAL MORTGAGE-

tranches
BACKED SECURITIES
• Sequential-pay CMOs are structures where each class of bond (the tranches) is retired • Non-agency RMBS share many features and structuring techniques with agency
sequentially. CMOs. However, two complementary mechanisms are usually required in
First, distribute all principal payments to Tranche 1 until
the principal balance for Tranche 1 is zero.
structuring non-agency RMBS.

The cash flows are distributed by rules, such as the

After Tranche 1 is paid off, do the same for
Tranche 2, and so on. 1 waterfall, that dictate the allocation of interest
payments and principal repayments to tranches with
various degrees of priority/seniority.
• 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.
There are rules for the allocation of realized losses,
• The key to the prepayment protection for the PAC tranches are the support tranches.
2 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.
COMMERCIAL MORTGAGE-BACKED
SECURITIES
CMBS typically offer investors significant protection
against early prepayment (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

Two measures of CMBS credit performance:
Debt-to-service coverage ratio,
which is the property’s net
Loan-to-value (LTV) ratio
operating income (NOI) divided by
the debt service
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
Auto loan ABS
ASSET-BACKED
The collateral SECURITIES
for an asset-backed security can be either:
Auto loan ABS The cash flows for auto loan ABS consist of
Amortizing loans Non-amortizing loans regularly scheduled monthly loan payments
or (interest payment and scheduled principal
(e.g., auto loans, personal and (e.g., credit card receivables)
commercial loans) repayments) and any prepayments.

For non-amortizing assets,

In amortizing structures, the
principal received from the
scheduled repayment and any
prepayments are distributed to the
bond classes on the basis of the
waterfall.
prepayments by borrowers do not
apply since there is no schedule of
principal repayments. All auto loan ABS have some form of credit
enhancement—often a senior/ subordinated so
the senior tranches have credit enhancement
In non-amortizing structures, because of the presence of subordinated
typically there is a lockout period, a tranches.
period where principal repayments
are reinvested in new assets.

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 Credit card
8. COLLATERALIZED DEBT OBLIGATIONS
receivable ABS A collateralized debt obligation (CDO) is a security backed by a
Credit card For a pool of credit card receivables, the cash flows
receivable ABS consist of finance charges collected, fees, and principal diversified pool of one or more of the following types of debt
repayments. obligations:

Corporate and emerging market bonds (CBOs)

Interest—fixed or floating—is paid to security holders
periodically.
Structured financial products, such as mortgage-backed and
asset-backed securities (structured finance CDOs)

Credit card receivable ABS have lockout periods during

which the cash flow that is paid out to security holders Bank loans (collateralized loan obligations, or CLOs)
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. Credit default swaps (synthetic CDOs)

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COLLATERALIZED DEBT OBLIGATIONS (CDOs) COLLATERALIZED DEBT OBLIGATIONS (CDOs)

CDOs require a CDO manager (collateral manager) responsible for buying or selling assets
for the CDO’s portfolio.
CDO tranches
• Senior tranche
• Mezzanine tranche
• Subordinate/equity tranche
Proceeds to meet the obligations to the CDO tranches (interest and
principal repayment) may come from the following:
Coupon interest payments of the underlying assets
Maturing assets in the underlying pools
rated
Sale of assets in the underlying pool
unrated

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 Calculating a COLLATERALIZED Calculating a COLLATERALIZED
DEBT OBLIGATION DEBT OBLIGATION
Example (continued)
Example. Consider the following US$100 million CDO: • 10-year Treasury rate: 7%
Tranche Par Value (US$) Coupon Rate
• Interest from collateral: (7% + 4%) × $100 million = $11 million
Senior 80,000,000 LIBOR + 70 bps • Interest to senior tranche: $80 million × (LIBOR + 70 bps)
Mezzanine 10,000,000 10-year US Treasury • Interest to mezzanine tranche: $10 million × (7% + 2%) = $0.9 million
rate + 200 bps • Interest from swap counterparty: $80 million × LIBOR
Subordinated/equity 10,000,000 • Interest to swap counterparty: 8% × $80 million = $6.4 million
• Net interest: $3.14 million

Assume the collateral consists of bonds that all mature in 10 years. The coupon rate is the Now, suppose asset management fees are $640,000. Calculate cash
10-year US Treasury rate + 400 bps. flow to subordinate/equity tranche and annual return.
The asset manager enters into an interest rate swap with a notional amount of US$80 • Cash flow: $3.14 million – $0.64 million = $2.5 million
million. The asset manager agrees to 1) pay a fixed rate each year equal to the 10-year • Return: $2.5 million/$10 million = 25% (assumes no defaults, no call)
Treasury rate + 100 bps and 2) receive LIBOR.
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José A. de Azevedo Pereira Fixed Income Products and Markets 33 José A. de Azevedo Pereira Fixed Income Products and Markets 34

Thank You

José A. de Azevedo Pereira Fixed Income Products and Markets 35 José A. de Azevedo Pereira Fixed Income Products and Markets 36