Commerce 4FJ3
Fixed Income Analysis
Week 8
CMBS and Asset Backed Securities
Commercial Mortgage Loans
• Loans secured by income producing
properties
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Multifamily dwellings
Office buildings
Shopping centers
Hotels
• Are usually non-recourse loans
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Credit Approval
• 2 main ratings of the credit of an applicant
– Debt to service coverage ratio (DSC); net
operating income to debt service charges
– Loan to Value (LTV); amount of principal
outstanding compared to the present value of
future net operating income
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Call Protection
• Most commercial mortgages do not allow
free prepayments
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Prepayment lockout
Defeasance
Prepayment penalty points
Yield maintenance charges
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Prepayment Lockout
• For a certain period of time, prepayments
are not permitted
• Lockout periods are often 2-10 years
• Many loans with lockout periods also have
other call protection that start once the
lockout period ends
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Defeasance
• Second strongest form of call protection
• To prepay, the borrower must pay an
amount great enough to replicate missed
cash flows with treasury securities
– Often used by municipal bond issuers
• Lenders may prefer getting prepayments as
it increases the value of their loans
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Prepayment Penalty Points
• A fixed percentage charge on prepayments
• Similar to call premiums on bonds
• 5-4-3-2-1 is a common schedule, 5%
penalty in year 1, dropping to 1% in year 5
• Penalty is paid even if interest rates are
rising and the lender could benefit from the
prepayment
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Yield Maintenance Charges
• Floating charges that make prepayments for
refinancing unattractive
• The lower the general level of interest rates
the higher the yield maintenance charges
– Simple model, bullet model, single discount
factor, truncated interest difference model...
• Usually drop to zero if interest rates are at
or above the coupon rate
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Balloons
• Commercial mortgages typically have a
balloon maturity provision
• Lender may allow an extension if the
borrower has difficulty refinancing, but
charge a higher default interest rate
– The possibility of default on the balloon
payment is called balloon risk and, with the
above provision can be a form of extension risk
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Commercial MBS
• Commercial mortgage backed securities are
backed by 1 or more commercial mortgages
• Can be issued by an agency (Ginne Mae,
Freddie Mac, Fannie Mae)
• More often issued privately due to not
qualifying for government loan guarantees
• Usually structured like CMOs
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Example CMBS
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From p. 321; National Bank
18 tranches rated AAA to BBB- or not rated
Different default risk layers
Senior tranches are sequential
Floating rate tranches created without
inverse floaters through use of swaps
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Balloon Risk in CMBS
• To offset balloon risk CMBS can include
– Internal tail; a contractual obligation for the
borrowers to provide proof of refinancing
efforts 1 year before maturity and a refinancing
commitment 6 months before maturity
– External tail; sets the maturity of the CMBS
longer than the maturity of the loans allowing
for a work-out period in the event of delayed
refinancing
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Clean-Up Call Provision
• Every CMBS transaction has a clean-up call
provision that permits the bond classes that are
outstanding to purchase the remaining mortgage
loans in a trust.
• The purpose of clean-up call in all securitizations
is to wind-down the transaction when the balance
remaining in the transaction is too small to justify
the ongoing administrative fees.
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Clean-Up Call Provision II
• Typically the cleanup call provision is limited to
when the balance of mortgage loans in the
mortgage pool represents 1% to 3% of the deal’s
original balance of the trust.
• Usually the price at which the remaining loans can
be repurchased is the outstanding balance of the
mortgage loans plus accrued interest.
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Single Borrower Deals
• Single borrower/multi-property deals allow
for some risk reduction through crosscollateralization and cross-default features
• To prevent the borrower from removing a
good asset from the pool and letting the
remainder go into default, there are often
property release provisions
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Multi-Borrower Deals
• CMBS deals put together by conduits
• If the deal contains a single large loan in
excess of $50 million and a large amount of
smaller mortgages it is called a fusion
conduit deal
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Services
• Can have a single servicer or multiple
– Sub-servicer; collects cash and information
– Master servicer; oversees the deal, verifies
details of the agreement, makes timely payment
of interest and principal (even when there are
late payments)
– Special servicer; deals with accounts more than
60 days overdue
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Analysis of Collateral
• Due to non-recourse basis the loans should
be analysed as stand alone businesses
– Performance indicators, LTV and DSC are
reported regularly
– Each type of business has it’s own set of
associated risks, types of risk and amount of
exposure are included in the prospectus
– Geographic distribution is also reported
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Stress Testing
• Various models can be used to determine
the impact of various levels of default and
prepayment experience on the different
tranches
• Often done by analysts and bond ratings
companies
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Asset Backed Securities
• Securities backed by pools of loans other
than first lien mortgages are referred to as
asset backed securities
• Major types include; automobile loans,
credit card receivables, home equity loans,
and manufactured housing loans
• Securitization not limited to loans; David
Bowie royalties, parking ticket receivables
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Credit Risk
• Since these loans are not guaranteed, the
investor faces credit risk
• Four factors to consider
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Credit quality of the collateral
Quality of the seller/servicer
Cash flow stress and service structure
Legal structure
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Credit Quality of the Collateral
• Analysis of the credit quality of the
collateral depends on the asset type
• Look at the borrower’s ability to pay and
the borrower’s equity in the asset
• Examine the experience of the lenders and
assess if the assets being sold have the same
qualities
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Concentration Risk
• With a large number of borrowers in a pool
there can be significant diversification
• If a few borrowers make up a large portion
of the total pool this diversification can be
lost, this is concentration risk
• Some ratings companies put limits on the
maximum percentage from one borrower
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Credit Enhancement
• As with MBS, asset backed securities often
include credit enhancement to get the credit
rating the issuer desires
– External enhancement; insurance, corporate
guarantees, letters of credit
– Internal enhancement; reserve funds, overcollateralization, senior/subordinated structure
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Quality of the Seller/Servicer
• Duff & Phelps, for example, reviews the
following when evaluating servicers:
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servicing history
experience
originations
servicing capabilities
human resources
financial condition
growth/competition/business environment.
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Cash Flow Stress and Payment
Structure
• The cash flow payments that must be made
are; interest and principal to investors,
servicing fees, and any other expenses for
which the issuer is liable
• Payment structure deals with payment
priorities between tranches… is the
structure a pass-through or pay-through
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Legal Structure
• If the corporate entity wishes to retain some
interest in the collateral, there is concern
that a bankruptcy court could redirect the
collateral’s cash flows or the collateral itself
• To avoid this, a bankruptcy-remote specialpurpose vehicle (SPV) is formed
• The wholly owned corporation buys the
loans and issues the asset backed security
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Cash Flows
• An asset backed security can have either
amortizing or non-amortizing cash flows
• If there are no scheduled principal payments
then the issue is non-amortizing, even if the
monthly minimum payment is greater than
the interest charges
• Prepayment and default rates must also be
forecast
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Automobile Loans
• Cash flow: amortized, fixed or floating rate
• Prepayments:
– Caused by, replacement, repossession, loss or
destruction, refinancing
– Repossession rates sensitive to economic
conditions
– Modelled using absolute prepayment rate
(ABS) as a percent of original balance
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Automobile Loans
• Payment structure
– Smaller deals often pass-through
– Larger deals usually pay-through
• Credit enhancement
– Typically uses senior/subordinated structure
– Often uses some other credit enhancement to
boost support to 8-12%
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Credit Card Receivables
• Cash Flow
– Non-amortized, fixed or floating rate
– Principal payments received in lockout or
revolving period (18 months to 10 years) are
reinvested in additional receivables
– After the lockout period, principal payments are
made to investors, this is called the principalamortization period
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Credit Card Receivables
• Early amortization triggers: if some event
happens, the reinvestment in receivables is
stopped early
• Monthly payment rate (MPR): monthly
payment divided by outstanding balance
tracked, low levels can lead to extension
risk and may trigger early amortization
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Credit Card Payment Structure
• Three different structures have been used:
– Pass-through structure
– Controlled amortization structure: payments are
the lesser of a low principal payment schedule
or the actual principal payments
– Bullet-payment structure: all principal repaid at
a certain date, during accumulation period,
principal payments invested in cash accounts
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C. C. Credit Enhancement
• Early securities used bank letters of credit
• Some credit downgrades of banks caused
this to go out of favour
• Common today are senior/subordinated
structures with cash collateral accounts (or
collateral invested accounts)
• Typical support levels around 11%
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HEL Backed Securities
• Home equity loans are 2nd or lower lien
mortgages; closed end is like a normal mortgage,
open ended is like a line of credit
• Cash Flow: monthly, similar to MBS, but
prepayments reach a high level faster and at a
higher level, with both tendencies exaggerated as
the credit quality of the borrower decreases
• Payment structures: any
• Credit enhancements: any
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Manufactured Housing
• Manufactured Housing (mobile homes)
loans can be issued as mortgages (if land
included) or consumer retail instalment
loans
• MHBS can be issued by Ginnie Mae or by
private entities
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Manufactured Housing
• Amortization period usually 15-20 years
• Prepayments lower than conventional MBS
– Lower prices, so less incentive to refinance
– Depreciation often faster than principal pay
down, so refinancing may be difficult
– Lower average credit rating of borrowers
• Payment structure and credit enhancement
as for any other mortgage backed security
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Dodd-Frank Wall Street Reform
and Consumer Protection Act
• Because of the turmoil that occurred in the
securitization market and related sectors of the
financial market, in July 2010, Congress passed
the Dodd-Frank Wall Street Reform and
Consumer Protection Act.
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Dodd-Frank Wall Street Reform
and Consumer Protection Act
• The key features of the act;
– Securitizes must retain a portion of the
transaction’s credit risk
– Reporting standards and disclosure
– Representations and warranties required to be
provided and the mechanisms for enforcing
them
– Due diligence requirements
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Collateralized Debt Obligations
• When the ABS market began, there was a
debt product that employed the
securitization to pool a diversified pool of
some asset type and issue securities backed
by the cash flow of the asset pool. These
debt products are called collateralized debt
obligations (CDOs)
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Collateralized Debt Obligations
• Although many types of asset classes have been
used as collateral in a CDO, the following are the
major ones:
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investment-grade corporate bonds
high-yield corporate bonds
emerging market bonds
nonagency residential mortgage-backed securities
commercial mortgage-backed securities (CMBS);
leveraged bank loans
collateralized debt obligations
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