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135
CHAPTER 7
INTRODUCTION TO
ASSET-BACKED SECURITIES
SOLUTIONS
packages relatively simple debt obligations, such as bank loans, into more complex struc-
tures. e process of securitization involves moving or selling assets from the owner of the
assets—in this case, the banks—into a special legal entity called a special purpose vehicle
(SPV).
purpose vehicle (SPV) is the legal entity that issues and sells the asset-backed bonds.
pay the originator by selling asset-backed securities that are backed or collateralized by the
originator’s assets. e servicer is responsible for both the collection of payments from the
borrowers and the recovery of underlying assets for delinquent loans.
136 Part II: Solutions
structures as a form of credit enhancement. Credit tranching structures allow investors to
choose the amount of credit risk that they prefer to bear.
on a loan is repaid.
amount of credit risk that they prefer to bear.
recourse/non-recourse feature indicates the rights of a lender in foreclosure. If Marolf had
a non-recourse loan, the bank would have only been entitled to the proceeds from the sale
of the underlying property, or 2.5 million EUR.
an interest-only mortgage.
to the proceeds from the sale of the underlying property.
claim against the borrower. e lender is simply entitled to foreclose on the home and
sell it.
property only if the loan was of the recourse (not non-recourse) type.
ance. In addition, a payment made in excess of the monthly mortgage payment is called
a prepayment. e prepayment of $5,000 is a partial pay down of the mortgage balance.
interest component.
which ignores the interest component of the total required payment.
agency (not non-agency) mortgage pass-through securities. An agency RMBS, rather than
Chapter 7 Introduction to Asset-Backed Securities 137
a non-agency RMBS, issued by a GSE (government sponsored enterprise), is guaranteed
by the respective GSE.
security, it is called a conforming mortgage. If a loan fails to satisfy the underwriting
standards, it is called a non-conforming loan.
Home Loan Mortgage Corporation).
the issue. e gross interest is calculated using the weighted average coupon (WAC) rate
for the mortgage loans in the pool. e total cash ow to be received by the investors is
includes the scheduled repayment of principal, any prepayments, and gross coupon inter-
est less the amount equal to servicing and other fees.
is less than the monthly cash ow of the underlying pool by an amount equal to servicing
and other fees which total $337,500 + $58,333 = 395,833.
in the given month. e prepayment rate over the life of mortgages in the mortgage pool
could only be computed at the end of the life of the mortgages.
can only be projected based on an assumed prepayment rate.
(which typically occurs when interest rates decline). Extension risk is the risk that when
interest rates rise, there are fewer prepayments and, as a result, the security becomes longer
138 Part II: Solutions
in maturity than anticipated at the time of purchase. Balloon risk (common with com-
mercial mortgage-backed securities), a type of extension risk, is the risk that a borrower
will not be able to make the balloon payment when due.
Extension risk is the undesired lengthening in the expected life of a security.
ipated when the security was purchased.
loon payment date. e interest rate on a new loan to re nance the balloon balance on the
balloon payment date is unknown, and thus the borrower is exposed to interest rate risk.
loan balance. Call protection addresses prepayment risk. Investors have considerable call
protection at both the structure and the loan level with CMBS. At the loan level, there are
four mechanisms that o er investors call protection: prepayment penalty points, prepay-
ment lockouts, yield maintenance charges, and defeasance.
defeasance.
risk, not prepayment risk. Internal credit enhancements are available for CMBS, but are
not needed for an agency RMBS, which is issued with a guarantee by its respective GSE.
e DSC ratio level is used as a key indicator of the potential credit performance of the
property underlying a commercial mortgage loan.
reduce credit risk. Both credit enhancement and government guarantees address credit
risk, not prepayment risk.
Chapter 7 Introduction to Asset-Backed Securities 139
residential mortgage loans. Both ratios are indicators of credit performance and do not
address prepayment risk.
excess spread is a design feature of the structure. Time tranching (not an excess spread
account) addresses prepayment risk (extension or contraction) to allow investors a choice
in the type of prepayment risk that they prefer to bear.
is no longer reinvested but paid to investors.
investors.
