1. Commercial Mortgages, CMBS, ABS, CDO
Commercial Mortgages & MBS – Ch14
ABS -- Ch15
Collateralized debt obligations – Ch16
Ch14-15

2. Commercial Mortgages
A commercial mortgage loan is originated to finance a commercial purchase or to refinance a prior mortgage obligation.
Commercial mortgage loans are for income-generating properties, including
Multifamily properties (apartment buildings)
Office building
Industrial properties
Shopping centers
Hotel
Health care facilities
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3. Characteristics of C. Mortgages
Commercial mortgage loans are non-recourse loans – lenders can only look to the income-producing property backing the loan for interest and principal repayments.
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4. Performance Indictors
Debt-to-service coverage ratio (DSC)
The ratio of property’s net operating income (NOI) divided by the debt service
NOI = rental income – cash operating expenses
Critical value is 1
Loan-to-value ratio
Value is the present value of the expected cash flow, different from market value or appraised value for residential mortgage
Valuation requires projecting an asset’s cash flow (NOI) and discounting at an appropriate interest rate (capitalization rate)
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5. Call Protection Prepayment lockout (2-10 years) Defeasance
The borrower provides sufficient funds for the servicer in a portfolio of treasury securities that replicates the cash flows that
Prepayment Penalty Points ( )
Yield Maintenance Charge
A yield to make the lender indifferent as to the timing of prepayments. The charge is based on the difference between the mortgage coupon and the prevailing Treasury rate.
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6. CMBS
A commercial mortgage-backed security is a security backed by one or more commercial mortgage loans. It can be issued by agency or none agency backed.
Ginnie Mae-issued securities are backed by FHA, called project loans
The purpose is to provide funding for commercial mortgages
Single borrower/multi-property deals and multi-borrower deals
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7. CMBS vs RMBS Much lower prepayment risk for CMBS
Lower probability of default for CMBS – the loan can be transferred by the servicer to a special servicer when the borrower is in default, imminent default, or in violation of covenant, who has the responsibility to modify the loan terms in case of an imminent default to reduce the likelihood of default.
Servicer: collecting monthly loan payments, keeping records related payments, maintaining property escrow for taxes and insurance …
Special servicer: duties arise when a loan becomes more than 60 days past due
See page 324
Investors of CMBS typically are knowledgeable real estate investors and they have reviewed the proposed pool of mortgages when the structure is being created.
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8. Asset-backed Securities
Definition: A security created by pooling loans other than residential prime mortgage loans and commercial mortgage loans is referred to as an asset-backed security.
Categorizing ABS:
Existing asset securitizations or future flow securitizations
Consumer ABS and commercial ABS
Consumer ABS
Commercial ABS
Home equity loan
Trade receivables (health care rec.)
Auto loan and leases
Equipment leasing
Credit card receivables
Operating assets (e.g., aircrafts, cargo containers)
Tariff receivables
Entertainment assets (film rights, music royalties)
Manufactured housing loans
Franchise loans
Student loans
Small business loans
Home improvement loans
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9. Creation of an ABS 1. Granting a loan 2. Securitization process
Underwriting standards
Originator of a loan
2. Securitization process
Special purpose vehicle (SPV): the ABS issuer
Legal implication: rating of ABS will be independent of the originator (page 356)
Conduit: the party who buys the loans and sell them to SPV.
3. Credit enhancements
External – bond insurance (page 358)
Internal
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10. Two-step Securitizations
Intermediate SPV (known as the depositor)
A wholly owned subsidiary of the originator
Purchase assets from the originator
Sell the assets to second SPV
Second SPV (known as the issuer)
Issue the ABS
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11. Roles of SPV The potential for reducing funding costs (page 334)
To diversify funding sources
To accelerate earnings for financial reporting purposes
For regulated entities, potential relief from capital requirements.
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12. Credit Enhancement of ABS
External credit enhancement
Guaranty from third party like bond insurance
Internal credit enhancement
Cash flow waterfall (or simply waterfall)
-- cash flow to senior bondholders first, then to lower priority classes.
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13. Collateral Type and Securitization Structure
Amortizing assets
Nonamortizing assets -- page 336
Amortization schedule
Amortization period – page 336
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14. Credit Risks with ABS Asset risk Structure risk
Credit quality
Concentration risk
Structure risk
-- make sure if the collateral’s cash flows match the payments that must be made to satisfy the issuer’s obligations.
Third-party providers
-- Page
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15. Credit Card Receivable-Backed Securities
This is an example of ABS -- Page 340.
Credit card issuers have receivables
financing charges collected, fees and principals.
IBs use the future cash flows from credit card receivables as collaterals to issue ABS or CDOs
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16. Other types of ABS Auto loan-backed securities Rate reduction bonds
Prepayment is a concern
Rate reduction bonds
Backed by a special charge (tariff) included in the utility bills of utility customers.
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17. Dodd-Frank Wall Street Reform and Consumer Protection Act
Securitizers retain a portion of the transaction’s credit risk
Reporting standards and disclosure for a securitization transaction
The representation and warranties required to be provided in securitization transactions and the mechanisms for enforcing them
Due diligence requirement with respect to loans underlying securitization transactions
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18. Collateralized Debt Obligations
A security backed by a diversified pool of one or more of the following types of debt obligations
U.S. domestic investment-grade and high-yield corporate bonds
U.S. domestic bank loans
Emerging market bonds
Special situation loans and distressed debt
Foreign bank loans
Asset-backed securities
Residential and commercial mortgage-back securities
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19. Structure of A CDO Collateral managers Collateral Collateral assets
The funds to purchase collateral assets come from the issuance of debt obligations.
Structure of debt obligations
Senior tranches
Mezzanine tranches
Subordinate/equity tranches
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20. Categories of CDOs Arbitrage transactions
when the motivation of the sponsor is to earn the spread between the yield offered on the collateral and the payments made to the various tranches
Balance sheet transactions
when the motivation is to remove debt instruments (primarily loans) from its balance sheet, typically financial institutions such as banks seeking to reduce their capital requirement specified by bank regulators
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21. Cash vs Synthetic Structures
Synthetic CDO structures involve the use of credit derivatives.
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22. Arbitrage Transactions
Create an arbitrage CDO is whether a structure can offer a competitive return for the subordinate/equity tranche as below:
Tranche
Par Value
Coupon Value
Coupon Rate
Senior
$80,000,000
Floating
LIBOR+70 basis points
Mezzanine
$10,000,000
Fixed
Treasury rate basis point
Subordinate/Equity

23. Assumptions The collateral of the CDO: To finance the senior tranche,
bonds that all mature in 10 years
The coupon rate for every bond is a fixed rate
The fixed rate at the time of purchase of cash bond is the 10 year treasury plus 400 basis points
To finance the senior tranche,
collateral manager enters into an interest-rate swap with another party with a notional principal 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 basis points
Receive LIBOR
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24. Cash flows
Assuming the 10-year rate at the time the CDO is issued is 7%.
Interest received from collatoral:
Interest to senior tranche:
Interest to mezzanine tranche:
Interest to swap counterpart:
Interest received from swap counter part
As a result,
Total interest received:
Total interest paid:
Net interest
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25. Synthetic CDOs
In a synthetic CDO, the collateral absorbs the economic risk associated with specified assets but does not have legal ownership of those assets
Requires the use of CDS
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