An Introduction to Asset-Backed Securities for the CFA Exam
On the CFA Level 1 exam there is an entire reading dedicated to introducing asset-backed securities (ABS) within the introduction to fixed-income valuation study session
ABS securities are alternative fixed-income assets that offer an alternative to traditional corporate bonds. These include asset-backed securities (ABS), mortgage-backed securities (MBS), and collateralized debt-obligations (CDOs), all of which can be invested in and broken into different tranches to tailor the relative risk/reward and timing of payoff for investors.
What will the CFA Exam test with regards to Asset-backed securities?
For CFA Level 1 be prepared to answer questions around extension vs. contraction risk, including the ability to identify which tranche is more exposed to one or another. The bulk of this section focuses in on mortgage-backed securities. You should understand the impact of prepayment risk, and be able to calculate and interpret SMM and various ratios such as the debt-to-service coverage ratio and loan-to-LTV ratio.
What is securitization and why does it help investors?
Securitization is the process in which an entity purchases financial assets (mortgages, loans, accounts receivable etc.) and then pools those assets and issues securities together. The periodic interest payments made to investors in the pool are thus supported by a more diverse basket of cash flows.
Primary benefits of securitization
- Increases the liquidity of the underlying financial assets
- Offers better diversification and risk reduction for buyers of the pooled assets who can optimize their own allocations across interest rate and credit risk
- Reduces funding costs for the firms that sell the assets to the securitizing entity (borrowing cost ↓)
- Investors have a stronger legal claim on the collateral
- Financial intermediaries can originate more loans because of the increased investor demand. This increased supply benefits organizations that need to borrow
Types of Securitized Financial Products
There are a variety of types of structured financial products.
An asset-backed security (ABS) is a security specifically backed by a pool of loans or receivables. These include: credit cards, consumer loans, auto loans, commercial assets, and home equity loans.
- Most ABS’s are created using a special purpose vehicle (SPV) whose operations are separated from the main entity and limited to the acquisition and financing of specific assets.
- The primary reason for creating an ABS is to move an illiquid asset off the balance sheet and monetize the assets.
- When the loans/assets in question are mortgages we call them Mortgage-backed securities (MBS). A key risk with ABS/MBS is prepayment risk.
Tranching within an ABS
Tranching is the practice of creating different classes of holder of the security with different seniority of claims. The more junior tranches are riskier and will absorb losses first, but must be compensated for this extra risk with higher yield. We refer to the junior tranche as being subordinated to the senior tranche.
Types of tranching
- Time tranching – Divide the assets by timing of cash flows
- Credit tranching – Investors choose amount of credit risk they want to bear
- Subordination – Different bond classes differing in how losses (defaults) are split among the tranches. The higher the proportion of subordinated bonds overall the more protection the senior tranche(s) are afforded
Residential Mortgage Loans and Residential Mortgage-Backed Securities (RMBS)
A mortgage loan is an amortizing loan that is secured by some form of real estate. The loan begins when the borrower makes a down payment, which constitutes their equity position. Over time, this equity value/percentage will change (1) as the property’s market value shifts and (2) because the borrower’s interest payments includes a principal component.
Basic Factors in Evaluating a Residential Mortgage Loan
- Loan-to-Value (LT) – The loan-to-value ratio is the % of the value of the collateral loaned to the borrower (amount of mortgage ÷ purchase price). The lower the LTV the higher the borrower’s equity in the property and the lower the credit/default risk
- Maturity – Differs geographically, in US 15-30 years is standard, elsewhere is longer
- How interest is charged – Fixed-rate vs. adjustable-rate mortgage
- Amortizement of the principal – Fully amortizing, partially amortizing, and interest only mortgages. With fully amortizing loans the beginning payments are mostly interest, but by the end they are mostly principal. Partially amortizing loans still have a balloon payment at the end. Interest only mortgages have no scheduled principal repayment.
- Terms of prepayment – Prepayment is an excess or early payment of principal by the mortgage holder. Can be caused by selling the home or refinancing, or just higher payments to reduce principal. Prepayments introduce reinvestment risk and some loans have penalties for it.
- Foreclosure – The rights of the lender in case of default is important. Non-recourse loans give the lender no claim to borrower assets except for the property itself, recourse loans let the lender go after other borrower assets
Agency RMBS vs Non-Agency Backed RMBS
In the U.S. mortgage-backed securities can be agency or non-agency. Think of agency as all the high-quality mortgages and non-agency RMBS as all the rest.
An agency RMBS is issued by government-sponsored entities (Fannie/Freddie/Ginnie). These are backed by the U.S. government (to varying degrees) and are considered to have very high credit quality as they must meet certain criteria including minimum down payments, max LTV ratios, max size etc.
Non-agency RMBS are mortgage pass-through securities with each security representing a claim to the cash flows from a pool of mortgages. Each mortgage will have different features. The weighted average maturity (WAM) and the weighted average coupon (WAC) are key metrics. The pass-through rate given to investors will be less than the net interest or net coupon of the mortgages to account for fees. Credit risk is more important for non-agency RMBS and they will often have credit enhancements built in as a result.
Mortgage Pass-Through Securities
A mortgage pass-through security is created in order to sell shares in a pool of mortgage loans.
Now as an investor, the amount and timing of the cash flows you receive from this pool are highly dependent on the average life of the RMBS, and this in turn depends on assumptions about the prepayment speed of the borrowers on each mortgage.
Note that we define prepayments are early or excess payments of the principal by the borrowers. The higher the prepayment speed the shorter the average life of the mortgage-backed security.
Our assumptions about prepayment rates are calculated using single monthly mortality (SMM).
- Single Monthly Mortality (SMM) is the % reduction in the outstanding principal caused by prepayments over a 1 month period. In other words it compares the month’s ending principal balance against what it would have been with no prepayments.
- The Conditional Prepayment Rate (CPR) is an annualized measure of prepayments—it’s the annualized SMM. CPR assumes prepayments depend on the weighted avg coupon rate, current interest rates, and prior repayments of principal.
- Finally, the Public Securities Association (PSA) Benchmark is a monthly series of annual CPRs that assumes that prepayments increase as the mortgage pool ages (becomes seasoned).
PSA 100 is the norm. A PSA of 40 means the prepayment level is only 40% of the benchmark, a PSA of 150 means it is 150% of the PSA benchmark CPR. Remember that because of prepayments an MBS pool will have an average life < its weighted maturity.
Extension and Contraction Risk
Prepayments highlight the primary risk for pass-through securities—namely that any cash you receive back is capital you need to put back to work.
In other words, prepayments cause substantial reinvestment risk.
And since reinvestment risk is already higher with amortizing securities such as mortgages (due to the inclusion of principal repayments in each payment) investors need to be especially careful measuring this risk. It can help to think of a homeowner’s right to prepay their loan as being similar to a call option on a callable bond.
But the reinvestment risk we’re talking about is actually two sided—there’s a risk of early prepayments and a risk of slower prepayments.
- Extension risk – Is the risk that prepayments will be slower than expected
- Occurs when rates ↑ which means the lender cannot reinvest at the new, higher interest rates
- Contraction risk – Is the risk that prepayments will be faster than expected
- This reduces the total interest paid over the life of the loan
- Even worse, faster prepayments often occur when interest rates fall (due to the greater incentive for homeowners to refinance their mortgage)
- Think of contraction risk as capping the upside potential of the pass-through security
Mortgage-backed securities are vital to understand. They do not just appear for CFA level 1 but will also show up on level 2 and level 3.
Collateralized Mortgage Obligations (CMOs)
Collateralized mortgage obligations (CMOs) are securities that are collateralized by multiple RMBS. They are in effect securities backed by other securities.
Most CMOs are set up using a sequential-pay tranche structure in which each class of bond is retired sequentially. Essentially, interest rate payments are made to each tranche based on its coupon rate but any principal payments are first used to retire Tranche A, then Tranche B after A has been paid off and so on.
This means that a CMO has a set of tranches that are each created to have different exposure to prepayment risk.
- Investors concerned with extension risk can invest in a tranche with more front-loaded interest payments
- Investors concerned with contraction risk can invest in a tranche with more back-end interest payments
Planned Amortization Class Tranches (PACs)
PACs are a common structure within CMOS as they offer the greatest predictability of cash flows. The PAC tranche essentially has priority over all other support tranches when it comes to receiving exactly the amount of specified principal payments (note there can be more than 1 PAC and support tranche in a CMO).
The greater certainty for the PAC tranche means the support tranches have greater cash flow uncertainty. In fact, these support tranches have both greater extension and contraction risk.
Here’s how it works under different scenarios:
- If prepayments > expected, the support tranche receives the excess principal repayments not allocated specifically to the PAC tranche
- If prepayments < expected, the support tranche receives fewer principal repayments so that the PAC tranche can still receive its allocation
- The larger the support tranches relative to the PAC tranches the lower the probability that the CFs to the PAC will differ from the scheduled payments
- The extent of required absorption by the support tranches is governed by an initial PAC collar (say 100 – 400 PSA). Within that range the PAC avg. life is constant.
Commercial Mortgage-Backed Securities (CMBS)
CMBS are backed by income producing real estate such as apartments, warehouses, shopping centers, office buildings, health care facilities, senior housing, and hotels.
Investors in a commercial mortgage-backed security rely on tenants and customers paying their leases to provide the cash flow to meet their mortgage payments. The specific risks therefore depend somewhat on the type of tenants needed (e.g. shopping centers depend on retail sales whereas apartment buildings depend on housing demand).
All CMBS are nonrecourse loans. The lender can only look to the collateral to repay the loan. As a result risk analysis for CMBS focuses on the credit risk of the property itself rather than the credit risk of the borrower.
CMBS amortize the principal over a longer period than the loan term, meaning there is a balloon payment due at the end. This increases extension risk.
Evaluating Credit Risk for CMBS
As mentioned investors focus on property specific credit risk when evaluating a CMBS. There are two main measures to do this—the debt-to-service coverage ratio and the loan-to-value ratio.
Debt-to-service coverage ratio (DSC) – The basic cash flow coverage ratio that shows the amount of cash flow from the property available to make debt payments compared to the cost of that required debt:
The higher the ratio the better for the lender. A ratio over one shows that the cash flow covers debt servicing costs. Note that net operating income subtracts real estate taxes but NOT income taxes. This ratio is usually between 1 and 2.
Loan-to-value ratio (LTV) – Compares the loan amount relative the market or appraised value of the property:
The lower the LTV ratio the better for the lender/the lower the credit risk.
Call Protection Mechanisms for CMBS
Most CMBSs are structured with significant call protection (protection against prepayment risks) which results in these securities trading more like corporate bonds than RMBSs.
Call protection can occur at the CMBS structure level (tranches) and/or at the loan level.
Types of loan-level call protections:
- Prepayment restrictions
- Defeasance – The borrower invests prepayment funds into a treasury portfolio that replicate the mortgage cash flows
- Prepayment penalty points – Borrowers pay a fixed rate premium for prepayments, the amount of which declines over time
- Yield maintenance charges – Known as “make whole charges” the borrower must pay a premium on prepayments that allow the lender to maintain the yield of the original mortgage contract. This results in the lender being indifferent to prepayment timing and the borrower no longer caring about refinancing
Non-Mortgage Asset Backed Securities
While usually less tested on the CFA Level one exam as compared to the sections dealing with mortgage-backed securities you should still understand the basics here.
Outside of mortgages there are a variety of other asset classes that are used to create ABSs. At a high level we can group these into just two categories—amortizing loans and non-amortizing loans.
Amortizing loans include automobile loans (and the already covered residential mortgages). With amortizing loans we need to be aware of interest payments, principal repayments, and prepayments.
Non-amortizing loans such as credit card receivables have no scheduled principal payment.
Whether the underlying assets in the ABS are amortizing or non-amortizing has a significant effect on how the security is put together. Most importantly, non-amortizing loans usually have a revolving structure, where the actual underlying collateral changes over the life of the ABS. This happens when any prepayments are either used to purchase additional loans or are passed back to the investors.
Auto Loan ABS
Auto loan ABS are backed by auto loan and lease receivables and usually amortize over a 3-5 year period. The cash flows include interest, principal payments, and prepayments.
Prepayments occur if the car is sold, traded, repossessed, or stolen/wrecked or borrower just makes higher payments. Investors in auto loan receivable-backed securities can create credit enhancements via a senior/subordinate structure or internal structures like overcollateralization.
Credit Card ABS
Credit card ABS are backed by pools of credit card debt, which is revolving, non-amortizing debt. The interest rates on credit card ABS are usually set as floating rates (but can be fixed).
Cash flows include finance charges, scheduled (annual) fees, and principal repayments.
One common structure with a credit card ABS is to include a lockout period, which is a period of time after the ABS is created in which no principal payments are paid back to the holders of the security. If principal payments are made during this period the securitizer purchases additional credit card receivables. Once the lockout period is over there are usually provisions for earlier amortization if the credit quality deteriorates
Collateralized Debt Obligations (CDOs)
A CDO is a general term used to describe any security backed by a diversified pool of one or more debt obligations. There are many different classes of CDO depending on the nature of the underlying collateral securities, but in general the underlying cash flows stem from coupon payments, principal payments, and proceeds from any sale of assets. The basic goal of a CDO manager is to create a leveraged transaction where the returns from the borrowed funds is greater than the funding costs.
We can also create synthetic CDOs where the collateral is a portfolio of credit default swaps. Credit default swaps increase in value as the credit quality of their reference securities decrease. Think of them as a credit risk insurance product.
The Basic CDO transaction
- Issue debt to obtain the funds to purchase the collateral assets to create the CDO
- Divide the debt obligation into senior, mezzanine, & subordinated bond (equity/residual) tranches. Note, the yield for senior and mezzanine tranches will usually be higher than a comparable corporate bond
- Any excess returns after the required yield on the first 2 tranches accrues to the equity tranche, allowing for equity-like returns. The equity tranche is usually 70-80% of the total CDO
If you think a CDO seems very similar to an ABS you would be right. The main difference is that CDOs are more actively managed in order to try and earn alpha for the equity tranche.
This was a rather detailed overview of the types of asset-backed securities you should expect to be tested on for the CFA Level 1 exam. You need to be familiar with each structure, how they are packaged, the differences in tranches, and some of the basic calculations.