1. Asset-Backed Sector of the Bond Market

2. Asset-Backed Securities (ABS)
A security created by pooling loans other than mortgage loans is referred to as an asset-backed security (ABS).
There are certain types of mortgage loans that in the United States are classified as part of the asset-backed securities market: home equity loans and manufactured housing loans.
Two types of ABS: consumer asset-backed securities and commercial asset-backed securities.

3. Major Types of Consumer ABS
Home equity loans
Auto loans and leases
Credit card receivables
Manufactured housing loans
Student loans
Other consumer loans such as home improvement loans

4. Major Types of Commercial ABS
Trade receivables
Equipment leasing
Operating assets (aircraft, marine cargo containers)
Entertainment assets
Franchise loans
Small business loans

5. Fixed-Rate Versus Floating-Rate Assets
The assets that are securitized can have a fixed rate or a floating rate.
The type of rate chosen impacts the structure in terms of the coupon rate for the bonds issued.
For example, a structure with all floating-rate bond classes backed by collateral consisting of only fixed-rate contracts exposes bondholders to interest rate risk.
To deal with situations where there may be a mismatch between the cash flow characteristics of the asset and the liabilities, interest rate derivative instruments are used in a securitization.

6. Credit Risks Associated with Investing in ABS
Investors in ABS are exposed to credit risk and rely on rating agencies to evaluate that risk for the bond classes in a securitization.
While the three agencies have different approaches in assigning credit ratings, they do focus on the same areas of analysis.
Moody’s, for example, investigates:
asset risks
structural risks
third parties to the structure

7. Asset Risks
Evaluating asset risks involves the analysis of the credit quality of the collateral.
The rating agencies will look at the underlying borrower’s ability to pay and the borrower’s equity in the asset.
If there are a few borrowers in the pool that are significant in size relative to the entire pool balance, this diversification benefit can be lost, resulting in a higher level of credit risk referred to as concentration risk.

8. Structural Risks
The decision on the structure is up to the seller. Once selected, the rating agencies examine the extent to which the cash flow from the collateral can satisfy all of the obligations of the bond classes in the securitization.
In reflecting on the structure, the rating agencies will consider
the loss allocation
the cash flow allocation
the interest rate spread between the interest earned on the collateral and the interest paid to the bond classes plus the servicing fee,
the potential for a trigger event to occur that will cause the early amortization of a deal
how credit enhancement may change over time.

9. Third-Party Providers
In a securitization, third parties who are involved include:
credit guarantors (most commonly bond insurers)
the servicer
a trustee, issuer’s counsel
a guaranteed investment contract provider (this entity insures the reinvestment rate on investable funds)
accountants.
The rating agency will investigate all third-party providers.
For the third-party guarantors, the rating agencies will perform a credit analysis of their ability to pay.

10. Bonds Issued Prepayment tranching or time tranching
To redistribute the prepayment risk associated with the collateral.
A senior-subordinate structure or is referred to as credit tranching
To redistribute the credit risk associated with the collateral.

11. Classification of Collateral and Transaction Structure
Type of collateral: amortizing or non-amortizing
When amortizing assets are securitized, there is no change in the composition of the collateral over the life of the securities except for loans that have been removed due to defaults and full principal repayment or prepayment.
For an ABS transaction backed by non-amortizing assets, the composition of the collateral changes.

12. Credit Enhancements All asset-backed securities are credit enhanced.
Credit enhancement levels are determined relative to a specific rating desired by the issuer for a security.
Two types of credit enhancement structures: external and internal.

13. External Credit Enhancements
External credit enhancement involves a guarantee from a third party.
The most common third party is a monoline insurance company, which is referred to bond insurance or a wrap.
Two less common forms of external credit enhancement are a letter of credit form a bank and a guarantee by the seller of the assets.
There is credit risk in a securitization when there is a third-party guarantee because the downgrading of the third party.

14. Internal Credit Enhancements
The most common forms of internal credit enhancement:
1. Reserve funds
- cash reserve funds
- excess spread accounts
2. Over-collateralization
3. Senior/Subordinate structures

15. Over-Collateralization
Over-collateralization in a structure refers to a situation in which the value of the collateral exceeds the amount of the par value of the outstanding securities issued by the SPV.
For example, if
- $100 million par value of securities are issued and
- at issuance the collateral has a market value of $105 million, - there is $5 million in over-collateralization.
Over time, the amount of over-collateralization changes due to (1) defaults, (2) amortization, and (3) prepayments.

16. Senior/Subordinate Structure
The subordinate bond classes are also referred to as junior bond classes or non-senior bond classes
The creation of a senior/subordinate structure is to provide credit tranching.
The subordinate bond classes provide credit support for the senior bond classes.
For example, A (senior): $90 million, B (subordinate): $10 million.
The first $10 million in losses is absorbed by the subordinate bond class B.

17. Call Provisions
Call provision gives the issuer the right to retire the bond issue prior to the stated maturity date.
Asset-backed securities typically have call provisions.
The motivation is twofold.
The issuer (SPV) will want to take advantage of a decline in interest rates.
The trustee may want to call in the issue because the par value of a bond class is small and it is more cost-effective to payoff.

18. Home Equity Loans
A loan backed by residential property. Typically the borrower has either an impaired credit history and/or the payment-to-income ratio is too high for the loan to qualify as a conforming loan for securitization by Ginnie Mae, Fannie Mae, or Freddie Mac.
There are differences in the prepayment behavior for home equity loans and agency MBS.

19. Manufactured Housing-Backed Securities
In contrast to site-built homes, manufactured homes are built at a factory and then transported to a site.
Manufactured housing-backed securities are issued by Ginnie Mae and private entities.
Prepayments are more stable for manufactured housing-backed securities because they are not sensitive to refinancing. For reasons
1. The loan balances are typically small.
2. The rate of depreciation of mobile homes may be such that in the earlier years depreciation is greater than the amount of the loan paid off. This makes it difficult to refinance the loan.
3. Typically borrowers are of lower credit quality.

20. Auto Loan-Backed Securities
Auto loan-backed securities are issued by
1. the financial subsidiaries of auto manufactures
2. commercial banks
3. independent finance companies and small financial institutions specializing in auto loans
The loans are of high credit quality for the following reasons.
Prepayments due to repossession and subsequent resale are sensitive to the economic cycle.
Re-financings are of minor importance for auto loans.

21. Auto Loan-Backed Securities--- Measuring Prepayments
Prepayments for auto loan-backed securities are measured in terms of the absolute prepayment speed, denoted by ABS. (For historical reason.)
The ABS is the monthly prepayment expressed as a percentage of the original collateral amount.
The relationship between the SMM and the ABS is

22. Credit Card Receivable-Backed Securities
A credit card receivable-backed security is a non-amortizing security.
During the lockout period or revolving period, the principal payments made by credit card borrowers comprising the pool are retained by the trustee and reinvested in additional receivables to maintain the size of the pool.
The lockout period can vary from 18 months to 10 years.
After the lockout period, the principal is no longer reinvested but paid to investors.
There are three different amortization structures that have been used in credit card receivable-backed security deals: (1) passthrough structure, (2) controlled-amortization structure, and (3) bullet-payment structure.

23. 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:
1. U.S. domestic high-yield corporate bonds
2. structured financial products
3. emerging market bonds
4. bank loans
5. special situation loans and distressed debt.

24. CBO and CLO
When the underlying pool of debt obligations are bond-type instruments (high-yield corporate, structured financial products, and emerging market bonds), a CDO is referred to as a collateralized bond obligation (CBO).
When the underlying pool of debt obligations are bank loans, a CDO is referred to as a collateralized loan obligation (CLO).

25. Structure of a CDO
There is an asset manager responsible for managing the portfolio of debt obligations.
There are restrictions imposed as to what the asset manager may do and certain tests that must be satisfied.
The funds to purchase the collateral assets are obtained from the issuance of debt obligations, including: senior tranches, mezzanine tranches, and subordinate/equity tranche.
A CDO may or may not have mezzanine tranche.

26. Structure of a CDO (Continued)
For the senior tranches, at least an A rating is typically sought.
For the mezzanine tranches, a rating of BBB but no less than B is sought.
The subordinate/equity tranche receives the residual cash flow; hence, no rating is sought for this tranche.

27. Structure of a CDO (Continued)
The proceeds to meet the obligations to the CDO tranches can come from
1. coupon interest payments of the underlying assets
2. maturing assets in the underlying pool, and
3. sale of assets in the underlying pool
In a typical structure, one or more of the tranches is a floating-rate. Interest rate swaps are required to eliminate the mismatch between floating-rate and fixed-rate.

28. Family of CDOs Cash CDOs and Synthetic CDOs
Both a cash CDO and a synthetic CDO are further divided based on the motivation of the sponsor:
- arbitrage CDOs
- balance sheet CDOs.
Cash CDOs that are arbitrage transactions are further divided in
- cash flow CDOs
- market value CDOs.

29. Cash Versus Synthetic Structures
CDOs are also classified in terms of cash CDO structures and synthetic CDO structures.
The latter involve the use of credit derivatives.

30. Arbitrage Versus Balance Sheet Transactions
The categorization depends on the motivation of the sponsor of the transaction.
In an arbitrage transaction, the sponsor seeks to earn the spread between the higher yield received on the collateral assets and the lower yield paid to the various tranches in the structure.
In a balance sheet transaction, the sponsor’s motivation is to remove debt instruments from its balance sheet.

31. Arbitrage Transactions
The key as to whether it is economically feasible to create an arbitrage CDO is whether a structure can offer a competitive return for the subordinate/equity tranche.
In determining whether or not to create a CDO, dealers will look to see if there is a potential return available to the equity tranche of a minimum amount.

32. Types of Arbitrage Transactions
Arbitrage transactions can be divided into two types depending on the primary source of the proceeds from the collateral to satisfy the obligation to the tranches.
If the primary source is the interest and maturing principal from the collateral, then the transaction is referred to as a cash flow transaction.
If instead the proceeds to meet the obligations depend heavily on the total return generated from the collateral (i.e., interest income, capital gain, and maturing principal), then the transaction is referred to as a market value transaction.

33. Cash Flow Transactions
In a cash flow transaction, the objective of the collateral manager is to generate cash flow for the senior and mezzanine tranches without the need to actively trade bonds.
There are three relevant periods.
The first is the ramp-up period.
This is the period that follows the closing date of the transaction where the collateral manager begins investing the proceeds from the sale of the debt obligations issued.
This period usually lasts from one to two years.
The reinvestment period or revolving period is where principal proceeds are reinvested
This period usually lasts for five or more years.
In the final period, the collateral is sold and the debtholders are paid off.

34. Cash Flow Transactions (continued)
Income is derived from interest income from the collateral assets and capital appreciation.
The income is used as follows.
Payments are first made to the trustee and administrators and then to the senior collateral manager.
Once these fees are paid, then the senior tranches are paid their interest.
At this point, before any other payments are made, certain tests must be passed.
These tests are called coverage tests.
If the coverage tests are passed, then interest is paid to the mezzanine tranches.
Once the mezzanine tranches are paid, interest is paid to the subordinate/equity tranche.

35. Cash Flow Transactions (continued)
The principal cash flow is distributed as follows after the payment of the fees to the trustees, administrators, and senior managers.
If there is a shortfall in interest paid to the senior tranches, principal proceeds are used to make up the shortfall.
After all the debt obligations are satisfied in full, if permissible, the equity investors are paid.
Management is permitted to share on some prorated basis once the target return is achieved.

36. Restrictions on Management: Quality Tests
In rating a transaction, the rating agencies are concerned with the diversity of the assets.
Consequently, there are tests that relate to the diversity of the assets and these tests are called quality tests .
Quality tests consider:
maturity restrictions
restrictions imposed on the concentration of bonds in certain countries or geographical regions for collateral consisting of emerging market bonds
A diversity score is a measure that is constructed to gauge the diversity of the collateral’s assets.

37. Restrictions on Management: Quality Tests
There are two types of coverage tests to ensure that the performance of the collateral is sufficient to make payments to the various tranches.
These two types are called par value tests and interest coverage ratio tests.
A par value test specifies that the par value of the collateral be at least a specified percentage above the liability to the bondholders.

38. Restrictions on Management: Quality Tests
The percentage in the par value test is called the trigger, and the trigger is different for each rated bond.
Specifically, the trigger declines as the rating declines.
While par value tests focus on the market value of the collateral relative to the par value of the bonds issued, interest coverage tests look at the ability to meet interest payments when due.

39. Market Value Transactions
In a market value transaction, the cash flow generated to pay the bondholders depends upon the ability of the collateral manager to maintain and improve the market value of the collateral.
Funds to be used for liability principal payments are obtained from liquidating the collateral.
The collateral manager focuses on maximizing total return while minimizing volatility.
Ratings are based on price volatility, liquidity, and market value of the collateral assets.

40. Market Value Transactions (continued)
The order of priority of the principal payments in the capital structure is as follows.
Fees are paid first for trustees, administrators, and managers.
After these fees are paid, the senior facility class and the senior notes class are paid.
The senior-subordinated notes would be paid, followed by the subordinated notes.
All of this assumes that the overcollateralization tests are satisfied.
If not, the senior notes are then paid down until the overcollateralization tests are brought into compliance.

41. Market Value Transactions (continued)
When rating a cash flow transaction, the rating agencies look at the ability of the collateral to generate sufficient current cash flow to pay interest and principal on rated notes issued by the CDO.
The ratings are based on the effect of collateral defaults and recoveries on the receipt of timely interest and principal payments from the collateral.
If the overcollateralization tests are not met, then cash flow is diverted from the mezzanine and subordinated classes to pay down senior notes, or cash flow is trapped in a reserve account.
Failing the overcollateralization tests does not force sale of the collateral.

42. Overcollateralization Tests
Overcollateralization tests in market value transactions are based on the market value of the collateral, not the par value.
The advance rates are the key in the overcollateralization tests and critical in market value transactions.
Advance rates are determined by the rating agencies based on a combination of three factors:
price volatility
correlation among securities
liquidity
There is then an advance rate assigned to each asset type based on the structure of the transaction, and the composition of the collateral.

43. Overcollateralization Tests
Suppose that the collateral consists of three asset types with the assumed advance ratings for the particular rating sought for a tranche (shown in the next page)
The market value of the collateral is $100 million. The adjusted market value that must be used in the overcollateralization tests for this tranche would then be found by multiplying the market value of an asset type by the advance rate and then summing over all asset types. So, for our hypothetical collateral, the adjusted market value is found as follows:
($50M × 0.80) + ($30M × 0.75) + ($20M x 0.70) = $76,500,000

44. Asset Type Market Value Advance Rate
Performing High-Yield Bonds Rated Baa $50 million
Performing High-Yield Bonds Rated B $30 million
Performing High-Yield Bonds Valued Below Caa $20 million

45. Cash CDOs
A cash CDO is backed by a pool of cash market debt instruments.
In an arbitrage transaction, the motivation of the sponsor is to earn the spread between the yield .
In a balance sheet transaction, the motivation of the sponsor is to remove debt instruments from its balance sheet.
In a cash flow CDO the primary source is the interest and maturing principal from the underlying assets.
In a market value CDO the proceeds to meet the obligations depend heavily on the total return generated from the portfolio.

46. An Example---Cash CDO Arbitrage
Tranche Par Value Coupon Rate
Senior $80,000,000 LIBOR + 70 basis points
Mezzanine 10,000, year Treasury rate bps
Subordinate/Equity 10,000,
The collateral consists of bonds that all mature in 10 years and the coupon rate for every bond is the 10-year Treasury rate plus 400 basis points.
The asset manager enters into an interest rate swap agreement with another party with a notional amount of $80 million in which it agrees to do the following:
- pay a fixed rate each year equal to the 10-year Treasury rate plus 100 bps
- receive LIBOR

47. An Example---Cash CDOs (Continued)
Received:
Interest from collateral: $100 million * (T-rate + 4%)
Interest from swap : $80 million * LIBOR
Paid:
Interest to senior tranche: $80 million * (LIBOR + 0.7%)
Interest to mezzanine tranche: $10 million * (T-rate + 2%)
Interest to swap: $80 million * (T-rate + 1%)
Total interest received: ($100 million * T-rate) + $4 million + ($80 million * LIBOR)
Total interest paid: ($90 million * T-rate) + $1.56 million + ($80 million * LIBOR)
Net interest: ($10 million * T-rate) + $2.44 million

48. Synthetic CDOs
A long position in a corporate bond has essentially the same credit risk as the seller of protection in a credit default swap.
A synthetic CDO is a CDO where the investor has the economic exposure to a pool of debt instrument via a credit derivative instrument.
Instead, a portfolio of credit default swaps is sold and the the resulting credit risks are allocated to tranches.
As with a cash CDO structure, liabilities are issued. The proceeds received will be invested in assets with low risk.

49. Payoff if there is a default by reference entity=100(1-R)
CDS Structure
90 bps per year
Default
Protection
Buyer, A
Default
Protection
Seller, B
Payoff if there is a default by reference entity=100(1-R)
Recovery rate, R, is the ratio of the value of the bond issued by reference entity immediately after default to the face value of the bond 49

50. Credit Default Swaps
Buyer of the instrument acquires protection from the seller against a default by a particular company or country (the reference entity)
Example: Buyer pays a premium of 90 bps per year for $100 million of 5-year protection against company X
Premium is known as the credit default spread. It is paid for life of contract or until default
If there is a default, the buyer has the right to sell bonds with a face value of $100 million issued by company X for $100 million (Several bonds may be deliverable) 50

51.  Cash CDO Structure Tranche 4 Loss >25% Bond 1 Yield = 6% Bond 2
Bond n
Average Yield
8.5%
Tranche 3
Losses: 15-25%
Yield = 7.5%
Trust
Tranche 2
Losses: 5-15%
Yield = 15%
Tranche 1
Losses: 0-5%
Yield = 35% 51

52. Synthetic CDOs (continued)
As with a cash CDO structure, liabilities are issued.
The proceeds received from the tranches will be invested by the collateral manager in assets with low risk.
In addition, the collateral manager will enter into a credit default swap with another entity in which it will provide credit protection.
Because it is selling credit protection, the collateral manager will receive the credit default swap fee. 52

53. Synthetic CDOs (continued)
If a credit event does not occur, the return realized by the collateral manager that will be available to meet the structure’s obligations will be the return on the collateral consisting of low risk assets plus the fee received from the credit default swap.
If there is a default on any of the referenced assets, the collateral manager must make a payment to the counterparty.
This reduces the return available to meet the structure’s obligations. 53

54. Synthetic CDOs (continued)
There are structures that include elements of both cash flow and synthetic transactions.
That is, with the proceeds obtained from the sale of the bond classes, the collateral manager
uses a portion to purchase for the portfolio bonds and/or loans (as in a cash flow transaction)
invests the balance in high-quality debt instruments (as in a synthetic transaction)
sells credit protection on selected reference entities (as in a synthetic transaction) 54