Securitization

Neeraj Gupta,CFA CFP MBA

What is Securitisation??
⚫ The securitization process transfers ownership of assets such as
loans or receivables from the original owners into a special legal
entity. The special legal entity then issues securities, using the
asset cash flows to pay interest and repay the principal to investors.
These securities are referred to generically as asset-backed
securities (ABS), and the pool of assets from which their cash
flows are generated is called collateral or securitized assets.
⚫ These loans and receivables typically include residential mortgage
loans (mortgages), commercial mortgages, automobile (auto) loans,
student loans, bank loans, accounts receivable, or credit card
receivables.
⚫ While the ABS market in the United States remains the largest in
the world, securitization has recently expanded in both Asia and
Europe as well as to other income-yielding assets, such as airport
landing slots, toll roads, and cell tower leases.
⚫ The growing depth and breadth of the global ABS market
underscores the importance of a solid understanding of
securitization among issuers, investors, and financial analysts.

Neeraj Gupta,CFA CFP MBA

Types of Securitization
◦ Mortgage Backed Securities (MBS) are backed by a pool of
mortgage loans with real estate property as a collateral
◦ Residential MBS are backed by residential mortgages and
could be issued by:
● Federal agencies
● Private entities
◦ Commercial MBS are backed by commercial mortgages
◦ Asset Backed Securities (ABS) are backed by receivables
other than mortgages

Neeraj Gupta,CFA CFP MBA

How Securitization Works

⚫ An Example of a Securitization (asset backed securities)

How Securitization Works

⚫ An Example of a Securitization (Mediquip)

◦ Let’s suppose there is a company called Mediquip, which is a manufacturer of medical equipment.
◦ It sells its equipment through loans (maturity of 5 years and fixed interest rate) granted by the
company to its customers, and the medical equipment serves as collateral for the loans.
◦ The loans are fully amortizing with the monthly payments (which includes principal and interest)
repaid in 60 loan payments.
◦ The credit department decides whom to grant the loan and administers different aspects of loan
including collecting payments from borrowers, notifying borrowers who may be delinquent, and
recovering and disposing of the medical equipment if the borrower defaults.
◦ Let’s see how the loans are securitized: Assume that the total loan granted by Mediquip are $100
million, which is shown as asset on the balance sheet.
◦ Since, the $100 million loan will be paid off to Mediquip in around 5 years, and if the company wants
to raise money before 5 years, it can either do it through raising debt, bank loan, or securitization.
◦ As the treasurer of Mediquip is aware of the low funding costs of securitization, he decides to raise
the money by securitizing the loans instead of corporate bonds.
◦ In order to do the same, the company sets up a separate legal entity called Medical Equipment Trust
(MET). It sells the loans to this legal entity referred to as a Special Purpose Entity (SPE) and
sometimes also called a Special Purpose Vehicle (SPV) or a Special Purpose Company (SPC).
◦ MET issues and sells securities that are backed by the pool of securitized loans and receives cash.
 Securitization: Process
Credit
Obligors Enhancement
Providers
2 Collectio 3 Credit
Origin ns enhancement 9 Issue of
1 Cash
al securities
Loan flows
11
10 SPV Investors
Collection Servicing
Sale
Agent of 6 of
securities
asset
4 Ratin 8 Subscription to
Originator 7 g securities
Purchase
Rating Agency
consideration Arranger

5
Contracts
Structuri Ongoing cash flows
ng
Structure Initial cash flows

6
Neeraj Gupta,CFA CFP MBA
How Securitization Works

▪ An Example of a Securitization (Mediquip) Contd.

◦ MET is legally independent and is considered bankruptcy remote
from the seller of the loans. This means that if Mediquip files
bankruptcy, the loans backing the ABS that are issued by
MET are secure within the SPE and the creditors of
Mediquip have no claim on them.
◦ The cash payments (including principal and interest) that are received
from the collateral are used to make the periodic cash payments to
the security holders (the owners of ABS).
 Role in Securitization
▪ Three main parties are involved: The Originator, the SPV, and the
Servicer
▪ The originator and the SPV are the main counterparties
▪ Other parties like trustees, underwriters etc. including servicer
(when different from seller) are referred to as third parties to the
transaction

⚫ Roles:
▪ Lawyers: Preparing legal documents
▪ Trustee or Trustee agent: Safeguards the assets after they have been
placed in the trust
▪ Underwriters and Rating agencies: Same function as they have in
corporate bond offering
▪ Guarantors: Guarantees part of the obligations issued by the SPV

Neeraj Gupta,CFA CFP MBA

Key Role of the Special Purpose
Entity
⚫ The SPE plays a pivotal role in securitization. In fact, the setup of a
legal entity that plays the same role as an SPE in terms of
protecting the rights of ABS holders is a prerequisite in any country
that wants to allow securitization.
⚫ Indeed, without a provision in a country’s legal system for the
equivalent of an SPE, the benefits of using securitization by an
entity seeking to raise funds would not exist.

⚫ Assume that Mediquip has a credit rating from a credit-rating

agency, such as Standard & Poor’s, Moody’s Investors Service, or
Fitch Ratings. A credit rating reflects the agency’s opinion about the
creditworthiness of an entity and/or the debt securities the entity
issues. Suppose that the credit rating assigned to Mediquip is BB or
Ba2. Such a credit rating means that Mediquip is below what is
referred to as an investment-grade credit rating.

Neeraj Gupta,CFA CFP MBA

 Key Role of the SPV
▪ SPV plays a pivotal role in the securitization process
▪ SPV or equivalent institution is prerequisite in any country that wants to
allow securitization
▪ Securitization is better than a corporate bond secured with the same
collateral
• SPV is a bankruptcy – remote vehicle
• In Securitization, the assets belong to SPV and not to the entity
• In liquidations, the absolute priority rule generally holds. But at times
when a company is reorganized, courts may not uphold absolute
priority rule
• Courts have no discretion in case of securitization, so can’t change
seniority

Neeraj Gupta,CFA CFP MBA

Benefits of Securitization
Economic Benefits
◦ Brings financial and capital markets together
◦ Financial assets are created in the financial markets and securitization connects the capital
and financial markets by converting these financial assets into capital market commodities
◦ Agency and other costs are reduced

Benefits to Investors
◦ Securitization can more closely align financial instruments to investor needs
◦ Securitization asset classes have shown much higher rating resilience
◦ Default history of securitized products is much lower (past 16 years) and much higher
default recovery rate (better legal claims) than in case of defaulted corporate bonds

Benefits to Originator
◦ Banks improve profitability by increasing the loan origination i.e. increase the funds available
to lend
◦ Easy to sell: better liquidity than the original loans on the bank balance sheet

Neeraj Gupta,CFA CFP MBA

Neeraj Gupta,CFA CFP MBA
Neeraj Gupta,CFA CFP MBA
Neeraj Gupta,CFA CFP MBA
Securitization: Motivation
◦ There are different kind of structures in securitization
◦ The motivation of creating different structures is to redistribute the prepayment
risk
◦ Prepayment Risk: Uncertainty of receiving cash flows on times different than
scheduled time
◦ Second most important structure is subordination also referred to as “Credit
Tranching”
◦ Instrument is divided into various classes based on seniority. Losses are first
realized by subordinate class and then by senior class. Following is the example:

Bond Class Par Value ($ Mn)

A (Senior) 35
B (Subordinated) 10
Total 45

◦ All losses are absorbed by Bond B than they are realized by Bond A
◦ In case losses are less than $10 mn, then there will be no loss for Bond A
◦ In case losses are above $10 mn (e.g. $12 mn), then Bond B will take a hit of $10
mn loss and Bond A will realize a loss of $2 mn

Neeraj Gupta,CFA CFP MBA 15

⚫ The structure of a securitization may also allow the
redistribution of another type of risk, called
“prepayment risk,” among bond classes.
◦ Prepayment risk is the uncertainty that the cash flows will be
different from the scheduled cash flows as set forth in the loan
agreement because of the borrowers’ ability to alter payments,
usually to take advantage of interest rate movements. For
example, when interest rates decline, borrowers tend to pay off
part or all of their loans and refinance at lower interest rates.
⚫ The creation of bond classes that possess
different expected maturities is referred to as time
tranching.

Neeraj Gupta,CFA CFP MBA

Neeraj Gupta,CFA CFP MBA
Example

Agneelli industries (Agnelli), a manufacturing of the industrial machine tools based in

Bergamo, Italy, has €500 milliom of corporate bonds outstanding. These bonds have a
credit rating below investment grade. Agnelli has €400 million of receivables on its
balance sheet that it would like to securitize. The receivables represent payments that
Agnelli expects to receive for machine tools that it has sold to various customers in
Europe. Agnelli sells the receivables to the Agnelli trust, a special purpose entity.
Agnelli trust then issue ABS, backed by the pool of receivables, with the following
structure:
Securitization volumes reaching all
time high
⚫ The volume of securitization grew by 123% as figures
soared to Rs1.9 lakh crore in fiscal’ 19 compared to Rs
85,000 crore in fiscal ’18.
⚫ Mortgages, vehicle loans and microfinance loans
constituted the three major asset classes comprising of
84% of the total volume.

Neeraj Gupta,CFA CFP MBA

Neeraj Gupta,CFA CFP MBA
3 Reasons…
⚫ First, a few big players who stayed away from the
market returned after the GST Council clarified that
securitized assets are not subject to GST.
⚫ Second, non-banking companies rushed to
securitize their receivables as traditional
sources of financing dried up after September
2018. This was the aftermath of the failure of a leading
NBFC, and concerns about liquidity strain in some of
the HFCs. After this, banks started preferring portfolio
buyouts over taking credit exposure on the NBFCs.

Neeraj Gupta,CFA CFP MBA

⚫ Third, in a year where banks were still reeling
under NPA crisis and credit off take by way of
new bank lending was limited, acquisition of
pools from NBFCs seemed to be the way
to achieve credit growth.

Neeraj Gupta,CFA CFP MBA

Neeraj Gupta,CFA CFP MBA
PTC v/s DA

Neeraj Gupta,CFA CFP MBA

India vs Global Counter Parts

Neeraj Gupta,CFA CFP MBA

Few Deals in 2018
⚫ Highlight: The pool consists of two corporate loans
pertaining to ‘The Bombay Dyeing and
Manufacturing Company Ltd.’ (BDMCL) &
‘SCAL Services Limited’ (SCAL). However, SCAL
is a Mumbai based company engaged in Real Estate,
which is owned by BDMCL and its other group of
companies.
⚫ Total Deal Volume: Rs. 1700 Crs. (inclusive of
junior tranche kept as collateral)

Neeraj Gupta,CFA CFP MBA

Tranches…..

Neeraj Gupta,CFA CFP MBA

Neeraj Gupta,CFA CFP MBA
Credit Enhancement

⚫ 1. Total pool principal- 1700 Cr.-Junior tranche

amounting to Rs. 325 Cr. (19.12% of pool
principal) provided as credit enhancement
⚫ 2. Further an amount equivalent to one
month’s interest of the total pool principal will
be retained with designated Banks.

Neeraj Gupta,CFA CFP MBA

Key Features of the
Transactions
⚫ 1. The loan bears concentration risk as the pool
comprises of 2 underlying loans. The geographical
concentration is also high as both the project
loans are for construction of residential towers
in Mumbai. The risks are partly offset due to the
projects being close to completion and Mumbai being a
prominent residential market.

⚫ 2. SCAL has entered into multiple MoUs with BDMCL

to purchase 188 flats to further sell it down and have
paid an advance of 187 Cr. towards booking. Risk
arises if the SCAL is unable to sell the units for which
it has MoUs with BDMCL.
Neeraj Gupta,CFA CFP MBA
Development of the Indian
securitization market.

Neeraj Gupta,CFA CFP MBA

Neeraj Gupta,CFA CFP MBA
Asset classes prevalent in Indian
securitizations

Neeraj Gupta,CFA CFP MBA

Highlights on the 2012 Guidelines
⚫ Assets eligible for securitization:
◦ The 2012 Guidelines talk about securitization of
performing loans. Securitization of non-performing loans
is covered by separate guidelines. The pool of loans
securitized should be homogenous in nature.

⚫ Assets not eligible for securitization:

◦ Under the 2012 Guidelines the following are not eligible
assets for securitization:
◦ Single loans;
◦ Revolving credit facilities;
◦ Assets purchased from other entities;
◦ Loans with bullet repayment of principal and interest.

Neeraj Gupta,CFA CFP MBA

⚫ Third party credit enhancements:
◦ In case of direct assignments even a third
party can provide credit enhancements. This
would bring down the cost for the
originators and increase the capital relief

Neeraj Gupta,CFA CFP MBA

Criteria for Home Loans for
Securitization
⚫ The borrower should be individual(s).
⚫ The home loans should be current at the time of
selection/securitization.
⚫ The home loans should have a minimum seasoning
of 12 months (excluding moratorium period).
⚫ The Maximum Loan to Value (LTV) Ratio permissible
is 85%. Housing loans originally sanctioned with an
LTV of more than 85% but where the present
outstanding is within 85% of the value of the security,
will be eligible.
⚫ The Maximum Installment to Gross Income ratio
permissible is 45%.

Neeraj Gupta,CFA CFP MBA

Criteria for Home Loans for
Securitization
⚫ The loan should not have overdues outstanding for
more than three months, at any time throughout
the period of the loan.
⚫ The Quantum of Principal Outstanding Loan size
should be in the range of Rs.0.50 lakh to Rs.100
lakhs.
⚫ The pool of housing loans may comprise of fixed and/
or variable interest rates.
⚫ The Borrowers have only one loan contract with
the Primary Lending Institution (PLI).
⚫ The loans should be free from any encumbrances/
charge on the date of selection/securitization. The sole
exception to this norm being loans refinanced by NHB.

Neeraj Gupta,CFA CFP MBA

Securitization in Home Loans
⚫ The transactions are typically such that the originator, servicer and loan
administrator is an HFC or bank, NHB sets up the special purpose
vehicle (SPV) and acts as a trustee to the transaction.

⚫ The HFC/ bank assigns the retail housing loan pool to NHB SPV
and the SPV in turn issues certificates called Pass through certificates
(PTCs) to the investors that are institutional investors including
Insurance Companies, Mutual Funds, Financial Institutions,
and Commercial Banks.
⚫ The PTCs are in the nature of trust certificates and represent
proportionate undivided beneficial interest in the pool of housing loans.
⚫ PTCs again are issued in tranches of Class A and Class B.
⚫ While Class A tranche PTCs are subscribed by the investors, Class
B, the subordinated class is retained by the originator as the first
loss piece, which means it acts like a credit enhancement for Class A
investors to attain AAA rating

Neeraj Gupta,CFA CFP MBA

⚫ NHB placed its first mortgage backed securitization
transaction before the capital markets in 2000 and has
so far launched ten issues of RMBS with total loan
size of Rs.665 crore.

Neeraj Gupta,CFA CFP MBA

Neeraj Gupta,CFA CFP MBA
 Residential Mortgage Loans
▪ Mortgage is a loan secured by some sort of real estate property as a
collateral
▪ Lender has the right to foreclose the loan in case borrower defaults – the
lender will take possession or sell the collateral (mortgage property)
▪ Usually, Property Price > Loan Amount
▪ Mortgage Rate: Interest charged on mortgage loan. There are mainly
four kinds of rate:
• Fixed Rate: The rate throughout the life of the loan remains the same.
This is the most common type of rate used in US
• Variable Rate: The interest rate is adjusted periodically (depending on
the loan terms
• Initial period fixed rate: The rate is fixed for initial few years and the it
becomes variable rate
• Convertible: Borrower has the option to switch the loan type from
fixed to variable or vice-versa

Neeraj Gupta,CFA CFP MBA 44

 Residential Mortgage Loans: Prepayment
◦ Home-owners have a prepayment option under which they can pay the bank the
outstanding principal at any time and be freed from the obligation of making further
payments
◦ Prepayments for a less than the entire outstanding mortgage balance are called
curtailments
◦ Prepayment option makes amount and timing of the cash flow uncertain
◦ Homeowner is similar to an issuer of a callable bond with a call option to make the
prepayment of a mortgage loan if interest rate drops below fixed mortgage rate
◦ Thus fixed mortgage rate acts like a strike price and determines the prepayment risks
◦ Because of this risk, there might be some prepayment penalty for the borrower

Foreclosure: There can be two kind of mortgage:

◦ Recourse Loan: In case of default, lender has claim on other assets other than
collateral in case there is a shortfall between the loan balance and proceeds from the
sale of the collateral
◦ Non-recourse Loan: In case of default, lender has claim only on collateral. In case
the collateral value goes below mortgage balance, borrower can opt for “Strategic
Default”. In this, even borrower has the means of paying the loan amount, will not pay
the loan
Neeraj Gupta,CFA CFP MBA 45
 Residential Mortgage Backed Securities
◦ RMBS – Instruments (bonds) which are created through securitization of
mortgage loans
◦ In US, RMBS is of two types:
● Agency RMBS: Loan pool must satisfy some standards
Guaranteed by Federal agency (Ginnie Mae): It carries the guarantee of
US government with respect to timely interest and principal payments
Guaranteed by either of two GSEs (Government Sponsored Enterprises:
Fannie Mae and Freddie Mac): These do not carry the full faith of US
government
A loan which meets specified conditions/standards for an agency RMBS
is called “Conforming Mortgage”
● Non – agency RMBS: There is no restriction on the loan pool
Issued by Private entity
A loan which doesn’t meet specified conditions/standards for an agency
RMBS is called “Non – Conforming Mortgage”
◦ Agency RMBS are more credit worthy than non-agency RMBS because of
government guarantee
◦ To increase credit worthiness, non-agency RMBS uses credit enhancement
Neeraj Gupta,CFA CFP MBA 46
 Mortgage Pass-through Securities

Mortgage 1 Investor
1
Mortgage 2 Investor
Pool 2
… …

Mortgage Investor
N N
Passthrough securities backed by
the pool are issues to investors

Neeraj Gupta,CFA CFP MBA 47

Example

An example on WAC and WAM

Weighted Average Coupon Rate and Weighted Average Maturity
Assume that a pool includes three mortgages with the following characteristics:

Mortgage Outstanding Mortgage Coupon Rate Number of Months

Balance (%) to Maturity
(US$)
1 1,000 5.1 34
2 3,000 5.7 76
3 6,000 5.3 88

The outstanding amount of three mortgages is US$10,000. Thus, the weights of Mortgages 1, 2, and 3 are 10%, 30%, and
60%, respectively.
Solution

The WAC is:

10% * 5.1% + 30% * 5.7% + 60% * 5.3% = 5.4%.

The WAM is:

10% * 34 + 30% * 76 + 60% * 88 = 79 months

Source: CFA curriculum

 Prepayment Risks Contd…..
Prepayment Mortgage
Security

Standard Bond

◦ Contraction risk refers to consequences resulting from a decline in interest

rates for a pass-through security. It results in faster prepayments leading to
shortening of life
● Limited upside potential for a pass-through security
● Reinvestment risk that received cash flow have to be invested at a much lower
interest rate
◦ Extension risk refers to consequences resulting from a increase in interest
rates.
● It results in slower prepayments leading to lengthening of average life
● Unlimited downside potential with a limited upside makes pass-through security
unattractive
Neeraj Gupta,CFA CFP MBA 50
Residential Mortgage-backed Securities

◦ Pre-payment Rate Measures: The two key pre-payment measures are as follows:
● Single Monthly Mortality rate (SMM): It shows the dollar amount of pre-payment
expected for the month, as a proportion of mortgage-balance after taking into
consideration the scheduled principal repayment for the month.

An SMM of 0.5% means that 0.5% of the beginning mortgage balance is expected to
be paid by the end of the month

● Conditional Pre-payment rate (CPR): It is the annualized SMM. For example, a

CPR of 6% means that ~6% of the outstanding mortgage balance at the beginning of the
year is expected to be prepaid by the end of the year.
Residential Mortgage-backed Securities

◦ Public Securities Association (PSA): The pattern describing pre-payment rates in

terms of a pre-payment pattern is referred to as PSA (expressed as a series of monthly pre-
payment rates).

● 100 PSA: The standard for the PSA model is 100 PSA, which means that investors can
expect pre-payments to follow the PSA pre-payment benchmark.

● Benchmark means that pre-payments would be at a rate of 0.20% for the first month
and would increase by 0.2% every month, until the first 30 months. After that, it
would remain constant at 6% every month. A PSA assumption greater than 100 PSA
means that pre-payments are assumed to be faster than the standard, and a PSA lower
than 100 PSA means that pre-payments are assumed to be slower than the standard.
Commercial Mortgage-backed Securities

⚫ Collateralized Mortgage Obligations (CMO): It is the re-structuring of securities that can help
redistribute the cash flows of mortgage-related products into different bond classes or tranches. Such classes
or tranches have different exposures to pre-payment risk, and thus are different risk–return patterns relative
to the mortgage-related product from which they were created. These restructured securities are referred to
as CMOs. Note that the creation of a CMO structure cannot eliminate or change pre-payment
risk; it can only distribute it into different bond classes. Some common CMO structures are as follows:

◦ Sequential-Pay CMO Structures: The rule here says first, distribute all principal payments to Tranche
A, until its principal is paid completely. Then distribute all the principal payments to Tranche B, until its
principal balance is zero. And so on.
Commercial Mortgage-backed Securities

◦ If we assume that the pre-payment rate is 165 PSA, the mortgage pass-through security’s average life was
8.6 years. However, the actual PSA could be different than the assumed PSA, in which case the security’s
average will also be different. The variability of the average lives of the tranches remains a big problem that
can be resolved to a large extent by introducing Planned Amortization Class (PAC) tranches that is covered
next.
Commercial Mortgage-backed Securities

◦ CMO Structures Including Planned Amortization Class and Support Tranches: A PAC tranche offers
greater predictability of the cash flows given that the pre-payment rate is within a specified band over the
collateral’s life. The reduction of pre-payment risk comes from the existence of non-PAC tranches or support
tranches.

● Until the pre-payment rate is within the specified band, called the PAC band, all pre-payment risk is
absorbed by the support tranche. However, if the pre-payments are slower than expected, the support
tranches do not receive any principal repayment, until the PAC tranches receive their scheduled principal
repayment that reduces the extension risk of the PAC tranches.

● Likewise, if the collateral pre-payments are faster than expected, then the support tranches absorb any
excess principal repayments. This ultimately reduces the contraction risk of the PAC tranches.

● Note than if the support tranches are paid off quickly due to higher pre-payments, they stop providing
any protection to the PAC tranches.
Commercial Mortgage-backed Securities

● This exhibit shows the average life of the PAC and support tranches, under various actual pre-
payment rates. Notice that between 100 PSA and 250 PSA, the average life of the PAC tranche is
constant at 7.7 years. However, at the slower and faster PSA, the schedule is broken and the
average life changes. Even then, the variability in average life of the PAC tranche when compared
with that of the support tranche is much less.

◦ Other CMO Structures: It is also possible to construct a floating rate tranche even if the collateral
pays a fixed rate of interest. This is accomplished by constructing issuing floater and an inverse floater
tranche. Because the floating-rate tranche pays a higher rate when interest rates increase and the inverse
floater pays a lower rate when interest rates increase, they would offset each other. Thus, a fixed-rate
tranche can be used to satisfy the demand for a floating-rate tranche.
 Collateralized Mortgage Obligation
◦
(CMO)
Extension risks & contraction risks can be mitigated by transferring the prepayment
cash flows to different bond classes or tranches: CMO
◦ Tranches are a various class of securities which have different prepayment risk patterns
and different risk-return profile from that of the pass-through security
◦ CMO does not eliminate prepayment risks, it only distributes this risk
among various tranches
◦ In case of a sequential CMO, each class of bond would be retired sequentially
Class A (T-bill + 50 bps) $20 mn Highest Contraction
Expected life = 3 yrs
Risk
$100 mn, Class B (T-bill + 75 bps) $25 mn
9% Expected life = 5 yrs
30 year
Fixed Class C $30 mn
Expected life = 7 yrs
Start with
Class D $17 mn
FNMA
Pass-through Expected life = 20 yrs

$3 mn
Residual

Highest Extension
Risk
◦ A Principal Window for a tranche is the time period between the starting and ending
of the principal payment to the tranche
◦ Still persists the problem of a variability of an average life for the tranches
Neeraj Gupta,CFA CFP MBA 57
 Planned Amortization Class (PAC)
◦ Planned Amortization Class tranche
● PAC tranche is amortized similar to sinking bond
schedule and comes with lower & upper PSA
prepayment assumptions
● Lower & upper PSA are referred to as initial PAC
collar 300
● PAC bondholders gets priority over the other PSA
tranches in receiving principal payments
● PAC tranches provides protection from both 90
contraction risks as well as extension risks, as PSA
planned amortization schedule provides a highly
predictable life
● Prepayments to the PAC tranches will be slow if the
prepayment speed is between PAC collar
● PAC window is the time-frame over which expected
principal repayments are made

• Creating PAC tranche does not eliminate prepayment risks, but just transfers risks
from PAC tranches to other tranches which provides protection to PAC tranches,
known as support tranche
• If the all support tranches of CMO are paid off, the structure becomes plain sequential pay
CMO
• PAC tranche in which all the support tranches have been paid off is called a Busted PAC
• PAC with the wider initial collar offers greater protection from prepayment risks
Neeraj Gupta,CFA CFP MBA 58
 Support Tranche
◦ Tranches or class of the bonds which provide prepayment
protection to all PAC tranches.
◦ This tranche can be divided to create another support
tranche with a principal payment schedule.
◦ There is inverse relationship between prepayment
risks of PAC tranche and prepayment risks of
support tranche.

Neeraj Gupta,CFA CFP MBA 59

 Agency And Nonagency Mortgage-
backed Securities
◦ Underlying mortgage loans which qualify to the
underwriting standards of government agency
guaranteeing the mortgage backed security, are known as
agency backed mortgage securities
◦ Following are the three main underwriting standards:
● The maximum Loan to Value ratio (LTV)
Ratio of the mortgage loan amount to the market
value of the underlying property
Lower the ratio, greater the protection to
lender
Loans which fails to conform agency standards
because of higher LTV ratio are called jumbo loans
● The maximum payment to income ratio
● The maximum loan amount
Neeraj Gupta,CFA CFP MBA 60
◦ Loans which fails to qualify agency underwriting standards
because of the first two standards pose higher credit risks to
the lender compared to conforming loans
◦ Quality of the servicer plays an important role in
assessing the credit risk of a non-agency security
◦ In case of agency CMO, underlying asset is a pool of securitized
pass-through securities
◦ In case of non-agency CMO, underlying asset is unsecuritized
mortgage loans known as whole loans
◦ Non-agency CMOs are commonly referred to as whole loan
CMOs
◦ No government guarantee of interest payment on non-agency
CMO compared to agency CMO

Neeraj Gupta,CFA CFP MBA

 Non – Agency: Credit Enhancement
◦ Because of the higher credit risk involved in non-agency securities, these securities are credit
enhanced and are rated by nationally recognized statistical rating agency
◦ All asset backed securities are credit enhanced
◦ Rating agency calculates the exact amount of credit enhancement required for a particular credit
rating sought by an issuer
◦ There are two types of credit enhancement:
● External Credit Enhancement: In case of default, there is a financial guarantee from the third
party e.g. insurance
Bond insurance
❖ Third party insurance companies like monoline guarantees certain percentage of the
par value at origination
❖ These type of securities are also known as wrapped securities
❖ According to 'weak link approach' employed by rating agencies, credit rating of a
bond cannot be higher than a credit rating of the third party credit enhancer
❖ Downgrading of credit rating of a third party insurer results into downgrading of
asset backed securities
Corporate guarantee
❖ Sponsor or originator provides guarantee to a certain portion of the issue
Letter of credit
❖ Bank letter of credit provides guarantee to a certain percentage of the collateral

Neeraj Gupta,CFA CFP MBA 62

 Non – Agency: Credit Enhancement
● Internal Credit Enhancement: Following are the most common type
of internal credit enhancement:
Senior/subordinated structures:
❖ Subordinate bond provides a certain level of credit protection to senior bond,
similar to credit tranching
❖ Percentage weightage in the form of outstanding mortgage balance of
subordinate tranche to the total outstanding mortgage balance of the structure,
is known as subordination or subordinate interest
❖ Higher the subordinate interest, greater is the percentage protection to senior
bonds
❖ Faster prepayments will pay off the subordinate tranches first deteriorating
credit protection to senior bond
❖ This problem can be solved by shifting interest mechanism, under which
subordinate interest is maintained at a minimum level to provide protection to
senior bonds by paying down the senior bond tranche more quickly
❖ Application of this mechanism results into increasing contraction risks, thus
this mechanism results into trade-off between credit risk & contraction risk

Neeraj Gupta,CFA CFP MBA 63

 Reserve Funds:
❖ Certain amount of cash generated from the underwriting process is
invested in money market as a buffer
❖ Cash reserve funds is generally used along with external credit
enhancements
❖ In case of excess spread account, excess spread from the various
tranches after deducting interest payment, servicing fee and all other
operating expenses is used as buffer to fund losses on the collateral

Overcollateralization:
❖ In this case, value of the underlying collateral exceeds the outstanding
amount of bond
❖ Amount of overcollateralization keeps on changing due to defaults,
amortization & prepayments
❖ This surplus amount of collateral can be used to absorb the losses and
hence reduces the default risk of tranches increasing their credit rating

Neeraj Gupta,CFA CFP MBA

Commercial Mortgage-backed Securities
(CMBS)
◦ Commercial mortgage backed securities are backed by commercial mortgage loans on properties
like office buildings, industrial property, shopping center, hotel etc. producing rental income
◦ Conduits are commercial lending entities floated for the purpose of generating collateral to
securitize
◦ CMBS deal structures which are the most popular among bond investors are
● Multi-property single borrower
● Multi-property conduits
◦ Commercial mortgage loans are non-recourse loans, which means that in case of a default
lender can take charge of the income producing property but has not any recourse on borrower
◦ Credit analysis of every individual loan forming a part of a collateral pool is performed, as each
income producing property has unique economic characteristics
◦ Net Operating Income (NOI) is defined as a rental income left after accounting for cash
operating expenses
◦ Debt to service coverage ratio is the ratio of NOI to the property's debt service expenses
◦ Ratio of more than 1 signifies that cash flow is sufficient enough to cover debt servicing
◦ NOI received from collateral is used to pay the interest to all tranches of CMBS
◦ Any cash flow to CMBS in the form of prepayment or default will be utilized to repay the highest
rated tranche first
◦ Losses because of defaults are borne by the lowest rated CMBS tranche against its outstanding
principal

Neeraj Gupta,CFA CFP MBA 65

◦
CMBS
Salient feature of a CMBS compared to residential mortgage backed securities is call protection
against prepayment risks
◦ Call protection comes in two forms
● Call protection at the loan level
Prepayment lockout – during a prespecified period of time known as lockout period,
prepayment by borrower is prohibited by legally binding contract
Defeasance – in this form of call protection, borrower compensates lender in the form of
cash which can be invested in treasury securities to replace the cash flows that would have
come in the absence of prepayments
Prepayment penalty points – penalty points are the predetermined penalties which has
to be paid by borrower in case he wants to refinance his mortgage
Yield maintenance charges – these charges are designed in such a way that timing of
prepayments doesn't affect lenders. These charges makes it uneconomical for an investor to
refinance to get the benefit of low mortgage rates
● Call protection at the CMBS structure level
CMBS structure is designed in such a way that higher rated tranches are paid off first in case
of prepayments. Thus providing call protection to lower rated tranches. But losses caused by
the defaults are borne by lower rated tranches first
◦ Most of the commercial mortgage loans are non-amortizing, which increases the risk that borrower
would not be able to arrange for refinancing at the due date or cannot sale the property to
generate enough funds
◦ This is a type of extension risk termed as balloon risk

Neeraj Gupta,CFA CFP MBA 66

Auto Loan Backed Securities
◦ Auto loans are a secured form of lending
◦ Auto loan is short term in nature and is an amortizing loan
◦ In case of auto loan backed securities, prepayments occurs
because of the following major reasons
● Sale of vehicle requiring full payment of outstanding loan
● Re-possession and subsequent resale of the automobile
● Loss or destruction

Neeraj Gupta,CFA CFP MBA 67

 Credit Card Receivable Backed
Securities
◦ Credit card receivable backed securities is backed by pool of credit card receivables
like finance charges, annual fees etc.
◦ Interest rate on the receivables may be fixed or floating and floating rate is uncapped
◦ Credit card receivable security is non amortizing in nature
◦ For a initial period of time, the lockout period, principal repayment are retained and
reinvested by trustees in addition to receivables to maintain the size of collateral pool
◦ Three different types of structures are used to create a credit card receivable backed
security
● Pass-through structure – prepayment is distributed on pro rata basis
● Controlled amortization structure – similar to PAC structure
● Bullet payment structure – total principal amount in a single payment
◦ Net yield on this security is equal to gross yield minus service charges
◦ Delinquencies are the percentage amount of receivables that are due for the last 30, 60
or 90 days
◦ Monthly Payment Rate (MPR) depicts principal repayment by borrower and the
monthly payment of finance and other charges
◦ If actual MPR is at low level, there are quite high chances of extension risk to the
principal payments on the bonds, whereas in worst case scenario if MPR reaches an
extremely low level there won't be sufficient funds to pay off the security
Neeraj Gupta,CFA CFP MBA 68
Constructing a CDO
A CDO is constructed as follows:
⚫ A special purpose entity (SPV) acquires a portfolio of credit.
◦ Common assets held include mortgage-backed securities, Commercial Real
Estate (CRE) debt, and high-yield corporate loans.
⚫ The SPV issues different classes of bonds and equity and the proceeds
are used to purchase the portfolio of credits.
◦ The bonds and equity are entitled to the cash flows from the portfolio of
credits, in accordance with the Priority of Payments set forth in the
transaction documents.
◦ The senior notes are paid from the cash flows before the junior notes and
equity notes.
◦ In this way, losses are first borne by the equity notes, next by the junior notes,
and finally by the senior notes.
◦ In this way, the senior notes, junior notes, and equity notes offer distinctly
different combinations of risk and return, while each reference the same
portfolio of debt securities.

Neeraj Gupta,CFA CFP MBA

 Collateralized Debt Obligations

⚫ There are four types of CDOs:

1. Cash Flow CDOs that make periodic payment of
interest and principal.

2. Market Value CDOs that are characterized by total

returns generated from the collateral: interest income,
capital gains, and principal.

3. Synthetic CDOs that are formed with derivatives

4. Balance Sheet CDOs consisting of bank loans in

which the objective is to sell or remove the loans from
the balance sheet.
Neeraj Gupta,CFA CFP MBA
Structure of a CDO.

Neeraj Gupta,CFA CFP MBA

 Collateralized Debt Obligations

Example
⚫ Next Slide shows a CDO with
◦ Four tranches
◦ Backed by a $200 million collateral investment consisting
of
1. Fixed-rate, investment-grade bonds with a par
value of $200 million
2. Weighted average maturity of five years
3. Yielding a return 200 basis points over the five-
year T-notes.

Neeraj Gupta,CFA CFP MBA

 Tranche Par Coupon Coupon Rate
Senior A1 $100m Fixed 5-year T-note Rate + 150bp
Senior A2 $60m Floating LIBOR + 100bp
Junior B $20m Fixed 5-year T-note Rate + 200bp
Subordinate/Equity $20m -- --
Collateral Requirements:
Collateralized ∙ Investment-grade bonds
Debt Obligations ∙ Weight average maturity of 5 years
∙ Average quality rating of A
Example Swap
∙ Manager will enter interest rate swap contracts to
fix the rate on the A2 Tranche
Senior-Subordinate Structure
∙ Tranche B is subordinate to A1 and A2
Initial Collateral Investment:
∙ $200 million investment in investment-grade portfolio yielding 8%
T-note rate at time of initial investment of 6%
Initial spread on portfolio of 200 basis points
Initial Swap Agreement:
∙ CDO manager agrees to pay 6% on $60m notional principal in return for a payment of LIBOR on $60m.
Projected First-Year Cash Flow

1. Interest from collateral = (.08)($200m) $16m

2. Payment to A1 tranche: ($100m)(.06 + .015)($100m) − $7.5m
3. Payment to A2 tranche: (LIBOR + .01)($60m) − (LIBOR + .01)($60m)
4. Interest paid to swap counterparty:
(.06)($60M) = $3.6m −$3.6m
5. Interest received from swap counterparty:
(LIBOR)($60m) + (LIBOR)($60m)
6. Payment to B Tranche: ((.06 + .02)($20m) − $1.6m
____________________________________________ ________________
Net $2.7m
____________________________________________ _________________
7. Payment to Subordinate/Equity Tranche $2.7m

Neeraj Gupta,CFA CFP MBA

 Collateralized Debt Obligations

Example
⚫ The CDO’s four tranches consist of:
1. A senior A1 trance with a par value of $100 million, paying a
fixed rate equal to the five-year T-note rate plus 150 basis points

2. A senior A2 tranche with a par value of $60 million and paying a

floating rate equal to LIBOR plus 100 basis points

3. A subordinate B Tranche with a par value of $20 million and

paying a fixed rate equal to the five-year T-note rate plus 200 basis
points

4. A subordinate/equity tranche with a par value of $20 million

that receives the excess return: return from collateral minus
returns paid to the other tranches.

Neeraj Gupta,CFA CFP MBA

 Collateralized Debt Obligations

Example
⚫ Since Tranche A2 pays a floating rate and the underlying
collateral is to consist of fixed-rate bonds, the CDO deal
allows the manager to take a derivative position to fix the
rate on the A2 tranche.

⚫ In this deal, the manager enters an interest rate swap

contract to pay a fixed rate of 6% on a $60 million notional
principal in return for the receipt of a floating rate payment
equal to the LIBOR on a $60 million notional principal.

Neeraj Gupta,CFA CFP MBA

 Collateralized Debt Obligations

Example
⚫ The interest rate swap contract when combined with the
floating rate loan obligation on Tranche A2 serves to fix
the rate on the tranche at 7%:

Tranche A2 Pay LIBOR + 100 basis point − (LIBOR + 1%)

Swap Pay 6% − 6%
Swap Receive LIBOR + LIBOR
Net Pay 6% + 1% − 7%

Neeraj Gupta,CFA CFP MBA