Library/CFA (Chartered Financial Analyst)/JuiceNotes 2024 Fixed Income/Asset-Backed Security (ABS) Instrument and Market Features

Asset-Backed Security (ABS) Instrument and Market Features

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Securitization Fundamentals and Covered Bonds5 min

Securitization involves transferring assets to a bankruptcy-remote SPE, which issues securities to investors. This process allows banks to remove risk from their balance sheets and reduce funding costs. In contrast, Covered Bonds are debt obligations where the collateral pool (cover pool) remains on the issuer's balance sheet. Covered bonds offer dual recourse: a claim on the cover pool and a claim on the issuer. They utilize dynamic pools where non-performing assets are replaced and may follow redemption regimes like hard-bullet (immediate default on non-payment), soft-bullet (extended maturity), or conditional pass-through structures.

Key Points

Securitization uses an SPE to isolate assets from the originator's bankruptcy.
Covered bonds remain on the balance sheet; investors have dual recourse.
Hard-bullet covered bonds trigger default immediately upon non-payment.
Soft-bullet and conditional pass-through structures allow for maturity extensions.

Credit Enhancements and Tranching5 min

Credit enhancement mitigates credit risk in securitizations. Internal enhancements include overcollateralization (assets value > bond value), excess spread (yield on assets > coupon on bonds), and subordination (tranching). Subordination creates a waterfall structure where losses are absorbed by the equity (junior) tranche first, protecting senior tranches. External enhancements involve third-party guarantees or letters of credit. Tranching allows the redistribution of credit risk, enabling investors to select securities matching their risk appetite.

Key Points

Internal enhancements: Overcollateralization, Excess Spread, Subordination.
Subordination (waterfall) directs losses to junior tranches first.
Excess spread is the difference between asset yield and bond coupon.
External enhancements rely on third-party financial guarantees.

Residential Mortgage-Backed Securities (RMBS) and CMOs7 min

RMBS are backed by pools of residential mortgages. Agency RMBS (GNMA, FNMA, FHLMC) carry government or GSE guarantees, while private-label RMBS do not. Prepayment risk is a central feature, manifesting as contraction risk when rates fall and extension risk when rates rise. Collateralized Mortgage Obligations (CMOs) restructure RMBS cash flows to manage this risk. Sequential-pay CMOs retire tranches in order, protecting later tranches from contraction and earlier ones from extension. PAC tranches offer stable cash flows within a prepayment collar, supported by support tranches that absorb variability.

Key Points

Agency RMBS have government or GSE backing; private-label do not.
Contraction risk occurs when rates fall; extension risk when rates rise.
Sequential-pay CMOs pay down tranches one by one.
PAC tranches offer stable lives if prepayments stay within a defined range.

Non-Mortgage ABS and CMBS6 min

Non-Mortgage ABS include Auto Loan ABS (amortizing) and Credit Card ABS (non-amortizing with a revolving period). Credit Card ABS feature a lockout period where principal is reinvested, followed by an amortization period. Early amortization triggers protect investors if credit quality declines. CMBS are backed by income-producing commercial properties and feature call protection (lockout, defeasance, penalty points) and balloon maturity risk. CMBS analysis focuses on Debt Service Coverage Ratio (DSCR) and Loan-to-Value (LTV).

Key Points

Auto ABS are amortizing; Credit Card ABS are non-amortizing (revolving).
Credit Card ABS have lockout periods where principal is reinvested.
CMBS feature call protection: Prepayment lockout, Defeasance, Penalties.
Balloon risk in CMBS is a form of extension risk.

CDOs and CLOs5 min

Collateralized Debt Obligations (CDOs) issue securities backed by a diversified pool of debt. Collateralized Loan Obligations (CLOs) specifically use leveraged bank loans as collateral. A collateral manager actively buys and sells assets to generate cash flows. The structure includes senior, mezzanine, and equity tranches. The equity tranche offers leveraged returns but absorbs the first losses. CDOs use overcollateralization tests to divert cash from junior to senior tranches if the collateral value falls below a threshold.

Key Points

CLOs are backed by leveraged bank loans.
Collateral managers actively manage the asset pool.
Equity tranches receive residual cash flows and bear the highest risk.
Structure includes a ramp-up period to acquire assets.

Questions

Question 1

Which of the following best describes the primary role of a Special Purpose Entity (SPE) in a securitization transaction?

Asset-Backed Security (ABS) Instrument and Market Features

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