Nonagency Residential MBSs, Commercial MBSs, and Other Asset-Backed Securities 1
Other Securitized Assets Ø Agency MBSs represent the largest and most extensively developed asset-backed security. Ø Since 1985, a number of other asset-backed securities have been developed. Ø The most common types are nonagency residential MBS, commercial MBSs, and asset-backed securities backed by automobile loans, credit card receivables, and home equity loans. Ø These asset-backed securities are structured as pass-through and many have prepayment tranches. Ø Different from agency MBSs, though, the collateral backing these asset -backed securities are subject to credit and default risk. 2
Nonagency Residential MBS 3
Nonagency Residential MBS Ø MBS created by one of the agencies are collectively referred to as agency MBSs, and those created by private conduits are called nonagency MBSs or private labels. 4
Nonagency Residential MBS Ø Agency residential MBSs are created from conforming loans. Ø All other mortgages that are securitized are nonagency MBSs. Ø Nonagency residential MBSs can, in turn, be classified as either prime MBSs, in where the underlying mortgages are all prime, or subprime MBSs, where the underlying mortgage pool consists of subprime mortgages. Ø In grouping the different types of securitized assets (residential mortgages, commercial mortgages, and other assets) nonagency subprime MBSs are typically grouped with asset-backed securities and not mortgage-backed securities. 5
Default Loss and Credit Tranches Ø Nonagency MBSs or nonagency CMOs are subject to default losses. Ø A portfolio of 30 -year, 8% mortgages with a 100 standard default assumption (SDA) has a cumulative default rate after 120 months of 3. 59% and one with a 300 SDA has a cumulative default rate of 10. 46%. Ø Different from agency MBSs, investors of nonagnecy MBS need to taken into account the expected default losses in determining the credit spread for pricing such securities. 6
Projected Cash Flows with Default Loss Mortgage Portfolio = $100, 000, WAC = 8%, WAM = 360 Months, 100 SDA Model 7
Cumulative Default Rates 100, 200, and 300 SDA Models Mortgage Portfolio = $100, 000, WAC = 8%, WAM = 360 Months 8
Default Loss and Credit Tranches Ø MBS conduits address credit risk on nonagency MBSs by providing credit enhancements designed to absorb the expected losses from the underlying mortgage pool resulting from defaults. Ø For nonagency MBSs or CMOs, credit enhancement include: 1. Senior-Subordinate Structures 2. Excess Spreads 3. Overcollateralization 4. Monoline Insurance 9
Senior-Subordinate Structures Ø A MBS issue with a senior-subordinate structure is formed with two general bond classes: a senior bond class and a subordinated bond class, with each class consisting of one or more tranches. Ø The next slide shows a $500 million senior-subordinate structured MBS with one senior bond class with a principal of $400 million and six subordinate or junior classes with a total principal of $100 million. 10
Senior-Subordinate Structures Bond Class Senior Subordinate Subordinate Tranche 1 2 3 4 5 6 7 Principal $400 million $40 million $20 million $10 million Credit Ratings AAA AA A BBB BB B Not Rated 11
Senior-Subordinate Structures Ø For this MBS issue, the default losses are absorbed first by Tranche 7 (starting at the bottom) and ascend up. Ø If losses on the collateral are less than $10 million, then only Tranche 7 will experience a loss Ø If losses are $30 million, then Tranches 7, 6, and 5 will realize losses Ø The senior-subordinated structured MBS spreads the credit risk amongst the bond classes. This is referred to as credit traunching. 12
Senior-Subordinate Structures Waterfalls Ø The rules for the distribution of the cash flows that include the distribution of losses are referred to as the cash flow waterfalls or simply waterfalls. Ø Because of the different levels of default risk, each of the subordinate tranches created in a senior-subordinate structured MBS are separately rated by Moody’s or Standard and Poor’s, with the lower tranches receiving lower ratings. 13
Senior-Subordinate Structures Senior Interest Ø The proportion of the mortgage balance of the senior bond class to the total mortgage deal is referred to as senior interest (initial senior interest = $400 m/$500 m =. 80). Subordinate Interest Ø The proportion of the mortgage balance of the subordinated bond classes to the total mortgage deal is referred to as subordinate interest (initial subordinate interest = $100 m/$500 m =. 20). Ø The greater the subordinate interest, the greater the level of credit protection for the senior bond. 14
Senior-Subordinate Structures Shifting Interest Schedule Ø Over the life of the MBS deal, the level of credit protection will change as principal is prepaid. Ø In general, with prepayment, senior interest will increase and the subordinate interest will decrease over time. Ø Because of this, most senior-subordinate structured MBS deals have a shifting interest schedule designed to maintain the credit protection for the senior bond class. 15
Senior-Subordinate Structures Shifting Interest Schedule Ø Shifting interest schedule is used to determine the allocation of prepayment that goes to the senior and subordinate tranches. Ø Example: Shifting Interest Schedule Years after Issuance 1 -5 6 7 8 9 10 After 10 Shifting Interest Percentage 100% 70% 60% 40% 20% 10% 0 16
Senior-Subordinate Structures Shifting Interest Schedule Ø In determining the allocation to the senior holders, their percentage of prepayment is equal to their initial senior interest (for example, 80% = $400 m/$500 m) plus the shifting interest (based on the schedule) times the subordinate interest (20% = ($100 m/$500 m): Senior prepayment Percentage = Initial Senior Interest Percent Initial + Subordinate Interest x Shifting Interest Proportion 17
Senior-Subordinate Structures Shifting Interest Schedule Senior prepayment Percentage = Initial Senior Interest Percent Initial + x Subordinate Interest Shifting Interest Proportion Ø Initial senior interest = $400 m/$500 m =. 80 Ø Initial subordinate interest = $100 m/$500 m =. 20 Years after Issuance Shifting Interest Percentage 1 -5 6 7 8 9 10 After 10 100% 70% 60% 40% 20% 10% 0 Ø Based on the above schedule: Ø 100% of the prepayment would go to the senior class for the first five years (= 80% + (1)(20%) = 100%) Ø 96% in year 6 (= 80% + (20%)(. 70) Ø 92% in year 7, and so on. Ø After year 10, the allocation of principal between senior and subordinate classes would match 18 their initial senior and subordinate interest proportions of 80% and 20%.
Senior-Subordinate Structures Step-Down Provision Ø The shifting-interest schedule from 100% to 70% in year 6, to 60% in year 7, to finally 0% after year 10 is known as a step-down provision; such a provision allows for reductions in the credit support over time. 19
Senior-Subordinate Structures Ø In many senior-subordinated structured MBS deals, provisions are included that allow for changes in the shifting interest schedule if credit conditions related to the underlying collateral deteriorate. Ø Typically, the provisions prohibit the step-down provision in the shifting interest schedule from occurring if certain performance measures are not met. Ø For example, if the cumulative default losses exceed a certain limit of the original balance or if the 60 -day delinquency rate exceeds a specified proportion of the current balance, then step downs would not be allowed. 20
Excess Interest Ø Excess interest (or excess spread) is the interest from the collateral that is not being used to pay MBS investors and fees (mortgage servicing and administrative services). Ø The excess spread can be used to offset any losses. Ø If the excess interest is retained, it can be accumulated in an account and used to offset futures default losses. Ø When this is done, the excess interest can be set up similar to a notional interest-only (IO) class, with the proceeds going to a reserve account and paid out to IO holders at some future date if there is an excess. 21
Overcollateralization Ø Overcollateralization is having the par value of the collateral exceeds the value of the MBS issued. Ø For example, if the MBS issue of $500 million had $550 million in collateral. Ø The $50 million excess would then be used to absorb default losses. 22
Monoline Insurance Companies Ø Some Nonagency MBSs also have external credit enhancements in the form of insurance provided by Monoline insurance companies. Ø Monoline insurance companies: Finance Guarantee Insurance Corporation, the Capital Markets Insurance Corporation, or the Financial Security Assurance Company. Ø The guarantees provided by monoline insurers, in turn, shifts the default risk to the insurer. 23
Commercial MBS 24
Commercial Mortgages Commercial Mortgage Loans Ø Real estate property can be either residential or nonresidential. Ø Residential includes houses, condominiums, and apartments; it is classified as either single-family or multiple-family. Ø Nonresidential includes commercial and agricultural property. Ø Commercial real estate loans are for income-producing properties. They are used to finance the purchase of the property or to refinance an existing one. 25
Commercial Mortgages Ø Commercial property can include: 1. 2. 3. 4. 5. 6. 7. Shopping centers Shopping strips Multifamily apartment buildings Industrial properties Warehouses Hotels Health care facilities 26
Commercial Mortgages Non-Recourse Ø In contrast to residential mortgages where the interest and principal payments come from borrowers’ incomegenerating ability or wealth, commercial mortgage loans come from income produced from the property. Ø As such, commercial mortgage loans are referred to as non-recourse loans. 27
Commercial Mortgages Assessing Credit Quality Ø Lenders in assessing the credit quality of commercial loans look at Ø The debt-to-service ratio (= Rental Income – operating expenses)/ Interest Payments) Ø The loan-to-value ratios, where value is equal to the present value of expected cash flows or the appraised value. 28
Commercial Mortgages Prepayment Protection Ø Commercial mortgage loans also differ from residential mortgage loans in that they typically have prepayment protection. Ø Prepayment protection can take the form of prepayment penalties, provisions prohibiting prepayment for a specified period, and defeasance. Ø Note: Defeasance is an agreement whereby the borrower agrees to invest funds in risk-free securities in an amount that would match the cash flows of a prepayment schedule. 29
Commercial Mortgages Balloon Risk Ø Unlike residential mortgage loans in which the principal is amortized over the life of the loan, commercial mortgage loans are typically balloon loans. Ø At the balloon date, the borrower is therefore obligated to pay the remaining balance. This is typically done by refinancing. Ø As a result, the lender is subject to balloon risk: The risk that the borrower will not be able to make the balloon payment because they either cannot refinance or sell the property at a price that will cover the loan. 30
Commercial Mortgages Special Servicer Ø With many commercial property loans, there is a special servicer who takes over the loan when default is imminent. Ø These servicers have the responsibility to try modify the loan terms to avert default. 31
Commercial Mortgage-Backed Security Ø Commercial Mortgage-Backed Security (CMBS) is a security backed by one or more commercial mortgage loans. Ø Some CMBSs are backed by Fannie Mae, Freddie Mac, and Ginnie Mae. These agency CMBSs are limited to multifamily mortgages and healthcare facilities. Ø Most CMBSs are private labels formed by either a single borrower with many properties or by a conduit with multiple borrowers. 32
Commercial Mortgage-Backed Security Features Ø Similar to nonagency residential MBSs, many CMBSs have Ø Credit tranches (senior-subordinated structures) Ø Credit enhancements (overcollaterialization, excess interests, and monocline insurance) Ø Prepayment tranches (sequential-pay, PACs, notional interest-only (NIO), floaters, etc. ) 33
Commercial Mortgage-Backed Security Features Ø One feature common to residential and commercial mortgage-backed securities is cross-collateralization: property used to secure one loan is also used to secure the other loans in the pool. Ø Cross-collateralization prevents the MBS investors/lenders from calling the loan if there is a default, provided there is sufficient cash flows from the other loans to cover the loan’s default loss. Such protection is called cross-default protection. 34
Commercial Mortgage-Backed Security Features Ø Commercial MBS can be formed with a fewer number of loans than residential MBS and with some loans being more important to the pool than others. Ø As a result, commercial MBSs often have less cross-default protection. Ø To redress this, some commercial MBSs include a property release provision that requires the borrower of a commercial loan to pay a premium (e. g. 105% of par) if the property is removed from the pool. Ø The provision is aimed at averting potential deterioration in the overall credit quality of the collateral when the best property in the pool is prepaid. 35
Commercial Mortgage-Backed Security Single Borrower with Multiple Properties Ø CMBSs can be formed from a single borrower with multiple properties. Ø These deals are often set up by large real estate developers who use commercial MBSs as a way to finance or refinance their numerous projects: shopping malls, office buildings, hotels, apartment complexes, and the like. 36
Commercial Mortgage-Backed Security Conduit Deals Ø The other type of commercial MBS deal is one in which there are multiple borrowers or originators with the MBS set up through a conduit—a conduit deal. Ø When the deal has one large borrower or property combined with a number of smaller borrowers, the deal is referred to as a fusion conduit deal. 37
Commercial Mortgage-Backed Security Conduit Deals Ø Conduit deals are often structured by large banks such as Bank of America, Well Fargo, or J. P, Morgan. Ø Note: It is not uncommon for the conduit deal to be used to finance properties totaling as much as $1 billion, with as many as 200 property loans, varying in type (office, multi, warehouses, etc. , ), geographical distributions, and credit enhancements. 38
Commercial Mortgage-Backed Security Conduit Deals Ø With such large deals, there are different servicing levels. Ø For example, there may be subservicing by the local originators who are required to collect payments and maintain records, a master servicer responsible for overseeing the commercial MBS deal, and a special servicer responsible for taking action if a loan becomes past due. 39
Commercial Mortgage-Backed Security CMBS Investors Ø Commercial MBS investors include institutional investors. Ø These investors, in turn, evaluate a commercial MBS issue not only in terms of issue’s general sensitivity to economic conditions and interest rates, but also assess each income-producing property on an ongoing basis. 40
Asset-Backed Securities 41
Asset-Backed Securities Ø Asset-Backed Securities (ABSs) are securities created from securitizing pools of loans other than residential prime mortgage loans and commercial loans; as noted, residential subprime MBS are included in the ABS category. 42
Asset-Backed Securities Ø Loans used to create ABSs include 1. Home Equity Loans 2. Credit Card Receivables 3. Home Improvement Loans 4. Trade Receivables 5. Franchise Loans 6. Small Business Loans 7. Equipment Leases 8. Operating Assets 9. Subprime Mortgages 43
Asset-Backed Securities Ø Like most securitized assets, ABS can be structured with different prepayment and credit tranches and can include different credit enhancements. Ø The three most common types of ABSs are those backed by: 1. Automobile Loans 2. Credit Card Receivables 3. Home Equity Loans 44
Automobile Loan-Backed Securities Ø Automobile loan-backed securities are often referred to as CARS (certificates for automobile receivables). Ø They are issued by the financial subsidiaries of auto manufacturing companies, commercial banks, and finance companies specializing in auto loans. 45
Automobile Loan-Backed Securities Ø The automobile loans underlying these securities are similar to mortgages in that borrowers make regular monthly payments that include interest and a scheduled principal. Ø Also like mortgages, automobile loans are characterized by prepayment. For such loans, prepayment can occur as a result of 1. Car sales 2. Trade-ins 3. Repossessions 4. Wrecks 5. Refinancing when rates are low 46
Automobile Loan-Backed Securities Ø CARS differ from MBSs in that they have 1. Shorter maturities 2. Their prepayment rates are less influenced by interest rates than mortgage prepayment rates 3. They are subject to greater default risk 47
Prepayment Ø The prepayment for auto loans is typically measured in terms of the absolute prepayment speed (APS). Ø APS measures prepayment as a percentage of the original collateral amount, instead of the prior period’s balance. Ø The relation between APS and the monthly prepayment rate (single monthly mortality rate maturity, SMM) is where M = month. 48
Prepayment Ø If the absolute prepayment speed is 2%, then the monthly prepayment rate in month 25 is 3. 8462%: 49
Installment Sales Contracts Ø A large part of auto manufacturers’ sales are sold from installment sales contracts, with the company’s credit department (often a financial subsidiary) making: Ø Administrative decisions on extending credit Ø Setting underwriting standards Ø Originating loans Ø Later servicing the loans 50
Special Purpose Vehicles Ø Automobile loan-backed securities are often created from installment sales loans and typically issued by special purpose vehicles (SPV) created by the manufacturer or its financial subsidiary; the financial subsidiary may also be set up as a special purpose vehicle. 51
Special Purpose Vehicles Example Ø A car manufacturer might have $500 million of installment loans resulting from monthly car sales. Ø The manufacturer could set up (or may already have set up) an SPV to sell the installment loans for $500 million cash. Ø The SPV would then sell the $500 million in securities backed by the loans as ABSs. 52
Special Purpose Vehicles Advantage of SPV over Issuing Debt Ø Instead of securitizing the installment loans as ABS through an SPV, the auto manufacturer could have alternatively raised $500 million by issuing corporate notes, either as a debenture or collateralized by the installment loans. Ø If the manufacturer were to default, though, all of its creditors would be able to go after all of its assets. 53
Special Purpose Vehicles Advantage of an SPV over Issuing Debt Ø If the manufacturer sells the installment loans to its SPV, though, the SPV owns the loans/assets and not the manufacturer. Ø Thus, if the manufacturer were forced into bankruptcy, its creditors would not be able to recover the installment loans of the SPV. 54
Special Purpose Vehicles Advantage of an SPV over Issuing Debt Ø Thus, when the SPV issues ABS, the investors only look at the credit risk associated with the installment loans and not the manufacturer. Ø As a result, by financing with securitization via an SPV, the ABS issue often has a better credit rating and a lower rate than the manufacturer’s notes. 55
Two-Step Securitization Ø In practice, a manufacturer often uses a two-step securitization process whereby it first sells the loans to its financial subsidiary (an intermediate SPV) who then sells the loans to the SPV who creates the ABS. Ø This two-step securitization process is done to ensure that the transaction is considered a true sale for tax purposes. Ø If the manufacturer’s financial subsidiary is considered a wholly owned subsidiary, then it may only be allowed to engage in purchasing, owning, and selling receivables. 56
Features Ø ABSs are characterized by having a number of features: 1. Credit tranches 2. Overcollateralization 3. Excess interest 4. Sequential-pay tranches 5. Derivative positions 57
ABS Example Ø ABS deal of a representative U. S. auto manufacturer’s financial subsidiary in which car loans are securitized. Ø The key features of the deal include: 1. Car loans totaling $1. 1 billion purchased from the car manufacturer’s financial subsidiary by a special purpose vehicle. 2. $1 billion of CARDS (auto-loan-backed securities) issue (overcollateralization). 3. A senior-subordinated structure consisting of $800 million senior class bond (A) and $200 million subordinate class bonds (B, C, and D). 58
ABS Example Ø The key features of the deal: 4. Bond classes Aa (A 1 a, 2 a, A 3 a) are fixed rate 5. Bond classes Ab (A 1 b and A 2 b) are floating rate 6. Senior bond classes A are sequential pay: 1, 2, and 3 7. Principal amount for senior fixed-rate is $600 million: 1. 2. 3. A 1 a = $300 million A 2 a = $200 million A 3 a = $100 million 59
ABS Example Ø The key features of the deal: 8. Principal amount for senior floating-rate is $200 million 1. A 1 b = $100 million 2. A 2 b = $100 million 9. Principal amount for subordinate fixed-rate is $200 million: 1. B = $100 million 2. C = $50 million 3. D = $50 million 60
ABS Example Ø The key features of the deal include: 10. The SPV entered into an interest rate swap with a financial institution for each of the floating rate bonds to fix the rate (swaps are discussed in Chapter 20). 11. Each month the cash flows from the collateral are used to pay the service fee and the payments to the swap. 12. Bank A is the Trustee. 61
ABS Example 62
Home Equity Loan-Backed Securities Ø Home-equity loan-backed securities are referred to as HELS. Ø They are similar to MBSs in that they pay a monthly cash flow consisting of interest, scheduled principal, and prepaid principal. Ø In contrast to mortgages, the home equity loans securing HELS tend to have a shorter maturity and different factors influencing their prepayment rates. 63
Home Equity Loan-Backed Securities Ø The home equity loans forming the pool backing a HEL issue are also subject to default. Ø Like nonagency MBS, commercial MBS, and CARDS, HEL deals are often structured with different prepayment tranches, credit tranches, and credit enhancements. 64
Credit-Card Receivable-Backed Securities Ø Credit-card receivable-backed securities are commonly referred to as CARDS (certificates for amortizing revolving debts). 65
Credit-Card Receivable-Backed Securities Nonamortized Loans Ø Securitized asset formed with home equity loans, residential mortgages, and auto loans are backed by loans that are amortized. Ø ABSs with amortizing assets are sometime referred to as selfliquidating structures. Ø In contrast, CARDS investors do not receive an amortized principal payment as part of their monthly cash flow. Ø That is, the credit card receivables backing a CARD are nonamortizing loans where there is not a schedule of periodic principal payments. Ø As such, prepayment does not apply for a pool of credit card receivable loans. 66
Credit-Card Receivable-Backed Securities Ø Credit cards are issued by banks (VISA and Master. Card), retailers, and global payment and travel companies (American Express). Ø Credit card borrowers usually make a minimum principal payment, in which if the payment is less than the interest on the debt, the shortfall is added to the principal balance, and if it greater, it is used to reduce the balance. Ø The cash flow from a pool of card receivables comes from 1. Finance charges (interest charges based on unpaid balance) 2. Principal collected 3. Fees 67
Credit-Card Receivable-Backed Securities Ø The CARDS formed from a pool of credit card receivables are often structured with two periods. 1. In one period, known as the lockout period (or revolving period) all principal payments made on the receivables are retained and either reinvested in other receivables or invested in other securities. Ø When new assets are added to an ABS deal, the structure is called a revolving structure. 2. In the other period, known as the principal-amortization period (or amortizing period), all current and accumulated principal payments are distributed to the CARD holders. 68
Credit-Card Receivable-Backed Securities Ø In structuring an ABS secured by credit card receivable, the issuer often sets up a master trust where the credit card accounts meeting certain eligibility requirement are pledged. Ø The master trust is very large, including millions of credit card accounts, totaling billions of dollars. 69
Credit-Card Receivable-Backed Securities Ø Numerous credit card deals or series are then issued from the master trust. Ø Each series is, in turn, identified by a year and a number: 2007 -1 2008 -1 2009 -1 2007 -2 2008 -2 2009 -2 2007 -3 2008 -3 2009 -3 2007 -4 2008 -4 2007 -5 70
Credit-Card Receivable-Backed Securities Ø Each series has a lockout period where, as noted, the principal payments made by the credit card borrowers are retained by the trustee and reinvested in additional receivables or securities. Ø During the lockout period, the cash flow to CARD investors comes from finance charges and fees. Ø This period can last a number of years. Ø The lockout period is followed by the principal amortizing period when principal received by the trustee is paid to CARD investors. Ø There can also be an early amortizing provision in some series that requires early amortization of principal if certain events occur. 71
Credit-Card Receivable-Backed Securities Evaluating CARD Ø In evaluating a CARD series, investors often monitor the monthly payment rate (MPR): the monthly payment of finance charges, fees, and principal repayment from the credit card receivable portfolio (e. g. , $50 million) as a percentage of the credit card debt outstanding (e. g. , $500 million; MPR = 10%). Ø For a CARD series with low or declining MPRs, there is a chance there may not be sufficient cash to pay off the principal. Ø If there is an early amortization provision, an MPR falling below a threshold MPR would be the trigger for early amortization. 72
Credit-Card Receivable-Backed Securities Evaluating CARD Ø Other important rate measures for evaluating CARDs include: 1. Gross Portfolio Yield: finance charges collected and fees as a proportion of the credit card debt outstanding 2. Charge-offs: the accounts charged off as uncollectable as a proportion of the credit card debt outstanding 3. Net portfolio Yield: gross profit yield minus charge-offs as a proportion of the credit card debt outstanding; this is the return CARD holders receive. 4. Delinquency Rate: Proportion of receivables that are past due— 30, 60, or 90 days 73
Credit-Card Receivable-Backed Securities Example Ø Like many ABS, CARDs are characterized by having a number of features. Slide 77 shows an example of a CARD deal of a representative credit card issuer. Ø Key features of the series include: 1. The issuing entity is the credit card issuer’s master trust Ø The depositors is the card issuer’s finance corporation Ø The sponsors and originators are the credit card issuer’s bank Ø The service is the credit card company Ø The CARD is identified as 2008 Series 1 74
Credit-Card Receivable-Backed Securities Example Ø Key features of the series include: 2. Total CARDS issue is $600 million. 3. There is a senior-subordinate structure with $550 million issued to the Senior A Class and $50 million to Subordinate B Class. 4. Interest payment to each class is equal to the monthly LIBOR + spread. 5. The final payment date of the series is anticipated to be 2015. 6. Principal collected during the lockout period is to be used to invest in additional receivables. Principal is to be accumulated in a “principal funding account. ” 75
Credit-Card Receivable-Backed Securities Example Ø Key features of the series include: 7. In January 2012, the Trust will begin accumulating collection of receivables for principal repayment and begin distributing principal to Bond Class A and Bond Class B. 8. Early amortization is triggered if the MPR for any three consecutive months is less than a specified base level. 9. If the collection of receivables is less than expected, principal may be delayed. 76
Credit-Card-Backed Security Deal Credit Card Bank Receivables Credit Card Master Trust $600 million Series 2008 -1 Class A $50 million Class B CARDS Holders Provisions: 1. Interest payment to each class is equal to the monthly LIBOR + spread. 2. The final payment date of the series is anticipated to be 2015. 3. Principal collected during the lockout period is to be used to invest in additional receivables. Principal is to be accumulated in a “principal funding account. ” 4. In January 2012, the Trust will begin accumulating collection of receivables for principal repayment and begin distributing principal to Bond Class A and Bond Class B. 5. Early amortization is triggered if the MPR for any three consecutive months is less than 10%. 6. If the collection of receivables is less than expected, principal may be delayed. 77
Collateralized Debt Obligations 78
Collateralized Debt Obligations Ø Collateralized Debt Obligations (CDOs) are securities backed by a diversified pool of one or more fixedincome assets or derivatives. Ø Assets from which CDOs are formed include: 1. Investment Grade Corporate Bonds 2. Asset-backed Securities 3. High-yield Corporate Bonds 4. Leveraged Bank Loans 5. Distressed Debt 6. Residential Mortgage-Backed Securities 7. Commercial Loans 8. Commercial Mortgage-Backed Securities 9. Real Estate Investment Trusts 10. Municipal Bonds 11. Emerging Market Bonds 79
Collateralized Debt Obligations Note: Ø The issuance of CDOs grew from the 1990 s to 2007, but stopped in 2008 in the aftermath of the 2008 financial crisis. There are still, though, a number of issues outstanding. Ø CDOs deals are set up with a collateral manager who is responsible for purchasing the debt obligation and managing the portfolio of debt obligations. Ø CDOs can vary in terms of their objectives. Ø CDOs are often structured with different tranches and credit enhancements. 80
Collateralized Debt Obligations Ø There are four types of CDOs: 1. Cash Flow CDOs that make periodic payment of interest and principal. 2. Market Value CDOs that are characterized by total returns generated from the collateral: interest income, capital gains, and principal. 3. Synthetic CDOs that are formed with derivatives 4. Balance Sheet CDOs consisting of bank loans in which the objective is to sell or remove the loans from the balance sheet. 81
Collateralized Debt Obligations Ø Before the financial crisis of 2008, synthetic CDOs were one of the fastest growing segments of the CDO market. Ø A common structure for a synthetic CDS was the issuance of the CDOs to finance the purchase of high quality bonds with the CDO manager then entering into credit default swap contracts as the seller to enhance the return Ø That is, from the swap position the fund would receive premiums for providing default protection against a bond or bond portfolio. 82
Collateralized Debt Obligations Example Ø Slide 84 shows a CDO with Ø Four tranches Ø Backed by a $200 million collateral investment consisting of 1. Fixed-rate, investment-grade bonds with a par value of $200 million 2. Weighted average maturity of five years 3. Yielding a return 200 basis points over the five-year T-notes. 83
Collateralized Debt Obligations Example Tranche Senior A 1 Senior A 2 Junior B Subordinate/Equity Par Coupon Rate $100 m $60 m $20 m Fixed Floating Fixed -- 5 -year T-note Rate + 150 bp LIBOR + 100 bp 5 -year T-note Rate + 200 bp -- Collateral Requirements: Investment-grade bonds Weight average maturity of 5 years Average quality rating of A Swap Manager will enter interest rate swap contracts to fix the rate on the A 2 Tranche Senior-Subordinate Structure Tranche B is subordinate to A 1 and A 2 Initial Collateral Investment: $200 million investment in investment-grade portfolio yielding 8% T-note rate at time of initial investment of 6% Initial spread on portfolio of 200 basis points Initial Swap Agreement: CDO manager agrees to pay 6% on $60 m notional principal in return for a payment of LIBOR on $60 m. Projected First-Year Cash Flow 1. 2. 3. 4. Interest from collateral = (. 08)($200 m) Payment to A 1 tranche: ($100 m)(. 06 +. 015)($100 m) Payment to A 2 tranche: (LIBOR +. 01)($60 m) Interest paid to swap counterparty: (. 06)($60 M) = $3. 6 m 5. Interest received from swap counterparty: (LIBOR)($60 m) 6. Payment to B Tranche: ((. 06 +. 02)($20 m) ______________________ Net ______________________ 7. Payment to Subordinate/Equity Tranche $16 m − $7. 5 m − (LIBOR +. 01)($60 m) −$3. 6 m + (LIBOR)($60 m) − $1. 6 m ________ $2. 7 m _________ $2. 7 m 84
Collateralized Debt Obligations Example Ø The CDO’s four tranches consist of: 1. A senior A 1 trance with a par value of $100 million, paying a fixed rate equal to the five-year T-note rate plus 150 basis points 2. A senior A 2 tranche with a par value of $60 million and paying a floating rate equal to LIBOR plus 100 basis points 3. A subordinate B Tranche with a par value of $20 million and paying a fixed rate equal to the five-year T-note rate plus 200 basis points 4. A subordinate/equity tranche with a par value of $20 million that receives the excess return: return from collateral minus returns paid to the other tranches. 85
Collateralized Debt Obligations Example Ø Since Tranche A 2 pays a floating rate and the underlying collateral is to consist of fixed-rate bonds, the CDO deal allows the manager to take a derivative position to fix the rate on the A 2 tranche. Ø In this deal, the manager enters an interest rate swap contract to pay a fixed rate of 6% on a $60 million notional principal in return for the receipt of a floating rate payment equal to the LIBOR on a $60 million notional principal. 86
Collateralized Debt Obligations Example Ø The interest rate swap contract when combined with the floating rate loan obligation on Tranche A 2 serves to fix the rate on the tranche at 7%: Tranche A 2 Swap Net Pay LIBOR + 100 basis point Pay 6% Receive LIBOR Pay 6% + 1% − (LIBOR + 1%) − 6% + LIBOR − 7% 87
Collateralized Debt Obligations Example Ø If the initial investment of collateral were in investment-grade bonds yielding 8% when five-year Treasuries were yielding 6%, then the CDO deal would be expected to yield an excess return of $3. 1 million in the first year, with the $3. 1 million going to the Equity/Subordinate Tranche. Ø As a rule, managers in structuring a cash flow CDO will estimate the expected return to the subordinate/equity tranche investors, as well as the return and risk of the Tranches to determine the feasibility of the CDO deal. 88
Collateralized Debt Obligations CDO Restrictions Ø Restrictions are imposed on what the collateral manager can do. Ø In the above example, the manager was required to invest the collateral in investment-grade bonds with an average maturity of five years. 89
Collateralized Debt Obligations CDO Restrictions Ø In general, the restrictions on CDOs include: 1. Constraints on the payment of interest and principal to the CDO investors 2. The credit management of the portfolio 3. The lengths of investment periods 90
Collateralized Debt Obligations CDO Restrictions Ø Example Ø Rules for the distribution of interest and principal could specify that the manager distribute all interest and principal to senior tranches but restrict the payment of principal to subordinate tranches if certain credit conditions are not met (e. g. a coverage ratio not being met). 91
Collateralized Debt Obligations CDO Restrictions Ø Example Ø There could also be credit restrictions that prohibit the manager from making certain investments if the asset fails to meet certain quality tests as it relates to the collateral’s diversification, maturity, and average credit quality. 92
Collateralized Debt Obligations CDO Restrictions Ø Credit restrictions are often specified in terms of a par value test that requires that the value of the underlying collateral be equal to a certain percentage (e. g. , 110%) of the par value of the CDOs or the par value of the senior CDO class. Ø If the collateral value were to drop below the par value test, then the manager would be required to take certain actions such as making all principal payments to senior tranche holders. Ø Similarly, the restriction might be defined in terms of an interest coverage tests that requires the collateral’s return to meet interest payments. 93
Collateralized Debt Obligations Event Of Default Ø Most CDO deals also have an early termination requirement if an event of default occurs. Ø Such an event relates to conditions that could significantly impact the performance of the collateral. Ø This could include a failure to comply with certain coverage ratios, the bankruptcy of an issuing credit, or the departure of the collateral management team. Ø Many of the CDOs that were based on subprime mortgage loans resulted in the CDOs issuing events of default notices. 94
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