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Asset-Backed Security (ABS) Instrument and Market Features

Fixed Income

ABS Structures to Address Credit Risk

Learning Outcome Statement:

describe typical credit enhancement structures used in securitizations

Summary:

The content discusses various credit enhancement structures used in securitizations to mitigate credit risk. These include overcollateralization, excess spread, and credit tranching (subordination). Overcollateralization involves having collateral value exceed the face value of issued bonds, providing a cushion against defaults. Excess spread refers to the difference between the interest earned on underlying assets and the interest paid to securities holders, which can absorb losses or build reserves. Credit tranching involves creating multiple bond classes with varying degrees of risk and return, where losses are absorbed by junior tranches first, protecting senior tranches.

Key Concepts:

Overcollateralization

Overcollateralization is a credit enhancement strategy where the value of the collateral exceeds the face value of the bonds issued. This provides a buffer to absorb losses from defaults, ensuring that there are sufficient assets to cover the payments to bondholders even in adverse scenarios.

Excess Spread

Excess spread is the difference between the interest rates received from the assets in the collateral pool and the interest rates paid to the bondholders. This spread can be used to cover losses from defaults or to accumulate in a reserve account to enhance credit protection.

Credit Tranching

Credit tranching, or subordination, involves structuring the securitization into multiple tranches with different levels of risk and return. Junior tranches absorb losses first, thereby protecting the more senior tranches. This structure allows investors to select tranches that match their risk appetite.

Formulas:

Overcollateralization Ratio

Overcollateralization Ratio=Total Collateral ValueTotal ABS Value\text{Overcollateralization Ratio} = \frac{\text{Total Collateral Value}}{\text{Total ABS Value}}

This formula calculates the ratio of the total collateral value to the total value of the issued ABS, indicating the degree of overcollateralization. A higher ratio suggests a greater buffer against potential losses from asset defaults.

Variables:
TotalCollateralValueTotal Collateral Value:
The total economic value of all the assets included as collateral.
TotalABSValueTotal ABS Value:
The total face value of the asset-backed securities issued.
Units: dimensionless (ratio)

Non-Mortgage Asset-Backed Securities

Learning Outcome Statement:

describe types and characteristics of non-mortgage asset-backed securities, including the cash flows and risks of each type

Summary:

Non-mortgage asset-backed securities (ABS) include various types of collateral such as credit card receivables and solar loans. These securities are structured to manage credit risk through mechanisms like subordination and credit tranching. The cash flows from these securities depend on the type of underlying collateral, with differences between amortizing and non-amortizing loans affecting the payment structures and risk profiles.

Key Concepts:

Credit Card Receivable ABS

Credit card receivable ABS are backed by pools of non-amortizing credit card debts where principal repayments during the revolving period are reinvested in new receivables. These ABS structures typically include credit enhancements such as subordination and overcollateralization to protect against credit risk.

Solar ABS

Solar ABS are backed by solar loans or leases, which are amortizing loans used for financing residential solar energy systems. These ABS may qualify as green bonds and include credit enhancements like overcollateralization and subordination to mitigate default risks.

Credit Enhancement

Credit enhancements in ABS include subordination, overcollateralization, and excess spread. These mechanisms improve the creditworthiness of the senior tranches by providing additional protection against losses from the underlying collateral.

Amortizing vs. Non-Amortizing Loans

Amortizing loans involve scheduled principal and interest repayments over the loan term, leading to a gradual decrease in the outstanding balance. Non-amortizing loans, such as credit card debts, do not have scheduled principal repayments during the revolving period, affecting the cash flow structure and risk profile of the ABS.

Formulas:

Loss Distribution Calculation

Vafter default=Vinitial−losses absorbedV_{\text{after default}} = V_{\text{initial}} - \text{losses absorbed}

This formula calculates the remaining value of each bond class after absorbing losses due to defaults in the underlying collateral. Losses are distributed first to the most junior tranches.

Variables:
Vafter defaultV_{\text{after default}}:
Value of bond class after default
VinitialV_{\text{initial}}:
Initial value of bond class
lossesabsorbedlosses absorbed:
Total losses absorbed by the bond class
Units: Monetary units (e.g., USD, EUR)

Covered Bonds

Learning Outcome Statement:

describe characteristics and risks of covered bonds and how they differ from other asset-backed securities

Summary:

Covered bonds are senior debt obligations issued by financial institutions, backed by a segregated pool of assets such as mortgages or public sector assets. Unlike other asset-backed securities (ABS), the loans in covered bonds remain on the issuer's balance sheet and are ringfenced into a separate cover pool. Investors have dual recourse in case of bankruptcy, first on the ringfenced loans and second on the unencumbered assets of the issuing institution. Covered bonds typically involve overcollateralization and strict loan-to-value criteria to mitigate risks, offering lower yields due to their lower credit risk compared to similar ABS.

Key Concepts:

Cover Pool

A segregated pool of assets, typically loans, that back the covered bond. These assets remain on the issuer's balance sheet but are ringfenced to provide security to bondholders.

Dual Recourse

In the event of issuer bankruptcy, covered bond investors have claims both on the ringfenced loans in the cover pool and on the unencumbered assets of the issuing institution.

Overcollateralization

A risk mitigation tool where the collateral underlying the transaction exceeds the face value of the issued bonds, providing a cushion against defaults.

Loan-to-Value (LTV) Criteria

The mortgages included in the cover pool must meet specific LTV standards to be eligible. Non-compliant mortgages are replaced to ensure adherence to these criteria.

Redemption Regimes

Mechanisms to align the covered bond's cash flows with the original maturity schedule in case of a default by the financial sponsor. Includes features like hard-bullet and soft-bullet covered bonds.

Collateralized Debt Obligations

Learning Outcome Statement:

describe collateralized debt obligations, including their cash flows and risks

Summary:

Collateralized Debt Obligations (CDOs) are complex financial instruments that pool various types of debt obligations and issue securities backed by these pools. CDOs can be backed by a variety of debt types, including corporate bonds, bank loans, and other CDOs. The structure typically involves multiple tranches with varying degrees of risk and return, managed by a collateral manager who actively manages the debt pool to meet the obligations to bondholders. The cash flows from the underlying assets are used to pay the bondholders, and the structure aims to provide higher returns to equity tranche holders through leveraging.

Key Concepts:

CDO Structure

CDOs issue securities backed by diversified pools of debt obligations. These can include corporate bonds, bank loans, and other structured securities. The structure typically includes multiple tranches (senior, mezzanine, and equity) that offer different risk-return profiles.

Collateral Manager

A key component of CDOs, the collateral manager actively manages the pool of debt obligations, buying and selling assets to generate sufficient cash flows to meet the obligations to bondholders and to maintain the performance of the CDO.

Cash Flows and Payments

The cash flows from the underlying collateral assets, such as interest payments and principal repayments, are used to pay the CDO bondholders. The structure of payments is designed to prioritize senior tranches over junior tranches, with equity holders taking on the most risk and potential for higher returns.

Risks

CDOs carry various risks including default risk of the underlying assets, management risk by the collateral manager, and market risks affecting the value and liquidity of the securities. The performance of the CDO heavily depends on the management of the collateral pool and the quality of the underlying assets.

Formulas:

Overcollateralization Ratio

Overcollateralization Ratio=Value of Collateral AssetsValue of CLO Debt\text{Overcollateralization Ratio} = \frac{\text{Value of Collateral Assets}}{\text{Value of CLO Debt}}

This ratio measures the extent to which the value of the collateral exceeds the value of the debt issued, providing a buffer against losses.

Variables:
ValueofCollateralAssetsValue of Collateral Assets:
Total value of the bank loans or other assets used as collateral
ValueofCLODebtValue of CLO Debt:
Total principal value of the notes issued by the CLO
Units: dimensionless (ratio)
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