What Is an AssetBacked Security ABS
Similar to an MBS, an ABS is a collection of a type of asset e.g. auto, student, credit card combined into a group and evaluated using weighted average characteristics WAC, WAM, WALA . To date, credit card, auto, home equity, equipment, stranded costs, and student loans have been used as collateral in the majority of ABS transactions. In an ABS, the bond partially derives its creditworthiness from this pool of underlying collateral. While the market is primarily comprised of triple-A...
The Collateral Managers Role in a CDO
A collateral manager is responsible for the performance of the collateral portfolio. He or she typically Selects the collateral portfolio Directs sales and purchases of collateral during the reinvestment period Oversees the work-out process for defaulted collateral and Monitors the collateral portfolio for compliance with the coverage, collateral quality, and other tests. The collateral manager's ability to generate high risk-adjusted returns through his or her research, market knowledge, and...
What Is a MortgageBacked Security MBS 1
The MBS assumes the same characteristics as the collateral that secure the principal and interest Bonds that are based on collateral with fixed rates are called fixed rate MBS. Bonds that are based on collateral with floating rates are called adjustable rate mortgage-backed securities, or ARMs Bonds that are based on collateral with a fixed period and then a floating period of rates are called hybrid MBS. The most common hybrid MBS are 3 1, 5 1, 7 1, and 10 1, meaning a fixed period of 3, 5,...
Mortgage Options
A standard mortgage option contract specifies Collateral Program, maturity and coupon. Strike price Strikes are usually quoted relative to the standard forward settlement price as of the option expiry date. Expiration date The standard expiration date is seven business days before the standard settlement date during the month of option expiration. However, other expiry dates are possible. If the option is exercised, the option holder writer must accept deliver TBA collateral. Mortgage options...
Types of CMBS Floating Rate Loans
Borrowers requiring transitional or interim financing typically prefer floating rate loans. Reasons for transitional or interim financing include Repositioning or renovating a property. Generally short term less than five-year loan maturity . Borrowers who think interest rates will drop also prefer floating rate loans. Borrowers who may want access to a prepayment option Can usually prepay after a 1 year lockout period. Seek to maintain financial flexibility. Expects to refinance after...
Examples of Underlying Sectors
Conduit, credit tenant leases, non-performing loans, franchise, commercial real estate repackagings Prime, subprime, second lien, manufactured housing, agency Credit cards, autos, student loans Equipment leases, airplane leases, whole business securitizations, future flow transactions Structured products, leveraged loans, high yield bonds, trust preferred, CDOs of CDOs Future flows, utility receivables, mutual fund fees, health care receivables
Rating Agency Methodology
In rating CDO debt tranches, the rating agencies generally analyze the risks in the collateral portfolio to determine whether collateral cash flows are adequate to pay interest and principal on the rated debt. The rating agencies typically analyze historical data specifically default probability, default correlation, default severity, prepayment and extension scenarios . The agencies usually do not base analysis for a cash flow CDO on the market value of the collateral portfolio. Using...
Loan Underwriting Standards
The debt service coverage ratio DSCR is the ratio of current net operating income NOI to current debt service. This is sometimes thought to be the primary indicator of the likelihood of default. A higher DSCR usually indicates a greater ability to make debt service payments. The loan-to-value ratio LTV measures property leverage and is the ratio of loan principal amount to appraised property value. With a lower LTV, if the property does default, it can usually be sold to recover most of the...
Types of CMBS Fixed Rate Loans
Fixed rate loans constitute the majority of CMBS originations to date. Loans are typically made on existing properties with stable operations. There is general prepayment protection on recent deals because many contain prepayment options that are prohibitively expensive. Interest rate sensitive prepayment is generally not a primary risk factor for investors in recent transactions due to penalties mostly lockout defeasance and other factors. Hence, the convexity of CMBS are more similar to that...
The ABS Market
The ABS market represents 8 1.7 trillion of the 22.1 trillion public US fixed income market. The largest parts of the ABS market are securitized credit card and home equity loans.
CDOs as Investment Vehicles Managed Investment Options
The choice of investment vehicle will depend on a variety of factors. It is also important to take into consideration the leverage of CDO equity when comparing options. Investor can influence investment guidelines Usually liquid varies with asset class Typically requires a relatively large investment amount Generally less diversified than alternatives for a given investment amount Full upside downside on asset performance Typically fixed investment style one size fits all Usually liquid, if it...
CDO Structure
A CDO typically has several distinct stages in its lifecycle. Pre-closing Period during which collateral is purchased by the collateral manager into a warehouse facility. Pricing date Date on which liabilities are priced and liability coupons spreads are set for the life of the CDO. Closing date Date on which liabilities and equity sales are settled with investors and collateral portfolio is purchased by the CDO from a warehouse facility. Effective date Date on which collateral portfolio is...
Credit Enhancement
In CMBS, the senior subordinate credit enhancement structure is typically most common. Subordinate classes provide credit support for senior classes. Usually the entire cash flow from the underlying collateral pool supports the senior classes until they are retired. This is because principal is allocated in a top down waterfall structure sequential pay . Each class typically has specified priority as to when it receives cash flows. Senior securities usually receive scheduled principal and...
CDO Structure Coverage Tests
Coverage tests are meant to ensure that sufficient collateralization or interest coverage levels are maintained to protect a CDO's rated debt tranches. Coverage tests generally consist of par value tests or collateralization tests and interest coverage tests. A par value test typically seeks to maintain a minimum ratio of collateral portfolio amount to the par amount of CDO debt tranches. - For example, in a Class A, collateral par value par amount of the Class A notes gt X the par value...
CDOs as Investment Vehicles Risk Profile of CDO Equity
CDO equity is a leveraged investment which must be taken into account when sizing an 1 of equity may be equivalent to 10 of a direct investment. It is similar to a call option in that, it has Unlimited upside, and limited downside relative to equivalent investment , But can lose entire premium, which is the equity investment. The Return on premium is volatile. Unique features of CDO equity include Usually current distribution of excess cash flow Typically no margin or mark-to-market features...
Credit Enhancement Subordination Terminology
Senior bonds are almost always rated triple-A. Mezzanine bonds are investment grade, but subordinate to senior bonds. Junior bonds or B-pieces are usually rated below investment grade and generally are exposed to the real estate risk of the underlying collateral pool. The first loss piece is usually the most junior class. Any significant loss on the collateral pool is most likely to eliminate this first loss piece. CMBS typically use CPR, as MBS do, to measure prepayments. Unlike agency MBS,...
Mortgage Option Terms
Delta is similar to duration and is the fraction of bonds that are expected to be delivered into an option. Delta's of calls range from 0 to 1, where a deeply out of the money call might have a delta close to zero, implying that there is almost no chance that it will be exercised, an at the money call might have a delta of .5, meaning that one bond is expected to be delivered for every two calls that are held, so it is equally likely to be exercised or not. Delta's of puts range from 0 to -1,...
CMBS Structures Conduit Deals
A fusion deal is a combination of a conduit deal with some large loan collateral. Pool size typically ranges from 1.5 billion to over 4 billion. Often defined as a deal where the top 10 loans make up more than 50 of the entire deal. There seems to have been a resurgence of fusion deals in recent years The events of September 11, 2001, led to investor concerns over single-asset CMBS transactions i.e., large loan deals . As a result, fusion deals have become more frequent, as there deals contain...
Mortgage Derivatives Inverse Floaters
The inverse inherits the duration and convexity of the floater inverse floater pair and are generally purchased because of this leverage. Therefore, you can consider an inverse a levered position of the underlying asset. An examples of how this can be used Suppose someone buys 100m GN 7.0s, at a price of 106-24 by using 6.75m of their own capital and by borrowing the other 100m at Libor 40bp subject to a 7 cap . Their net income is 7 from the GN bond, minus the L 40bps that they borrowed the...
The MBS Market Continued
Many different types of investors buy MBS. Mortgage- and asset-backed security holdings by investor type 2003 at year-end are as follows Other consists of Private Individuals, Finance Companies, MBS deal Inventory, REITs, Federal Credit Unions, HedgeFunds Non-Profits State and Local Gov't Other consists of Private Individuals, Finance Companies, MBS deal Inventory, REITs, Federal Credit Unions, HedgeFunds Non-Profits State and Local Gov't Mortgagors have the statutory right to re-finance at...
The ABS Market Fixed and Floating Securities
Prior to the mid-1990's, many more fixed securities were issued, however floating rate deals are now predominant. The rise in floating rate issuance generally reflects the following Enhanced securitization technology Modified regulations, allowing credit card rates to float Generally improved liquidity in the swaps market, allowing issuers to arbitrage relative value between fixed and floating rate issuance and Greater acceptance by global investors of floating rate ABS.
CDOs as Investment Vehicles Risk Profile With Replicating Portfolio
One way to compare CDO equity with a direct investment is to create a replicating portfolio. Cost of structure, rating agency fees, etc. 42 MM Equity Excess Return of Loan portfolio In this example, an investor replaces 89.5 of the risk of the leveraged loan portfolio with a portfolio of generally higher quality assets, while covering a portion of the cost of risk transfer. At the same time the investor retains the excess return exposure to the leveraged loan portfolio.
What Is CMM
The CMM index is the bond-equivalent yield on a new MBS TBA , which prices at par. The most common market this is indexed against is the 30-year agency mortgage market. The spot rates at any given date are typically priced as below Weighted Average based on 30 days from point of calculation Once spot rates exist, a forward curve can be constructed. This is an attempt to simplify the trading of mortgage price risk by transforming the most liquid portion of the mortgage market into a rate based...
CMO Structures Z Bonds
Z bonds are CMO classes that have the ability to pay their interest payments to another class while accreting in principal. Z bonds will not receive principal until the bonds prior to it in the CMO cash waterfall have been retired. Unlike other CMO classes, the Z bond will not pay interest to its bondholder while bonds prior to it in the waterfall are outstanding. Instead, its interest is used pay down the principal of another bond in the structure an accretion directed class . Simultaneously,...
CMO Structures Mortgage Derivatives
IO PO or interest only and principal only strips are a kind of mortgage derivative. Most other derivatives can be created from lOs and POs. In structuring collateral, payments can be stripped into interest cash flow streams and principal cash flow streams. IO PO strips can also be re-combined back into collateral. - The Price of IO Price of PO Price of Collateral and consequently, efficient market pricing mechanisms exist. - Note that this price enforcement does not usually exist in the REMIC...
A Mortgage Product Primer
Mortgage Strategies Goldman, Sachs amp Co. Fall 2004 II. Mortgage-Backed Security MBS Overview FHA VA Reperforming Scratch and Dent VI. Commercial Mortgage-Backed Securities CMBS VII. Asset-Backed Securities ABS VIII. Collateralized Debt Obligations CDOs Collateralized Loan Obligations CLOs IX. Constant Maturity Mortgage CMM
VADM or Very Accurately Defined Maturity Bonds
VADM structures were created to limit extension risk if rates rise and prepayments slow down. In a VADM bond, payments are scheduled within a prepayment band however, the range includes 0 PSA. There generally is no extension risk and VADMs mature on their stated maturity date. VADM structures are found only in CMOs with Z bonds. This is because all of their cash flows come from the period of lockout from the Z bond while the interest is creating accretion. If the Z bond is large enough to...
CMO Structures IO PO Characteristics
When rates rise, prepayments generally decrease, which causes the bond to extend. Generally, this will increase the value of the IO since there is more cash flow, and Typically will decrease the value of the PO since POs are purchased at a discount to par and the par payment is now received further out in the future. When rates fall, prepayments typically increase, which causes the bond to shorten. This generally decreases the value of the IO since there is less cash flow, and Generally...
CMM in the Market
Spot rates are determined by always pricing a security at par, so prepayments are not taken into account. Hence, this yield is not subject to prepayment modeling risk. Swaps allow the bond market to be viewed in a pure rate sense in a similar way, CMM allows this of the mortgage market. CMM can be used to hedge for mortgage products that are sensitive to changes in mortgage rates. Swaps Pay receive fixed and receive pay CMM. Swaptions Option to enter into CMM swap, either pay or receive CMM...
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As yields fall, mortgage rates fall and prepayments rise due to the refinancing incentive , which causes cash flows to increase in the near term and shortens the MBS. This will reduce duration. Conversely, as yields rise, mortgage rates rise and prepayments decrease, which decreases cash flows in the near term and extends the bond. This will increase duration. This reverse relationship is what causes negative convexity Holders of MBS generally do not want to be exposed to interest rate risk....