2021 Curriculum CFA Program Level I Fixed Income

Introduction

Previous readings examined risk characteristics of various fixed-income instruments and the relationships among maturity, coupon, and interest rate changes. This reading introduces an additional level of complexity—that of fixed-income instruments created through a process known as securitization. This process involves transferring ownership of assets from the original owners into a special legal entity. The special legal entity then issues securities backed by these assets, and the assets’ cash flows are used to pay interest and repay the principal owed to the holders of the securities. These securities are referred to generically as asset-backed securities (ABS); the pool of securitized assets from which the ABS’s cash flows are generated is called the collateral. Assets that are used to create ABS are called securitized assets. These assets are typically loans and receivables and include, among others, residential mortgage loans (mortgages), commercial mortgages, automobile (auto) loans, student loans, bank loans, accounts receivables, and credit card receivables. Advances and innovations in securitization have led to securities backed, or collateralized, by all kinds of income-yielding assets, including airport landing slots and toll roads.

This reading discusses the benefits of securitization, describes securitization, and explains the investment characteristics of different types of ABS. The terminology regarding ABS varies by jurisdiction. Mortgage-backed securities (MBS) are ABS backed by a pool of mortgages, and a distinction is sometimes made between MBS and ABS backed by non-mortgage assets. This distinction is common in the United States, for example, where typically the term “mortgage-backed securities” refers to securities backed by high-quality real estate mortgages and the term “asset-backed securities” refers to securities backed by other types of assets. Because the US ABS market is the largest in the world, much of the discussion and many examples in this reading refer to the United States. Note, however, that many non-US investors hold US ABS, including MBS, in their portfolios.

To underline the importance of securitization from a macroeconomic perspective, Section 2 discusses of the benefits of securitization for economies and financial markets. In Section 3, the reading describes securitization and identifies the parties involved in the process and their roles. Section 3 also discusses typical structures of securitizations, including credit tranching and time tranching. Sections 4–6 discuss securities backed by mortgages for real estate property. Many types of residential mortgage designs around the world are described in Section 4. Sections 5 and 6 focus on residential MBS and commercial MBS, respectively. Section 7 discusses ABS based on two types of non-mortgage loans that are typically securitized throughout the world: auto loans and credit card receivables. Collateralized debt obligations are covered in Section 8. Section 9 concludes the reading with a summary. 

Learning Outcomes

The member should be able to:

  • explain benefits of securitization for economies and financial markets;
  • describe securitization, including the parties involved in the process and the roles they play;

  • describe typical structures of securitizations, including credit tranching and time tranching;

  • describe types and characteristics of residential mortgage loans that are typically securitized;

  • describe types and characteristics of residential mortgage-backed securities, including mortgage pass-through securities and collateralized mortgage obligations, and explain the cash flows and risks for each type;

  • define prepayment risk and describe the prepayment risk of mortgage-backed securities;

  • describe characteristics and risks of commercial mortgage-backed securities;

  • describe types and characteristics of non-mortgage asset-backed securities, including the cash flows and risks of each type;

  • describe collateralized debt obligations, including their cash flows and risks.

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 than one bond class or tranche. Bond classes differ as to how they will share any losses resulting from defaults of the borrowers whose loans are in the collateral. The credit ratings assigned to the various bond classes depend on how the credit-rating agencies evaluate the credit risks of the collateral and any credit enhancements.

  • 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 commercial mortgages on income-producing property.

  • 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.

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