Investments & Securities Chapter 15 Assetbacked Securities Summary Security Created Pooling Loans Other Than Residential

CHAPTER 15

ASSET-BACKED SECURITIES

CHAPTER SUMMARY

A security created by pooling loans other than residential primemortgage loans and commercial

mortgage loans is referred to as an asset-backed security (ABS). The market classifies securities

backed by subprime mortgage loans as mortgage-related ABS. The two types of assets that can

used as collateral for an asset-backed securitization are existing assets/existing receivables or

assets/receivables to arise in the future. Securitizations with existing collateral are referred to as

CREATION OF AN ABS

A security created by pooling loans other than mortgage loans is referred to as an asset-backed

security (ABS). The textbook uses the following illustration to explain how an ABS is created

and the parties to a securitization. Suppose that Exception Dental Equipment, Inc. has a bulk of

and disposing of the collateral (i.e., the dental equipment in our illustration) if the borrower fails

to make the contractual loan payments. While the servicer of the loans need not be the originator

of the loans, in our illustration we are assuming that the originator (EDE) is also the servicer.

Suppose EDE has more than $300 million of installment sales contracts and wants to raise this

amount. Rather than issuing corporate bonds for $300 million, the EDE’s treasurer decides to

The Parties to a Securitization

In our hypothetical securitization, Exceptional Dental Equipment, Inc. (EDE) is not the issuer of

the ABS (although it is sometimes referred to as the issuer because it is the entity that ultimately

raises the funds). Rather, it originated the loans. Hence, in this transaction, EDE is called the

“seller” because it sold the receivables to DEAT. EDE is also called the “originator” because it

originated the loans. DEAT (i.e., the SPV in the securitization) is referred to as the “issuer” or

“trust” in the prospectus.

While in our simple transaction EDE manufactured the dental equipment and originated the

loans, there is another type of securitization transaction involving another company (called

a conduit) that buys the loans and securitizes them. A conduit that finances dental equipment

originator and has restrictions on its activities. It is the intermediate SPV that purchases the

assets from the originator. The intermediate SPV then sells the assets to the SPV that issues

the asset-backed securities (i.e., the issuing entity). In the prospectus for a securitization

transaction, the intermediate SPV is referred to as the depositor.

Transaction Structure

requirements.

We will only focus on the first of these reasons to see the critical role of the SPV in

a securitization. Suppose that Exceptional Dental Equipment, Inc. (EDE) has a BB credit rating.

If it wants to raise funds equal to $300 million by issuing a corporate bond, its funding cost the

going rate for a firm with a BB credit rating. If EDE defaults on any of its outstanding debt, the

on how the rating agencies will evaluate the credit risk based on the collateral (i.e., the loans). In

turn, this will depend on the credit enhancement for each bond class. So, due to the SPV, quality

of the collateral, and credit enhancement, a corporation can raise funds via a securitization where

some of the bond classes have a credit rating better than the corporation seeking to raise funds

and that in the aggregate the funding cost is less than issuing corporate bonds.

a predetermined schedule that prioritizes the manner in which principal and interest generated by

the underlying collateral must be used. This schedule, which is explained in the deal’s

prospectus, is known as the cash flow waterfall, or simply the waterfall. The cash flows that

remain after all of the scheduled periodic payment obligations are met can be associated with the

excess spread. The excess spread is the first line of defense against collateral losses, since deals

Optional Clean-Up Call Provisions

For ABS there is an optional clean-up call provision granted to the trustee. There are several

types of clean-up call provisions: percent of collateral call, percent of bond clean-up call, percent

of tranche clean-up call, call on or after specified date, latter of percent or date call, auction call,

and insurer call.

The most common is the percent of collateral call where the outstanding bonds can be called at

par value if the outstanding collateral’s balance falls below a predetermined percent of the

original collateral’s balance.

COLLATERAL TYPE AND SECURITIZATION STRUCTURE

Structuring a securitization will depend on the characteristics of the underlying assets. Two

characteristics affect the structure: amortization and interest rate. Specifically, the structure

a nonamortizing asset, the concept of a prepayment does not apply. Credit card receivables are

examples of nonamortizing assets.

Fixed-Rate Versus Floating-Rate Assets

The assets that are securitized can have a fixed rate or a floating rate. The type of rate chosen

impacts the structure in terms of the coupon rate for the bonds issued. For example, a structure

Asset Risks

Evaluating asset risks involves the analysis of the credit quality of the collateral. The rating

agencies will look at the underlying borrower’s ability to pay and the borrower’s equity in the

asset. If there are a few borrowers in the pool that are significant in size relative to the entire pool

balance, this diversification benefit can be lost, resulting in a higher level of credit risk referred

to as concentration risk.

Structural Risks

(most commonly bond insurers), the servicer, a trustee, issuer’s counsel, a guaranteed investment

contract provider (this entity insures the reinvestment rate on investable funds), and accountants.

The rating agency will investigate all third-party providers. For the third-party guarantors, the

rating agencies will perform a credit analysis of their ability to pay.

While still viewed as a “third party” in many securitizations, the servicer is likely to be the

(3) rate reduction bonds.

Credit Card Receivable-Backed Securities

Credit cards are issued by banks (e.g., Visa and MasterCard), retailers (e.g., JC Penney and

Sears), and leading global payments and travel companies (e.g., American Express). The cash

flow for a pool of credit card receivables consists of finance charge collections, principal

Each series is a separate credit card deal and the trust can issue bond classes to the public. For

example, a series can have a senior bond class and two subordinate bond classes. However, each

series will have a different level of credit enhancement. It is the cash flow from the trust portfolio

that is used to make the payments due to the bond classes for all the series.

Because a card receivable is a non-amortizing asset, it therefore has a revolving structure.

a provision, referred to as an early amortization provision or a rapid amortization provision

is included to safeguard the credit quality of the structure.

The only way that the principal cash flows can be altered is by occurrence of a pay-out event.

When early amortization occurs, the bond classes are retired sequentially (i.e., highest rated bond

class first, then the second highest rated bond class, and so on). This is accomplished by

quality of the structure. The only way that the principal cash flows can be altered is by triggering

the early amortization provision.

The following concepts must be understood in order to assess the performance of the portfolio of

receivables and the ability of the collateral to satisfy the interest obligation and repay principal as

scheduled: gross portfolio yield, charge-offs, net portfolio yield, delinquencies, and monthly

financial institutions specializing in auto loans. The cash flow for auto loan-backed securities

consists of regularly scheduled monthly loan payments (interest and scheduled principal

repayments) and any prepayments.

Prepayments for auto loan-backed securities are measured in terms of the absolute prepayment

speed (ABS). The ABS measure is the monthly prepayment expressed as a percentage of the

original collateral amount. The single-month mortality rate (SMM) is the monthly conditional

prepayment rate (CPR) based on the prior month’s balance. There is a mathematical relationship

between the ABS and SMM. Given the SMM (expressed as a decimal), the ABS (expressed as

a decimal) is obtained as follows:

SMM

where M is the number of months after origination (i.e., loan age). Given the ABS, the SMM is

obtained as follows:

SMM=

 

()

ABS

1 – ABS M –1

.

Rate Reduction Bonds

Rate reduction bonds are backed by a special charge (tariff) included in the utility bills of utility

customers in. The charge, called the competitive transition charge (or CTC), is effectively

a legislated asset. It is the result of the movement to make the electric utility industry more

DODD-FRANK WALL STREET REFORM AND CONSUMER PROTECTION ACT

Because of the turmoil that occurred in the securitization market and related sectors of the

financial market, in July 2010, Congress passed the Dodd-Frank Wall Street Reform and

Consumer Protection Act.

The key features of the act that impact securitizations are

The specifics regarding how the above requirements should be handled were not set forth in the

act. With respect to nonagency RMBS, joint rules are to be specified by the three federal banking

agencies. The rules dealing with the amount and form of credit risk that securitizers must retain

COLLATERALIZED DEBT OBLIGATIONS

When the ABS market began, there was a debt product that employed the securitization to pool

a diversified pool of some asset type and issue securities backed by the cash flow of the asset

pool. These debt products are called collateralized debt obligations (CDOs).

Although many types of asset classes have been used as collateral in a CDO, the following are

the major ones: investment-grade corporate bonds; high-yield corporate bonds; emerging market

bonds; nonagency residential mortgage-backed securities (nonagency RMBS); commercial

mortgage-backed securities (CMBS); leveraged bank loans; and, collateralized debt obligations.

CDOs backed by investment-grade corporate bonds, high-yield corporate bonds, and emerging

market bonds are referred to as collateralized bond obligations; those backed by nonagency

RMBS and CMBS are referred to as structured finance CDOs. CDOs backed by leveraged

bank loans are called collateralized loan obligations (CLOs). Finally, CDOs backed by bond

the tranches as they mature depends on the performance of the collateral. The proceeds to meet

the obligations to the CDO tranches (interest and principal repayment) can come from coupon

interest payments from the collateral assets, from maturing of collateral assets, and from sale of

collateral assets.

In a typical structure, one or more of the tranches has a floating rate. With the exception of deals

reinvestment period or revolving period is where principal proceeds are reinvested and is

usually for five or more years. In the final period, the collateral is sold and the debt holders are

paid off.

Income is derived from interest income from the collateral assets and capital appreciation. The

KEY POINTS

• Asset-backed securities are created by pooling loans and receivables through a process known

as securitization.

• The main parties to a securitization are the seller/originator (party seeking to raise funds),

special purpose vehicle, and servicer.

• The motivation for issuing asset-backed securities rather than issuing a corporate bond is the

potential reduction in funding cost. The key to this savings is the role of the special purpose

ANSWERS TO QUESTIONS FOR CHAPTER 15

(Questions are in bold print followed by answers.)

1. Why is the entity seeking to raise funds through a securitization referred to as the “seller”

or the “originator”?

A security created by pooling loans other than mortgage loans is referred to as an asset-backed

2. In achieving the benefits associated with a securitization, why is the special purpose

vehicle important to the transaction?

To understand the role of the special purpose vehicle (SPV) and the benefit derived from it, we

need to understand why a corporation would want to raise funds via securitization rather than

simply issue corporate bonds. There are four principal reasons why a corporation may elect to

of the collateral, and credit enhancement, a corporation can raise funds via a securitization where

some of the bond classes have a credit rating better than the corporation seeking to raise funds

and that in the aggregate the funding cost is less than issuing corporate bonds.

3. In a securitization, what is the difference between a servicer and a special purpose

vehicle?

4. Answer the below questions.

a. What is the difference between a one-step securitization and a two-step securitization?

In a one-step securitization, the originator of the loans sells the receivables to the SPV who is

referred to as the “issuer” or “trust” of the asset-backed securities (ABS). In a two-step

securitization, the securitization involves two SPVs. This is done to ensure that the transaction is

b. What is meant by the “depositor” in a securitization?

5. What is meant by a cash flow waterfall?