Nonagency Residential MBSs,
Commercial MBSs, and Other
Asset-Backed Securities
1
Other Securitized Assets

Agency MBSs represent the largest and most extensively developed
asset-backed security.

Since 1985, a number of other asset-backed securities have been
developed.

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.

These asset-backed securities are structured as pass-through and many
have prepayment tranches.

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
 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
 Agency residential MBSs are created from conforming
loans.
 All other mortgages that are securitized are nonagency
MBSs.
 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.
 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
 Nonagency MBSs or nonagency CMOs are subject to
default losses.
 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%.
 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 = $100,000,000,
WAC = 8%, WAM = 360 Months, 100 SDA Model
7
Cumulative Default Rates
100, 200, and 300 SDA Models
Mortgage Portfolio = $100,000,000,
WAC = 8%, WAM = 360 Months
SDA/Month
30
60
120
360
100
200
300
0.76%
1.52%
2.28%
2.19%
4.34%
6.46%
3.59%
7.06%
10.42%
3.90%
7.67%
11.29%
Total Loss
$3,904,891
$7,668,089
$11,294,229
8
Default Loss and Credit Tranches
 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.
 For nonagency MBSs or CMOs, credit enhancement
include:
1. Senior-Subordinate Structures
2. Excess Spreads
3. Overcollateralization
4. Monoline Insurance
9
Senior-Subordinate Structures
 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.
 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
Subordinate
Subordinate
Subordinate
Subordinate
Tranche
1
2
3
4
5
6
7
Principal
$400 million
$40 million
$20 million
$10 million
$10 million
$10 million
$10 million
Credit Ratings
AAA
AA
A
BBB
BB
B
Not Rated
11
Senior-Subordinate Structures
 For this MBS issue, the default losses are absorbed first by
Tranche 7 (starting at the bottom) and ascend up.
 If losses on the collateral are less than $10 million, then
only Tranche 7 will experience a loss
 If losses are $30 million, then Tranches 7, 6, and 5 will
realize losses
 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
 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.
 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
 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 = $400m/$500m = .80).
Subordinate Interest
 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 = $100m/$500m = .20).
 The greater the subordinate interest, the greater the level of credit
protection for the senior bond.
14
Senior-Subordinate Structures
Shifting Interest Schedule
 Over the life of the MBS deal, the level of credit protection
will change as principal is prepaid.
 In general, with prepayment, senior interest will increase
and the subordinate interest will decrease over time.
 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
 Shifting interest schedule is used to determine the
allocation of prepayment that goes to the senior and
subordinate tranches.
 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
 In determining the allocation to the senior holders, their
percentage of prepayment is equal to their initial senior
interest (for example, 80% = $400m/$500m) plus the
shifting interest (based on the schedule) times the
subordinate interest (20% = ($100m/$500m):
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
Subordinate
Interest
x
Shifting
Interest
Proportion
 Initial senior interest = $400m/$500m = .80
 Initial subordinate interest = $100m/$500m = .20
Years after Issuance
Shifting Interest Percentage
1-5
6
7
8
9
10
After 10
100%
70%
60%
40%
20%
10%
0
 Based on the above schedule:
 100% of the prepayment would go to the senior class for the first five years (= 80% + (1)(20%) =
100%)
 96% in year 6 (= 80% + (20%)(.70)
 92% in year 7, and so on.
 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
 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
 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.
 Typically, the provisions prohibit the step-down provision
in the shifting interest schedule from occurring if certain
performance measures are not met.
 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
 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).
 The excess spread can be used to offset any losses.
 If the excess interest is retained, it can be accumulated in
an account and used to offset futures default losses.
 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
 Overcollateralization is having the par value of the
collateral exceeds the value of the MBS issued.
 For example, if the MBS issue of $500 million had $550
million in collateral.
 The $50 million excess would then be used to absorb
default losses.
22
Monoline Insurance Companies
 Some Nonagency MBSs also have external credit
enhancements in the form of insurance provided by
Monoline insurance companies.
 Monoline insurance companies: Finance Guarantee
Insurance Corporation, the Capital Markets Insurance
Corporation, or the Financial Security Assurance
Company.
 The guarantees provided by monoline insurers, in turn,
shifts the default risk to the insurer.
23
Commercial MBS
24
Commercial Mortgages
Commercial Mortgage Loans
 Real estate property can be either residential or nonresidential.
 Residential includes houses, condominiums, and apartments; it is
classified as either single-family or multiple-family.
 Nonresidential includes commercial and agricultural property.
 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
 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
 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.
 As such, commercial mortgage loans are referred to as
non-recourse loans.
27
Commercial Mortgages
Assessing Credit Quality
 Lenders in assessing the credit quality of commercial
loans look at
 The debt-to-service ratio (= Rental Income –
operating expenses)/ Interest Payments)
 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
 Commercial mortgage loans also differ from residential
mortgage loans in that they typically have prepayment
protection.
 Prepayment protection can take the form of prepayment
penalties, provisions prohibiting prepayment for a
specified period, and defeasance.
 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
 Unlike residential mortgage loans in which the principal
is amortized over the life of the loan, commercial
mortgage loans are typically balloon loans.
 At the balloon date, the borrower is therefore obligated to
pay the remaining balance. This is typically done by
refinancing.
 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
 With many commercial property loans, there is a special
servicer who takes over the loan when default is
imminent.
 These servicers have the responsibility to try modify the
loan terms to avert default.
31
Commercial Mortgage-Backed Security
 Commercial Mortgage-Backed Security (CMBS) is a
security backed by one or more commercial mortgage
loans.
 Some CMBSs are backed by Fannie Mae, Freddie Mac,
and Ginnie Mae. These agency CMBSs are limited to
multifamily mortgages and healthcare facilities.
 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
 Similar to nonagency residential MBSs, many CMBSs
have
 Credit tranches (senior-subordinated structures)
 Credit enhancements (overcollaterialization, excess
interests, and monocline insurance)
 Prepayment tranches (sequential-pay, PACs, notional
interest-only (NIO), floaters, etc.)
33
Commercial Mortgage-Backed Security
Features
 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.
 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
 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.
 As a result, commercial MBSs often have less cross-default
protection.
 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.
 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
 CMBSs can be formed from a single borrower with
multiple properties.
 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
 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.
 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
 Conduit deals are often structured by large banks such as
Bank of America, Well Fargo, or J.P, Morgan.
 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
 With such large deals, there are different servicing levels.
 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
 Commercial MBS investors include institutional
investors.
 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
 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
 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
 Like most securitized assets, ABS can be structured with
different prepayment and credit tranches and can include
different credit enhancements.
 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
 Automobile loan-backed securities are often referred to
as CARS (certificates for automobile receivables).
 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
 The automobile loans underlying these securities are similar to
mortgages in that borrowers make regular monthly payments that
include interest and a scheduled principal.
 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
 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
 The prepayment for auto loans is typically measured in
terms of the absolute prepayment speed (APS).
 APS measures prepayment as a percentage of the
original collateral amount, instead of the prior period’s
balance.
 The relation between APS and the monthly prepayment
rate (single monthly mortality rate maturity, SMM) is
APS
SMM 
1  (ABS)(M  1)
where M = month.
48
Prepayment
 If the absolute prepayment speed is 2%, then the
monthly prepayment rate in month 25 is 3.8462%:
SMM 
APS
1  (ABS)(M  1)
SMM 
.02
 .038462
1  (.02)(25  1)
49
Installment Sales Contracts
 A large part of auto manufacturers’ sales are sold from
installment sales contracts, with the company’s credit
department (often a financial subsidiary) making:
 Administrative decisions on extending credit
 Setting underwriting standards
 Originating loans
 Later servicing the loans
50
Special Purpose Vehicles
 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
 A car manufacturer might have $500 million of
installment loans resulting from monthly car sales.
 The manufacturer could set up (or may already have set
up) an SPV to sell the installment loans for $500
million cash.
 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
 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.
 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
 If the manufacturer sells the installment loans to its
SPV, though, the SPV owns the loans/assets and not the
manufacturer.
 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
 Thus, when the SPV issues ABS, the investors only
look at the credit risk associated with the installment
loans and not the manufacturer.
 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
 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.
 This two-step securitization process is done to ensure
that the transaction is considered a true sale for tax
purposes.
 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
 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
 ABS deal of a representative U.S. auto manufacturer’s
financial subsidiary in which car loans are securitized.
 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
 The key features of the deal:
4. Bond classes Aa (A1a, 2a, A3a) are fixed rate
5. Bond classes Ab (A1b and A2b) 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.
A1a = $300 million
A2a = $200 million
A3a = $100 million
59
ABS Example
 The key features of the deal:
8. Principal amount for senior floating-rate is $200
million
1. A1b = $100 million
2. A2b = $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
 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
Auto Manufacturer
Auto Manufacturer Financial Subsidiary
Loan Depositor, Servicer, and Administrator
ABS
Example
$1.1 Billion Auto Loans
Bank A Trustee
Special Purpose Vehicle
$1 Billion CARDS
Senior Class $800m
$600m
Senior Class Fixed
Rate (a)
Sequential-Pay :1 and 2
A1a Notes: $300m
A2a Notes: $200m
A3a Notes: $100m
$200m
Senior Class Floating
Rate (b)
Sequential-Pay :1 and
2
A1b Notes: $100m
A2b Notes: $100m
$200m Subordinate Class
$200m Fixed Rate Notes
B Notes
$100m
C Notes
$50m
D Notes
$50m
Fixed-Rate Payer Swap
Contract with Financial
Institution
62
Home Equity Loan-Backed Securities
 Home-equity loan-backed securities are referred to as
HELS.
 They are similar to MBSs in that they pay a monthly
cash flow consisting of interest, scheduled principal, and
prepaid principal.
 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
 The home equity loans forming the pool backing a
HEL issue are also subject to default.
 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
 Credit-card receivable-backed securities are
commonly referred to as CARDS (certificates for
amortizing revolving debts).
65
Credit-Card Receivable-Backed Securities
Nonamortized Loans
 Securitized asset formed with home equity loans, residential
mortgages, and auto loans are backed by loans that are amortized.
 ABSs with amortizing assets are sometime referred to as selfliquidating structures.
 In contrast, CARDS investors do not receive an amortized
principal payment as part of their monthly cash flow.
 That is, the credit card receivables backing a CARD are
nonamortizing loans where there is not a schedule of periodic
principal payments.
 As such, prepayment does not apply for a pool of credit card
receivable loans.
66
Credit-Card Receivable-Backed Securities
 Credit cards are issued by banks (VISA and MasterCard),
retailers, and global payment and travel companies (American
Express).
 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.
 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
 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.
 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
 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.
 The master trust is very large, including millions of
credit card accounts, totaling billions of dollars.
69
Credit-Card Receivable-Backed Securities
 Numerous credit card deals or series are then issued
from the master trust.
 Each series is, in turn, identified by a year and a
number:
2007 -1
2007-2
2007 -3
2007-4
2007-5
2008-1
2008-2
2008-3
2008-4
2009-1
2009-2
2009-3
70
Credit-Card Receivable-Backed Securities
 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.
 During the lockout period, the cash flow to CARD investors comes
from finance charges and fees.
 This period can last a number of years.
 The lockout period is followed by the principal amortizing
period when principal received by the trustee is paid to CARD
investors.
 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
 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%).
 For a CARD series with low or declining MPRs, there is a chance
there may not be sufficient cash to pay off the principal.
 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
 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
 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.
 Key features of the series include:
1. The issuing entity is the credit card issuer’s master trust
 The depositors is the card issuer’s finance corporation
 The sponsors and originators are the credit card issuer’s bank
 The service is the credit card company
 The CARD is identified as 2008 Series 1
74
Credit-Card Receivable-Backed Securities
Example
 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
 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
 Collateralized Debt Obligations (CDOs) are securities
backed by a diversified pool of one or more fixedincome assets or derivatives.
 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:
 The issuance of CDOs grew from the 1990s to 2007, but stopped
in 2008 in the aftermath of the 2008 financial crisis. There are
still, though, a number of issues outstanding.
 CDOs deals are set up with a collateral manager who is
responsible for purchasing the debt obligation and managing the
portfolio of debt obligations.
 CDOs can vary in terms of their objectives.
 CDOs are often structured with different tranches and credit
enhancements.
80
Collateralized Debt Obligations
 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
 Before the financial crisis of 2008, synthetic CDOs were one
of the fastest growing segments of the CDO market.
 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
 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
 Slide 84 shows a CDO with
 Four tranches
 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
Tranche
Senior A1
Senior A2
Junior B
Subordinate/Equity
Collateralized
Debt Obligations
Example
Par
Coupon
Coupon Rate
$100m
$60m
$20m
$20m
Fixed
Floating
Fixed
--
5-year T-note Rate + 150bp
LIBOR + 100bp
5-year T-note Rate + 200bp
--
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 A2 Tranche
Senior-Subordinate Structure
 Tranche B is subordinate to A1 and A2
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 $60m notional principal in return for a payment of LIBOR on $60m.
Projected First-Year Cash Flow
1.
2.
3.
4.
Interest from collateral = (.08)($200m)
Payment to A1 tranche: ($100m)(.06 + .015)($100m)
Payment to A2 tranche: (LIBOR + .01)($60m)
Interest paid to swap counterparty:
(.06)($60M) = $3.6m
5.
Interest received from swap counterparty:
(LIBOR)($60m)
6.
Payment to B Tranche: ((.06 + .02)($20m)
____________________________________________
Net
____________________________________________
7.
Payment to Subordinate/Equity Tranche
$16m
− $7.5m
− (LIBOR + .01)($60m)
−$3.6m
+ (LIBOR)($60m)
− $1.6m
________________
$2.7m
_________________
$2.7m
84
Collateralized Debt Obligations
Example
 The CDO’s four tranches consist of:
1.
A senior A1 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 A2 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
 Since Tranche A2 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 A2 tranche.
 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
 The interest rate swap contract when combined with the
floating rate loan obligation on Tranche A2 serves to fix the
rate on the tranche at 7%:
Tranche A2
Swap
Swap
Net
Pay LIBOR + 100 basis point
Pay 6%
Receive LIBOR
Pay 6% + 1%
− (LIBOR + 1%)
− 6%
+ LIBOR
− 7%
87
Collateralized Debt Obligations
Example
 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.
 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
 Restrictions are imposed on what the collateral
manager can do.
 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
 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
 Example
 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
 Example
 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
 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.
 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.
 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
 Most CDO deals also have an early termination requirement if an
event of default occurs.
 Such an event relates to conditions that could significantly impact
the performance of the collateral.
 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.
 Many of the CDOs that were based on subprime mortgage loans
resulted in the CDOs issuing events of default notices.
94