Chapter 13

Introduction to Asset-Backed Securities

Understanding the structure, risks, and valuation of securities backed by pools of underlying assets

1

Securitization Process

Securitization is the process of pooling various types of contractual debt and selling their related cash flows to third-party investors as securities. This process transforms illiquid individual loans into tradable securities.
Basic Securitization Structure
The securitization process involves several key participants and steps:
Participant Role Key Functions
Originator Creates original loans Underwriting, initial funding
Special Purpose Vehicle (SPV) Bankruptcy-remote entity Owns assets, issues securities
Servicer Manages loan portfolio Collections, reporting, modifications
Trustee Represents investor interests Oversight, enforcement
Rating Agencies Assess credit quality Rating assignment, monitoring
Securitization Benefits
  • For Originators: Access to funding, risk transfer, capital relief
  • For Investors: Access to asset classes, diversification, yield enhancement
  • For Borrowers: Increased credit availability, potentially lower rates
  • For Markets: Improved liquidity, risk distribution, price discovery
True Sale vs. Secured Borrowing
For securitization to achieve its objectives, the asset transfer must be a "true sale" rather than a secured borrowing. This ensures bankruptcy remoteness and prevents consolidation with the originator's balance sheet.
2

Residential Mortgage-Backed Securities (RMBS)

RMBS are securities backed by residential mortgages, representing the largest segment of the ABS market. They can be divided into agency and non-agency RMBS based on the issuer and underlying mortgage characteristics.
Agency vs. Non-Agency RMBS
Characteristic Agency RMBS Non-Agency RMBS
Issuer Government agencies (Ginnie Mae, Fannie Mae, Freddie Mac) Private entities (banks, investment banks)
Credit Risk Minimal (government backing) Varies (depends on underlying mortgages)
Conforming Limits Below agency limits Above limits or non-conforming
Credit Enhancement Government guarantee Subordination, insurance, overcollateralization
Mortgage Cash Flow Characteristics
Mortgage cash flows consist of scheduled principal and interest payments plus any prepayments by borrowers.
Monthly Payment = P × [r(1+r)^n] / [(1+r)^n - 1]
where: P = Principal, r = Monthly interest rate, n = Number of payments
Prepayment Risk
Prepayment risk is the primary concern for RMBS investors:
  • Contraction Risk: Faster prepayments when rates fall
  • Extension Risk: Slower prepayments when rates rise
  • Negative Convexity: Price appreciation limited by prepayments
Prepayment Modeling
Several models are used to predict mortgage prepayments:
PSA (Public Securities Association) Model
The PSA model assumes prepayments start at 0% CPR (Conditional Prepayment Rate) and increase linearly to 6% CPR after 30 months, then remain constant.

100% PSA: Standard assumption
150% PSA: 50% faster prepayments
50% PSA: 50% slower prepayments
3

Commercial Mortgage-Backed Securities (CMBS)

CMBS are backed by commercial real estate mortgages, including office buildings, retail properties, hotels, and multifamily housing. They differ significantly from RMBS in structure and risk characteristics.
CMBS Structure and Features
CMBS typically have the following characteristics:
  • Non-Recourse Loans: Lender can only look to property for repayment
  • Balloon Payments: Large principal payment due at maturity
  • Call Protection: Borrowers face penalties for early repayment
  • Property Diversification: Geographic and property type spread
Feature RMBS CMBS
Prepayment Risk High (borrower option) Low (call protection)
Default Risk Lower (recourse) Higher (non-recourse)
Loan Size Smaller, standardized Larger, heterogeneous
Maturity 15-30 years 5-10 years with balloon
CMBS Credit Enhancement
CMBS use various forms of credit enhancement to achieve investment-grade ratings:
Subordination Structure
CMBS are typically structured with multiple tranches:
  • Senior Tranches (A): AAA-rated, first loss protection
  • Mezzanine Tranches (B, C, D): Investment grade ratings
  • Subordinate Tranches: Below investment grade
  • First Loss Piece: Unrated, highest risk/return
4

Non-Mortgage Asset-Backed Securities

Non-mortgage ABS are backed by various types of consumer and commercial assets, each with distinct cash flow patterns and risk characteristics.
Major ABS Types
ABS Type Underlying Assets Key Characteristics Primary Risks
Auto ABS Auto loans and leases Short maturity, amortizing Credit risk, early payoff
Credit Card ABS Credit card receivables Revolving structure Payment rates, charge-offs
Student Loan ABS Education loans Long maturity, deferment Default, deferment rates
Equipment ABS Equipment loans/leases Secured by equipment Residual value risk
Auto Loan ABS
Auto ABS are among the most popular non-mortgage ABS due to their predictable cash flows and strong collateral backing.
Auto ABS Characteristics
  • Monthly Payments: Principal and interest payments
  • Prepayments: Lower than mortgages but still significant
  • Charge-offs: Defaults result in loss after recovery from vehicle sale
  • Seasoning: Default rates typically peak within first 12-18 months
Credit Card ABS
Credit card ABS have a unique structure due to the revolving nature of the underlying receivables.
Credit Card ABS Structure
Revolving Period: Principal collections are used to purchase new receivables
Amortization Period: Principal is passed through to investors

Key Metrics:
  • Monthly Payment Rate (MPR): Monthly collections as % of receivables
  • Charge-off Rate: Monthly defaults as % of receivables
  • Yield: Interest and fee income as % of receivables
5

Collateralized Debt Obligations (CDOs)

CDOs are structured products backed by diversified pools of debt securities or other CDOs. They represent a more complex form of securitization with multiple levels of credit tranching.
CDO Types and Structure
CDO Type Underlying Assets Management Key Features
Cash CDO Bonds, loans, ABS Actively managed Asset manager discretion
Synthetic CDO CDS on reference portfolio Static or managed No cash bond ownership
CDO² Other CDO tranches Various Leveraged CDO exposure
CDO Waterfall Structure
CDOs distribute cash flows through a prioritized "waterfall" structure:
Typical CDO Waterfall
Senior Tranches: AAA-rated, 70-80% of structure
Mezzanine Tranches: A to BB-rated, 15-25% of structure
Equity Tranche: Unrated, 3-12% of structure

Payment Priority:
  1. Senior fees and expenses
  2. Senior tranche interest
  3. Mezzanine tranche interest
  4. Senior tranche principal
  5. Mezzanine tranche principal
  6. Equity tranche distributions
CDO Risks
  • Correlation Risk: Asset correlations may increase during stress
  • Manager Risk: Dependence on asset manager's skill
  • Complexity Risk: Difficult to analyze underlying exposures
  • Liquidity Risk: Limited secondary market trading
  • Model Risk: Valuation dependent on complex models
6

ABS Valuation and Risk Analysis

ABS valuation requires understanding cash flow dynamics, credit enhancement mechanisms, and various risk factors that affect performance.
Valuation Approaches
Method Application Key Inputs Limitations
Static Cash Flow Simple structures Prepayment assumptions Doesn't capture optionality
Monte Carlo Complex structures Interest rate scenarios Model and parameter risk
Option-Adjusted Spread Securities with embedded options Volatility assumptions Complex calibration
Key Risk Factors
Credit Enhancement Analysis
Evaluate the adequacy of credit enhancement:
  • Subordination Level: Percentage of structure below each tranche
  • Overcollateralization: Excess collateral value
  • Reserve Accounts: Cash or liquid investments
  • Third-Party Guarantees: Insurance or letters of credit
Stress Testing Scenarios
Common stress scenarios for ABS analysis:
  • Base Case: Expected performance based on historical data
  • Stress Case: Elevated default and slower prepayment rates
  • Severe Stress: Extreme scenarios (2-3 standard deviations)
  • Interest Rate Scenarios: Rising/falling rate environments
Credit Enhancement Level Formula

Credit Enhancement =
(Subordination + Overcollateralization + Reserve Accounts)
/ Pool Balance

Where:
Subordination = Junior tranches providing protection
Overcollateralization = Excess collateral value
Reserve Accounts = Cash reserves for losses
Pool Balance = Total asset pool value