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IFT Notes for Level I CFA® Program

LM04 An Introduction to Asset-Backed Securities

Part 6


8. Non-Mortgage Asset-Backed Securities

A wide range of assets apart from mortgage loans are used as collateral for asset-backed securities. The most popular non-mortgage ABS are auto loan receivable-backed securities and credit card receivable-backed securities. Based on the way the collateral pays, ABS can be categorized into two types: amortizing and non-amortizing.

Examples of amortizing loans backing an ABS: mortgage loans and automobile loans.

An example of non-amortizing loans backing an ABS: credit card receivables.

ABS must offer credit enhancement to be appealing to investors.

8.1 Auto Loan ABS

Cash flows consist of interest payment, scheduled principal repayments and any prepayments. For securities backed by auto loan receivables, prepayments result from any of the following:

  • Sales and trade-ins requiring full payoff of the loan.
  • Repossession and subsequent resale of vehicles.
  • Insurance proceeds received upon loss or destruction of vehicles.
  • Payoff of the loan with cash to save on the interest cost.
  • Refinancing of the loan at a lower interest rate.

All auto-loan backed securities have some form of credit enhancement such as:

  • A senior/subordinated structure so the senior tranches have credit enhancement.
  • Reserve account, overcollateralization, and excess interest on the receivables.
    • The purpose of a reserve account is to provide credit enhancement. More specifically, the reserve account is a form of internal credit enhancement that will protect the bondholders against losses up to x% of the par value of the entire issue.
    • Overcollateralization means that the aggregate principal balance of the automobile loan contract exceeds the principal balance of the notes. It represents another form of internal credit enhancement. Overcollateralization can be used to absorb losses from the collateral.

8.2 Credit Card Receivable ABS

Credit cards such as Visa and MasterCard are used to finance the purchase of goods and services, as well as for cash advances. When a cardholder makes a purchase using a credit card, he is agreeing to repay the amount borrowed (purchase amount) to the issuer of the card within a certain period, typically a month. If the outstanding amount is not repaid within this grace period, then a finance charge (interest rate) is applied to the balance not paid in full each month.

Credit card receivables are pooled together to act as a collateral for credit card receivable-backed securities. Cash flow, on a pool of credit card receivables consists of:

  • Finance charges: These represent the periodic interest the credit card borrower is charged on the unpaid balance after the grace period.
  • Fees and principal repayments. Fees include any late payment fees and any annual membership fees.

Characteristics of Credit Card Receivable-backed Securities

Payment Structure

  • The security holders are paid an interest periodically (e.g., monthly, quarterly, or semiannually). The interest rate may be fixed or floating.
  • The principal payments made by borrowers do not flow through to investors during a period known as the lockout period. Instead, the repayments are reinvested to issue new loans. As a result, credit card receivables increase during the lockout period. During this period, the cash flow to security holders comes from finance charges and fees.

Amortization Provision

  • Credit card receivable-backed securities are non-amortizing loans. The principal is not amortized during the lockout period.
  • Certain provisions in credit card receivable-backed securities require early amortization of the principal if certain events occur. Such provisions are referred to as “early amortization” or “rapid amortization” provisions and are included to safeguard the credit quality of the issue. The only way the principal cash flows can be altered is by triggering the early amortization provision. For example, if issuers believe there may be a default in credit card repayments, then the principal repayments will be used to pay security holders (investors) instead of reinvesting to issue new loans.

There are two differences between credit card receivable-backed securities and auto loan receivable-backed securities:

  • Collateral for credit card receivable-backed securities are non-amortizing loans, while the collateral for auto loan receivable-backed securities are fully amortizing loans.
  • For auto loan receivable-backed securities, outstanding principal balance declines as principal is distributed to bond classes each month. But, for credit card receivable-backed securities the principal is reinvested to issue new loans during the lockout period.

9. Collateralized Debt Obligations

A collateralized debt obligation 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, CMBS, or CDO).

Like an ABS, a CDO involves the creation of a SPV. But, in contrast to an ABS, where 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. The whole process is illustrated below:

9.1 CDO Structure

The key components of a CDO structure are as follows:

  • The CDO raises funds by issuing debt. The debt obligations are structured as bond classes or tranches, such as senior, mezzanine, or subordinated classes with varying risk and return expectations. Investors invest in a particular bond class based on their risk appetite.
  • The funds raised from the issuance of bonds are used by the collateral manager to invest in assets. He seeks to earn a higher return from these assets than what is paid to the bondholders.
  • The excess spread is used to pay the equity holders and the CDO manager.
  • The sources of cash flow to bondholders include interest, principal repayments, and sale of collateral assets.

9.2 An Example of a CDO Transaction                

Consider the following $100 million CDO. The collateral consists of bonds with a par value of $100 million paying a fixed rate of 11%.

Tranche Par value (US $) Coupon rate
Senior 80,000,000 Libor + 70 bps
Mezzanine 10,000,000 9%
Subordinated/equity 10,000,000

Since the senior tranche requires a floating rate payment, the CDO manager enters into an interest rate swap with another party for a notional amount of $80 million paying a fixed rate of 8% and receiving Libor. This removes any uncertainty with respect to interest rate movements.

Let us now evaluate the cash flows for each party.

Party Type of cash flow Amount
Collateral Pays interest each year. Coupon rate = 11% .11 x 100,000,000 = 11,000,000
Senior tranche Interest paid to senior tranche: Libor + 70 bps (Libor + 70bps) x 80,000,000 = Libor x 80,000,000 + 560,000
Mezzanine tranche Interest paid: 9% 0.09 x 10,000,000 = 900,000
Interest rate swap CDO to swap counterparty: 8% 0.08 x 80,000,000 = 6,400,000
Interest rate swap From swap counterparty to CDO: Libor 80,000,000 x Libor
Total interest received 11,000,000

+ Libor x 80,000,000

Total interest paid Libor x 80,000,000 + 560,000

+ 900,000 + 6,400,000

= 7,860,000 + Libor x 80,000,000

Net interest = Interest received – interest paid 3,140,000

From the net interest available, the CDO manager’s fees must be paid. If the fees are 640,000, then the cash flow available to the subordinated/equity tranches is 3,140,000 – 640,000 = 2,500,000. The annual return for this tranche with a par value of $10 million is 2,500,000/10,000,000 = 25%

CDOs: Risks and Motivations

In the case of defaults in the collateral, there is a risk that the manager will fail to earn a return sufficient to pay off the investors in the senior and mezzanine tranches. Investors in the subordinated/equity tranche risk the loss of their entire investment.

10. Covered Bonds

Covered bonds are senior debt obligations issued by a financial institution and backed by a segregated pool of assets that typically consist of commercial or residential mortgages or public sector assets.

Covered bonds are similar to ABS, but they differ because of their:

  • Dual recourse nature: Investors have claims against both the issuing financial institution and the underlying asset pool.
  • Balance sheet impact: The underlying asset pool remains on the issuing financial institution’s balance sheet. It is not transferred to a separate SPV. The covered pool bondholders retain a top-priority claim against the pool.
  • Dynamic cover pool: The underlying asset pool is not static. The issuing financial institution must replace any prepaid or non-performing assets in the cover pool to ensure sufficient cash flows until maturity. In contrast, ABS pass through default and prepayment risk to investors.
  • Redemption regimes in the event of sponsor default: In the event of sponsor default, redemption regimes align the covered bond’s cash flows as closely as possible to the original maturity schedule.

Because of these additional safety features, covered bonds usually have lower credit risks and therefore lower yields as compared to otherwise similar ABS.

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