CHAPTER 4

INTRODUCTION TO
ASSET-BACKED SECURITIES

FIN3010/7190 Fixed Income Securities

Ying Zhang
CONTENTS
1 Introduction
2 Benefits of Securitization for Economies and Financial Markets
3 How Securitization Works
4 Residential Mortgage Loans
5 Residential Mortgage-Backed Securities
6 Commercial Mortgage-Backed Securities
7 Non-Mortgage Asset-Backed Securities
8 Collateralized Debt Obligations
9 Summary

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© 2020 CFA Institute. All rights reserved.
 1. INTRODUCTION
• This topic examines fixed-income instruments created
through a process known as securitization. This process
involves transferring the ownership of assets from the
original owner into a special legal entity.
• The special legal entity issues securities backed by these
assets whose cash flows are used to pay principal and
interest are referred to as asset-backed securities (ABS).
• The pool of assets from which the ABS cash flows are
generated is called the collateral.

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 INTRODUCTION
• Assets that are typically used to create asset-backed
bonds are called “securitized assets” and include the
following, among others:

Residential mortgage Commercial Automobile

loans mortgage loans loans

Student loans Bank loans Credit card debt

• A mortgage-backed security (MBS) is, by definition, an

asset-backed security, but a distinction is often made
between MBS and ABS backed by non-mortgage assets.

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 2. BENEFITS OF SECURITIZATION FOR
ECONOMIES AND FINANCIAL MARKETS
• The securitization of pools of loans into multiple securities
provides an economy with a number of benefits:
• Allows investors to get a direct exposure to a portfolio of
mortgages or other receivables without having a bank as an
intermediary

• Allows banks to increase the amount of funds available to lend

and increase fee income

• Allows the creation of tradable securities with better liquidity

than the original loans on the bank’s balance sheet

• Benefits investors by creating access to securities matching

their risk, return and maturity profiles via financial innovation

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 3. HOW SECURITIZATION WORKS

Mediquip 1.Sale of medical

Originator equipment Customers
Insurance
financed by loans

3. Cash 6. Periodic
2. Sale of
payment for cash
loans
loans payments
Medical Equipment Trust
Special Purpose Entity (SPE)

4. Issuance 5. Cash 7. Periodic

and sale of payment for Cash
ABS ABS payments

Investors

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 SECURITIZATION PARTIES AND THEIR ROLES
The three main parties to a securitization are:

Originator • Originally owns the assets and sells

(seller of the collateral) them to the issuer (SPE)

Special purpose entity • Purchases the collateral and uses it to

(SPE) issue ABS to investors

Servicer of the • This may be the original seller or a

collateral third party

Other involved parties include independent accountants,

attorneys, trustees, underwriters, rating agencies and
financial guarantors.
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 STRUCTURE
OF A SECURITIZATION
ABS transactions may involve the sale of only one bond or
class, or use more complex multiple class bond structures:
In a subordination (senior/subordinated)
Credit tranching structure, the bond classes differ as to how they
will share any losses resulting from defaults of the
borrowers whose loans are in the pool of loans.

In such a structure, rules will be established for the

distribution of interest and principal to the bond
Time tranching classes. Some bond classes may receive
payments earlier than others and therefore face
prepayment risk.

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 4. RESIDENTIAL MORTGAGE LOANS

A mortgage loan, or Typically, the amount

simply mortgage, is The mortgage gives of the loan advanced
a loan secured by the lender the right to purchase the
the collateral of to foreclose on the property is less than
some specified real loan if the borrower the property’s
estate property that defaults (i.e., allows purchase price.
obliges the borrower the lender to take • The loan-to-value
to make a possession of the ratio is less than
predetermined mortgaged property 100%.
series of payments and then sell it).
to the lender.

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FIVE SPECIFICATIONS OF MORTGAGE DESIGN

Mortgage designs vary around the world in terms of:

1) The maturity of the loan

2) How the interest rate is determined

3) How the principal is to be repaid (i.e., the

amortization schedule)

4) Whether the borrower has the option to prepay and,

in this case, whether any prepayment penalties might
be imposed
5) The rights of the lender in a foreclosure

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 5. RESIDENTIAL MORTGAGE-BACKED
SECURITIES
In the United States, residential mortgage-backed securities
(RMBS) are divided into three sectors:

Those guaranteed by a federal agency

Those guaranteed by a government-sponsored

agency (GSE)

Those issued by a private entity and are not

guaranteed by a federal agency or a GSE (known as
non-agency RMBS)

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 MORTGAGE PASS-THROUGH SECURITIES
• A mortgage pass-through security is a security created when
one or more holders of mortgages form a pool of mortgages and
sell shares or participation certificates in the pool.
• The cash flows of a mortgage pass-through security depend on
the cash flows of the underlying pool of mortgages.

Monthly
mortgage Scheduled
Any
Cash flows payments repayment
prepayments
representing of principal
interest

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 MORTGAGE PASS-THROUGH SECURITIES
A mortgage pass-through security’s coupon rate is called the
pass-through rate.

The pass-through rate is less than the mortgage rate on

the underlying pool of mortgages by an amount equal to
the servicing and other fees.

Not all of the mortgages in a pool have the same mortgage

rate and maturity.

For each mortgage pass-through security, a weighted

average coupon (WAC) rate and a weighted average
maturity (WAM) are determined.

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WAC AND WAM CALCULATION

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 PREPAYMENT RISK COMPONENTS
Prepayment risk is the uncertainty of future cash flows
because of prepayment speed. It has two components:

• Risk that if interest rates decline, the

1. Contraction security will have a shorter maturity than
risk previously anticipated as homeowners
may refinance at now-available lower
interest rates

• Risk that if interest rates rise, fewer

prepayments occur as homeowners are
2. Extension risk reluctant to give up the benefits of a
contractual interest rate that looks low

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 MEASURES OF THE PREPAYMENT RATE
• The two key prepayment rate measures

2. Its corresponding
1. Single monthly mortality
annualized rate, the
(SMM) rate, a monthly
conditional prepayment
measure
rate (CPR)

• Forecasting the future prepayment rate is key. The Public

Securities Association (PSA) is a common benchmark.
Prepayment rates are stated as a percentage of a PSA
benchmark. 16
 CONDITIONAL PREPAYMENT RATE
In the standard PSA model, known as 100 PSA, the
CPR starts at 0.2% for the first month and then
increases at a constant rate of 0.2% per month to
equal 6% at the 30th month.
- After the 30th month, the CPR stays at a constant 6%.
- Thus, for any month t, the CPR is:

 t 
CPR  0.06 , if t  30
 30 
CPR  0.06, if t  30

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 CASH FLOW CONSTRUCTION

• Par value of underlying pool of mortgages is $800 million;

• The mortgages are fixed rate, level-payment, and fully amortizing loans
• Pass-through coupon rate 5.5%
• Weighted-Average Coupon Rate (WAC) of 6%
• Weighted Average Maturity (WAM) 357 months

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Beg. Bal SMM x Sch. Repay
(Beg. Bal. Sch. Repay
X +
- +
Pass- Prepayment
Sch. Prepayment
Through +
Rate/12 Repayment) Net Interest

Mtg. Pmt – Beg.

Bal x WAC/12 19
 AVERAGE LIFE OF A MORTGAGE
The average life of a mortgage in a pool is the
average time for a single mortgage in the pool to be
paid off, either by prepayment or by making
scheduled payments until maturity.
Example: For a pool of 30-year mortgages:
Prepayment Schedule Average Mortgage Life

100 PSA 11.2 years

165 PSA 8.6 years
250 PSA 6.4 years
400 PSA 4.5 years

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COLLATERALIZED MORTGAGE OBLIGATIONS
Collateralized mortgage obligations (CMOs) are bond
classes created by redirecting the interest and principal
from a pool of pass-throughs or whole loans.

The creation of a CMO cannot eliminate prepayment risk;

it can only transfer the various forms of this risk among
different classes of bonds called “tranches.”

A wide range of CMO structures exists.

From a fixed-rate CMO tranche, a floating-rate tranche

and an inverse floating-rate tranche can be created.

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 TRANCHES
• Sequential-pay CMOs are structures where each class of bond
(the tranches) is retired sequentially.
First, distribute all principal payments to Tranche 1
until the principal balance for Tranche 1 is zero.

After Tranche 1 is paid off, do the same for

Tranche 2, and so on.

• Planned amortization class (PAC) tranches offer greater predictability

of cash flows as long as the prepayment rate is within a specified band
over the collateral’s life.
- The key to the prepayment protection for the PAC tranches are the
support tranches.

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 SEQUENTIAL-PAY CMO
• Collateral includes:
- Par value is $800 million;
- Pass-through coupon rate 5.5%
- Weighted-Average Coupon Rate of 6%
- Weighted Average Maturity 357 months (29 years 9 month)

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 SEQUENTIAL-PAY CMO
• For payment of monthly coupon interest: Disburse monthly coupon
interest to each tranche on the basis of the amount of principal
outstanding for each tranche at the beginning of the month.
• For disbursement of principal payments: Disburse principal payments to
Tranche A until it is completely paid off. After Tranche A is completely paid
off, disburse principal payments to Tranche B until it is completely paid off.
After Tranche B is completely paid off, disburse principal payments to
Tranche C until it is completely paid off. After Tranche C is completely paid
off, disburse principal payments to Tranche D until it is completely paid off.

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 CMO WITH PAC
• Collateral includes:
- Par value is $800 million;
- Pass-through coupon rate 5.5%
- Weighted-Average Coupon Rate of 6%
- Weighted Average Maturity 357 months (29 years 9 month)

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 CMO WITH PAC
• For payment of monthly coupon interest: Disburse monthly coupon
interest to each tranche based on the amount of principal outstanding for
each tranche at the beginning of the month.
• For disbursement of principal payments: Disburse principal payments to
Tranche P based on its schedule of principal repayments. Tranche P has
priority with respect to current and future principal payments to satisfy the
schedule. Any excess principal payments in a month over the amount
necessary to satisfy the schedule for Tranche P are paid to Tranche S.
When Tranche S is completely paid off, all principal payments are to be
made to Tranche P regardless of the schedule.

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 NON-AGENCY RESIDENTIAL MORTGAGE-
BACKED SECURITIES
• Non-agency RMBS share many features and structuring
techniques with agency CMOs.
• In order to obtain a favorable credit rating, non-agency
RMBS often require one or more credit enhancements.
• The most common forms of credit enhancement is
subordination or credit tranching.

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 6. COMMERCIAL MORTGAGE-BACKED
SECURITIES
• Commercial mortgage-backed securities (CMBS) are
backed by a pool of commercial mortgage loans on
income-producing property.
• Commercial mortgage loans are non-recourse loans, and
as a result, the lender can only look to the income-
producing property backing the loan for interest and
principal repayment.
Two measures of CMBS credit performance:
Debt-to-service (DSC)
coverage ratio, which is the
Loan-to-value (LTV) ratio property’s net operating income
(NOI) divided by the debt
service

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COMMERCIAL MORTGAGE-BACKED SECURITIES
CMBS typically offer investors significant
protection against early prepayment (call
protection).

The degree of call protection available to a

CMBS investor is a function of (1) call
protection available at the loan level and (2)
call protection afforded from the actual CMBS
structure.
At the commercial loan level, call protection
can be in the form of a prepayment lockout, a
defeasance, prepayment penalty points, or
yield maintenance charges.
Many commercial loans backing CMBS transactions are balloon
loans that require substantial principal payment at maturity of the
loan.
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 7. NON-MORTGAGE
ASSET-BACKED SECURITIES
The collateral for an asset-backed security can be either:

Amortizing loans Non-amortizing loans

(e.g., auto loans, personal and or (e.g., credit card receivables)
commercial loans)
For non-amortizing assets,
prepayments by borrowers do not
In amortizing structures, the apply since there is no schedule
principal received from the of principal repayments.
scheduled repayment and any
prepayments are distributed to
the bond classes based on the In non-amortizing structures,
payment rule. typically there is a lockout period,
a period where principal
repayments are reinvested in new
assets.

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 AUTO LOAN ABS
Auto loan The cash flows for auto loan ABS consist of
ABS regularly scheduled monthly loan payments
(interest payment and scheduled principal
repayments) and any prepayments.

All auto loan ABS have some form of credit

enhancement—often a senior/ subordinated
so the senior tranches have credit
enhancement because of the presence of
subordinated tranches.

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 CREDIT CARD
RECEIVABLE ABS
Credit card For a pool of credit card receivables, the cash
receivable flows consist of finance charges collected, fees,
ABS and principal repayments.

Interest—fixed or floating—is paid to security

holders periodically.

Credit card receivable ABS have lockout

periods during which the cash flow that is paid
out to security holders is based only on finance
charges collected and fees. When the lockout
period is over, the principal is no longer
reinvested but paid to investors.
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 8. COLLATERALIZED DEBT OBLIGATIONS
A collateralized debt obligation (CDO) is a security backed by a
diversified pool of one or more of the following types of debt
obligations:

Corporate and emerging market bonds (CBOs)

Structured financial products, such as mortgage-backed

and asset-backed securities (structured finance CDOs)

Bank loans (collateralized loan obligations, or CLOs)

Credit default swaps (synthetic CDOs)

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COLLATERALIZED DEBT OBLIGATIONS (CDOS)
CDOs require a CDO manager (collateral manager) responsible
for buying or selling assets for the CDO’s portfolio.

CDO tranches
• Senior tranche
• Mezzanine tranche
• Subordinate/equity tranche

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 COLLATERALIZED DEBT OBLIGATIONS (CDOS)
Proceeds to meet the obligations to the CDO tranches (interest and principal
repayment) may come from the following:

Coupon interest payments of the underlying assets

Maturing assets in the underlying pools

Sale of assets in the underlying pool

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 CALCULATING A COLLATERALIZED
DEBT OBLIGATION
Example. Consider the following US$100 million CDO:
Tranche Par Value (US$) Coupon Rate
Senior 80,000,000 LIBOR + 70 bps
Mezzanine 10,000,000 10-year US Treasury
rate + 200 bps
Subordinated/equity 10,000,000

Assume the collateral consists of bonds that all mature in 10 years.

The coupon rate is the 10-year US Treasury rate + 400 bps.
The asset manager enters into an interest rate swap with a notional
amount of US$80 million. The asset manager agrees to 1) pay a fixed
rate each year equal to the 10-year Treasury rate + 100 bps and 2)
receive LIBOR.
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 CALCULATING A COLLATERALIZED
DEBT OBLIGATION
Example (continued)
• 10-year Treasury rate: 7%
• Interest from collateral: (7% + 4%) × $100 million = $11 million
• Interest to senior tranche: $80 million × (LIBOR + 70 bps)
• Interest to mezzanine tranche: $10 million × (7% + 2%) = $0.9 million
• Interest from swap counterparty: $80 million × LIBOR
• Interest to swap counterparty: 8% × $80 million = $6.4 million
• Net interest: $3.14 million

Now, suppose asset management fees are $640,000. Calculate cash

flow to subordinate/equity tranche and annual return.
• Cash flow: $3.14 million – $0.64 million = $2.5 million
• Return: $2.5 million/$10 million = 25% (assumes no defaults, no call)
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 9. SUMMARY
Benefits of securitization

• Allows investors direct access to liquid investments and

payment streams that would be unattainable if all the
financing were performed through banks.
• Enables banks to increase loan origination, monitoring, and
collections at economic scales greater than if they used only
their own in-house loan portfolios.
Securitization process
• The parties to a securitization include the special purpose
entity (SPE, also called the “trust”) that is the issuer of the
securities and the seller of the pool of loans (also called the
“depositor”).
• A common structure in a securitization is subordination,
which leads to the creation of more than one bond class or
tranche.
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© 2020 CFA Institute. All rights reserved.
 SUMMARY
Mortgage loans
• A mortgage loan 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.

Mortgage-backed securities
• There are two MBS sectors: (i) agency residential mortgage-
backed securities (RMBS), including those guaranteed by
the government or government-sponsored agencies, and (ii)
non-agency RMBS.
• The payments that are received from the collateral are
distributed to pay interest and repay principal to the security
holders as well as to pay servicing and other fees.

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© 2020 CFA Institute. All rights reserved.
 SUMMARY

Motivation for creating securitized structures with

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

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© 2020 CFA Institute. All rights reserved.
 SUMMARY

Commercial mortgage-backed securities

• Commercial mortgage-backed securities (CMBS) are
securities backed by a pool of commercial mortgage loans
on income-producing property.
• Two key indicators of the potential credit performance of
CMBS are the debt-to-service coverage ratio and the loan-
to-value ratio.
• CMBS have considerable call protection, which allows
CMBS to trade in the market more like corporate bonds than
like RMBS.

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© 2020 CFA Institute. All rights reserved.
 SUMMARY
Non-mortgage asset-backed securities
• The most popular non-mortgage ABS are auto loan
receivable-backed securities and credit card receivable-
backed securities.
• The collateral is amortizing for auto loan-backed securities
and non-amortizing for credit card receivable-backed
securities.
Collateralized debt obligations
• 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.
• 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 market return for
the equity holders.
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© 2020 CFA Institute. All rights reserved.