Investments & Securities Chapter 15 Collateral Must Used This Schedule Which Explained The Deals Prospectus Known The

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. At the top of the waterfall would be cash flows

due to senior bondholders (interest and principal, depending upon the principal repayment

6. Explain the difference in the treatment of principal received for a self-liquidating trust

and a revolving trust.

Typically when amortizing assets are securitized, the collateral is fixed over the life of the

7.In a securitization, (a) what are the three relevant periods in the distribution rules, and

(b) what is an early amortization provision?

(a) In a securitization, what are the three relevant periods in the distribution rules?

There are three relevant periods. The first is the ramp-up period . This is the period that

follows the closing date of the transaction where the collateral manager begins investing

(b) In a securitization, what is an early amortization provision?

There are provisions in credit card receivable-backed securities that require early amortization of

the principal if certain events occur. Such a provision, which is referred to as either an early

to zero or less. When early amortization occurs, the bond classes are retired sequentially (i.e.,

first the AAA bond then the AA rated bond, etc.). This is accomplished by distributing the

principal payments to the specified bond class instead of using those payments to acquire more

receivables. The length of time until the return of principal is largely a function of the monthly

payment rate (MPR). MPR expresses the monthly payment (which includes finance charges,

fees, and any principal repayment) of a credit card receivable portfolio as a percentage of credit

card debt outstanding in the previous month. For example, suppose a $600 million credit card

receivable portfolio in February realized $60 million of payments in March. The MPR for March

would then be 10% ($60 million divided by $600 million). The MPR is important for two

reasons. First, if the MPR reaches an extremely low level, there is a chance that there will be

extension risk with respect to the principal payments to the bond classes. Second, if the MPR is

very low, then there is a chance that there will not be sufficient cash flows to pay off principal.

This is one of the events that could trigger the early amortization provision.

8. Answer the below questions.

(a) Why is credit enhancement required in a securitization?

Credit enhancement is required for all asset-backed securities to provide greater protection to

investors against losses due to defaults by borrowers. More details on credit enhancement are

given below.

(b) What entity determines the amount of securities needed in a securitization?

While in our simple transaction example (described earlier and mentioned in the text),

Exceptional Dental Equipment, Inc (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. For example, consider a hypothetical

9. Why is the MPR for credit card receivable-backed securities important?

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

Sears), and travel and entertainment companies (e.g., American Express). The cash flow for

a pool of credit card receivables consists of finance charges collected, fees, and principal.

10. What is the limitation of a third-party guarantee as a form of credit enhancement?

As a form of external credit enhancements, the rating companies take the “weak link” approach

to ratings. That is, if the rating of the third-party guarantor is downgraded, the asset-backed

security’s rating will be downgraded even if the collateral is performing as expected. More

details including an example are given below.

11. An asset-backed security has been credit enhanced with a letter of credit from a bank

with a single A credit rating. If this is the only form of credit enhancement, explain whether

this issue can be assigned a triple A credit rating at the time of issuance.

The issue will not receive a triple A credit rating but a single A credit rating because there are no

other forms of credit enhancements such as reserve funds (cash reserves and excess servicing

spread) and overcollateralization. More details are given below.

12. A corporation is considering a securitization and is considering two possible credit

enhancement structures backed by a pool of automobile loans. Total principal value

underlying the asset-backed security is $300 million.

Principal Value for:

Structure I

Structure II

Pool of automobile loans

$324 million

Senior class

$250 million

$290 million

Subordinated class

$ 95 million

$ 50 million

Answer the below questions.

(a) Which structure would receive a higher credit rating and why?

Generally, a subordinated class will receive a lower credit rating. Thus, because structure II has a

smaller subordinate class, it will likely receive a higher credit rating even though its pool of

(b) What forms of credit enhancement can be used in both structures?

13. Answer the below questions.

(a) What is the problem of pooling a few borrowers of significant size relative to the entire

pool balance?

Concentration risk refers to a situation where a few borrowers of significant size are concentrated

in a pool. This results in a loss of diversification and higher default risk.

Analysis of the credit quality of the collateral depends on the asset type. The rating companies

will look at the borrower’s ability to pay and the borrower’s equity in the asset. The latter will be

a key determinant as to whether the borrower will default or sell the asset and pay off a loan. The

(b) How do rating agencies seek to limit the exposure of a pool of loans to concentration

risk?

concentration limits. Even if the exposure cannot be perfectly limited there are still other ways to

achieve a desired rating.

14. “As the analysis of prepayments can be performed on a pool level or a loan level, it

makes no difference between pool-level and loan-level analysis.” Do you agree?

Although the analysis of prepayments can be performed on a pool level or a loan level, it has

some differences. In pool-level analysis it is assumed that all loans comprising the collateral are

identical. For an amortizing asset, the amortization schedule is based on the gross weighted-

average coupon (GWAC) and weighted-average maturity (WAM) for that single loan. Pool-level

15. How do optional call provisions in a securitization differ from that of a call provision in

a standard corporate bond?

To answer this question it helps 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 raise funds via a securitization rather than a corporate bond. They are

the potential to reduce funding costs, to diversify funding sources, to accelerate earnings for

financial reporting purposes, and to achieve (if a regulated entity) relief from capital

requirements. These reasons can all be viewed as involving an option that a corporate bond does

not contain.

Let us focus on the first of the above reasons (i.e., to reduce fund costs) using the illustration

given previously and found in the text. 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 creditors will go after all of its assets, including the loans to its

customers.

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.

16. What factors do the rating agencies consider in analyzing the structural risk in

a securitization?

The decision on the structure is up to the seller. Once selected, the rating agencies examine the

extent to which the cash flow from the collateral can satisfy all of the obligations of the bond

classes in the securitization. The cash flow of the underlying collateral is interest and principal

repayment. The cash flow payments that must be made are interest and principal to investors,

servicing fees, and any other expenses for which the issuer is liable. This is described by the

structure’s cash flow waterfall. The rating agencies analyze the structure to test whether the

collateral’s cash flows match the payments that must be made to satisfy the issuer’s obligations.

This requires that the rating agency make assumptions about losses and delinquencies and

consider various interest rate scenarios after taking into consideration credit enhancements.

17. Why would an interest rate derivative be using in a securitization structure?

18. The below questions relate to auto loan-backed securities. Answer each one.

(a) What is the cash flow for an auto loan-backed security?

The cash flow for auto loan-backed securities consists of regularly scheduled monthly loan

payments (interest and scheduled principal repayments) and any prepayments. The monthly

interest rate may be fixed or floating.

(b) Why are prepayments of minor importance for automobile loan-backed securities?

Prepayments are less of a problem (say relative to mortgage refinancing) because auto loans are

less sensitive to changes in interest rates. For example, an auto loan is a relatively small loan

with short horizons so that refinancing may have little to gain. Furthermore, interest rates for the

automobile loans are already substantially below market rates if they are offered by

(c) How are prepayments on pools of auto loans measured?

19. The following questions relate to credit card receivable-backed securities. Answer each

one.

(a) What happens to the principal repaid by borrowers in a credit card receivable-backed

security during the lockout period?

In contrast to an auto loan-backed security, the principal repayment of a credit card receivable-backed

security is not amortized. Instead, for a specified period of time, referred to as the lockout period or

(b) What is the role of the early amortization provision in a credit card receivable-backed

security structure?

The role of an early amortization provision in a credit card receivable-backed security structure is

to provide a safeguard to protect the claims of those who purchase credit card receivable-backed

securities. More details are supplied below.

(c) How can the cash flow of a credit card receivable-backed security be altered prior to the

principal-amortization period?

The cash flow of a credit card receivable-backed security can be altered prior to the

principal-amortization period when credit card borrowers pay more or less than the interest due.

More details are given below.

In contrast to an auto loan-backed security, the principal repayment of a credit card

receivable–backed security is not amortized. For a specified period of time (varying from 18 months

to 10 years) before the principal-amortization period, the principal payments made by credit card

(d) Why is the monthly payment rate an important measure to examine when considering

investing in a credit card receivable-backed security?

It is important to look at the monthly payment rate so as to get a feel for how rapidly credit card

borrowers are paying off their debt. More details are given below.

The concept of prepayments does not apply to credit card receivable-backed securities because there

is no amortization schedule during the lockout period. Instead, for this sector of the asset-backed

20. The below questions relate to rate reduction bonds. Answer each one.

(a) What asset is the collateral?

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

competitive by deregulating the industry. More details are supplied below.

(b) What is a true up provision in a securitization creating 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. The CTC is initially calculated based on projections of utility usage and the

mechanism permits the utility to recompute the CTC on a periodic basis over the term of the

securitization based on actual collection experience. The advantage of the true-up mechanism to

the bond classes is that it provides cash flow stability as well as a form of credit enhancement.

21. What does the Dodd-Frank Wall Street Reform and Consumer Protection Act specify

regarding a securitizer retaining credit risk in a securitization transaction?

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. Instead, Congress delegated that responsibility and its implementation to three federal

banking agencies (Federal Reserve Board, Office of the Comptroller of the Currency, and the

Federal Deposit Insurance Corporation) and the Securities and Exchange Commission (SEC).

22. How does a CDO differ from an ABS transaction?

When the asset-backed security (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

23. Answer the below questions.

a. If there is a shortfall in interest paid to the senior tranches of a CDO, how is the shortfall

made up?

If there is a shortfall in interest paid to the senior tranches, principal proceeds are used to make

up the shortfall. However, the principal cash flow is distributed to the senior tranches only after

the payment of the fees to the trustees, administrators, and senior managers.

b. If coverage tests are failed for a CDO, how is the principal received from the collateral

used?

If the coverage tests are failed for a CDO, the principal cash flow is used to pay down tranches in

the following order: senior, mezzanine and subordinate/equity. More details are supplied below.

The principal cash flow is distributed as follows after the payment of the fees to the trustees,

administrators, and senior managers. If there is a shortfall in interest paid to the senior tranches,

principal proceeds are used to make up the shortfall. Assuming that the coverage tests are