Study Session 15 Reading 53 Summary

 Securitization involves pooling debt obligations, such as loans or receivables, and creating
securities backed by the pool of debt obligations called asset-backed securities (ABS). The cash
flows of the debt obligations are used to make interest payments and principal repayments to the
holders of the ABS.

 Securitization has several benefits. It allows investors direct access to liquid investments and
payment streams that would be unattainable if all the financing were performed through banks. It
enables banks to increase loan originations at economic scales greater than if they used only their
own in-house loan portfolios. Thus, securitization contributes to lower costs of borrowing for
entities raising funds, higher risk-adjusted returns to investors, and greater efficiency and
profitability for the banking sector.

 The parties to a securitization include the seller of the collateral (pool of loans), the servicer
of the loans, and the special purpose entity (SPE). The SPE is bankruptcy remote, which plays a
pivotal role in the securitization.

 A common structure in a securitization is subordination, which leads to the creation of more

 The motivation for the creation of different types of structures is to redistribute prepayment
risk and credit risk efficiently among different bond classes in the securitization. Prepayment risk
is the uncertainty that the actual cash flows will be different from the scheduled cash flows as set
forth in the loan agreements because borrowers may choose to repay the principal early to take
advantage of interest rate movements.

 Because of the SPE, the securitization of a company’s assets may include some bond classes
that have better credit ratings than the company itself or its corporate bonds. Thus, the
company’s funding cost is often lower when raising funds through securitization than when
issuing corporate bonds.

 A mortgage is a loan secured by the collateral of some specified real estate property that
obliges the borrower to make a predetermined series of payments to the lender. The cash flow of
a mortgage includes (1) interest, (2) scheduled principal payments, and (3) prepayments (any
principal repaid in excess of the scheduled principal payment).

 The various mortgage designs throughout the world specify (1) the maturity of the loan; (2)
how the interest rate is determined (i.e., fixed rate versus adjustable or variable rate); (3) how the
principal is repaid (i.e., whether the loan is amortizing and if it is, whether it is fully amortizing
or partially amortizing with a balloon payment); (4) whether the borrower has the option to
prepay and if so, whether any prepayment penalties might be imposed; and (5) the rights of the
lender in a foreclosure (i.e., whether the loan is a recourse or non-recourse loan).
 In the United States, there are three sectors for securities backed by residential mortgages: (1)
those guaranteed by a federal agency (Ginnie Mae) whose securities are backed by the full faith
and credit of the US government, (2) those guaranteed by a GSE (e.g., Fannie Mae and Freddie
Mac) but not by the US government, and (3) those issued by private entities that are not
guaranteed by a federal agency or a GSE. The first two sectors are referred to as agency
residential mortgage-backed securities (RMBS), and the third sector as non-agency RMBS.

 A mortgage pass-through security is created when one or more holders of mortgages form a
pool of mortgages and sell shares or participation certificates in the pool. The cash flow of a
mortgage pass-through security depends on the cash flow of the underlying pool of mortgages
and consists of monthly mortgage payments representing interest, the scheduled repayment of
principal, and any prepayments, net of servicing and other administrative fees.

 Market participants measure the prepayment rate using two measures: the single monthly
mortality rate (SMM) and its corresponding annualized rate—namely, the conditional
prepayment rate (CPR). For MBS, a measure widely used by market participants to assess is the
weighted average life or simply the average life of the MBS.

 Market participants use the Public Securities Association (PSA) prepayment benchmark to
describe prepayment rates. A PSA assumption greater than 100 PSA means that prepayments are
assumed to occur faster than the benchmark, whereas a PSA assumption lower than 100 PSA
means that prepayments are assumed to occur slower than the benchmark.

 Prepayment risk includes two components: contraction risk and extension risk. The former is
the risk that when interest rates decline, the security will have a shorter maturity than was
anticipated at the time of purchase because homeowners will refinance at the new, lower interest
rates. The latter is the risk that when interest rates rise, fewer prepayments will occur than what
was anticipated at the time of purchase because homeowners are reluctant to give up the benefits
of a contractual interest rate that now looks low.

 The creation of a collateralized mortgage obligation (CMO) can help manage prepayment risk
by distributing the various forms of prepayment risk among different classes of bondholders. The
CMO’s major financial innovation is that the securities created more closely satisfy the
asset/liability needs of institutional investors, thereby broadening the appeal of mortgage-backed
products.

 The most common types of CMO tranches are sequential-pay tranches, planned amortization
class (PAC) tranches, support tranches, and floating-rate tranches.

 Non-agency RMBS share many features and structuring techniques with agency CMOs.
However, they typically include two complementary mechanisms. First, the cash flows are
distributed by rules that dictate the allocation of interest payments and principal repayments to
tranches with various degrees of priority/seniority. Second, there are rules for the allocation of
realized losses, which specify that subordinated bond classes have lower payment priority than
senior classes.
 In order to obtain favorable credit ratings, non-agency RMBS and non-mortgage ABS often
require one or more credit enhancements. The most common forms of internal credit
enhancement are senior/subordinated structures, reserve funds, and overcollateralization. In
external credit enhancement, credit support in the case of defaults resulting in losses in the pool
of loans is provided in the form of a financial guarantee by a third party to the transaction.

 Commercial mortgage-backed securities (CMBS) are securities backed by a pool of

 Two key indicators of the potential credit performance of CMBS are the debt-service-
coverage (DSC) ratio and the loan-to-value ratio (LTV). The DSC ratio is the property’s annual
net operating income divided by the debt service.

 CMBS have considerable call protection, which allows CMBS to trade in the market more
like corporate bonds than like RMBS. This call protection comes in two forms: at the structure
level and at the loan level. The creation of sequential-pay tranches is an example of call
protection at the structure level. At the loan level, four mechanisms offer investors call
protection: prepayment lockouts, prepayment penalty points, yield maintenance charges, and
defeasance.

 ABS are backed by a wide range of asset types. The most popular non-mortgage ABS are
auto loan ABS and credit card receivable ABS. The collateral is amortizing for auto loan ABS
and non-amortizing for credit card receivable ABS. As with non-agency RMBS, these ABS must
offer credit enhancement to be appealing to investors.

 A collateralized debt obligation (CDO) is a generic term used to describe a security backed by
a diversified pool of one or more debt obligations (e.g., corporate and emerging market bonds,
leveraged bank loans, ABS, RMBS, and CMBS).

 A CDO involves the creation of an SPE. The funds necessary to pay the bond classes come
from a pool of loans that must be serviced. A CDO requires a collateral manager to buy and sell
debt obligations for and from the CDO’s portfolio of assets to generate sufficient cash flows to
meet the obligations of the CDO bondholders and to generate a fair return for the equity holders.

 The structure of a CDO includes senior, mezzanine, and subordinated/equity bond classes.

(Institute 516-518)

Institute, CFA. 2018 CFA Program Level I Volume 5 Equity and Fixed Income. CFA Institute,
07/2017. VitalBook file.