Asset-Backed & Mortgage-Backed Securities

Securitization

An originator (bank, finance company, credit card issuer) pools loans/receivables and issues marketable securities backed by those cashflows. This transfers credit and liquidity risk from the originator to investors and provides funding to the originator.

• ABS: Asset-Backed Securities (backed by auto loans, credit card, student loans, leases, etc.).
• MBS: Mortgage-Backed Securities (backed by residential (RMBS) or commercial mortgages (CMBS)).
• CLO: Collateralized Loan Obligation — securitization of leveraged (corporate) loans.
• CDO: Collateralized Debt Obligation — historically pooled loans/bonds or synthetic exposures; tranches of different seniorities.

Purpose for Issuers/Investors

• Issuers: Access cheaper funding, reduce balance sheet risk, regulatory capital management.
• Investors: Exposure to diversified cash flows, higher yield than government bonds, ability to choose risk/return by tranche.

The "waterfall" is the core concept, defining the priority of payments.

1. Pool Cash Inflows: Borrower interest + scheduled principal + prepayments + recoveries.
2. Fees & Expenses: Servicer fees, trustee fees, guarantee fees deducted first.
3. Interest Distribution: Interest due to tranche investors (based on tranche coupon).
4. Principal Distribution: According to tranche priority (waterfall). Senior tranches get principal before subordinated tranches.
5. Residual/Equity: The last to receive any remaining cash.

Key structural levers: subordination (credit support), overcollateralization (OC), reserve accounts, excess spread, credit enhancement (third-party wrap / guarantee).

A. Types of MBS

• Agency MBS (Ginnie Mae, Fannie Mae, Freddie Mac): Government or GSE guaranteed; typically pass-through securities, monthly paythroughs, highly liquid.
• Non-agency (private-label) RMBS: No government guarantee, credit risk depends on mortgage underwriting and structure.
• CMBS (Commercial MBS): Backed by commercial mortgages; usually non-recourse, structured with loan-level covenants and special servicing.
• REMIC: A tax/structural wrapper used to create tranches with different characteristics while allowing tax efficiency.

B. Pass-through securities (Example & Arithmetic)

A pass-through MBS pays investors a pro rata share of the monthly cashflow from the mortgage pool after fees.

Example: Pool principal = $100,000,000; Pool WAC = 5.00%; Servicing fees = 0.50% → Pass-through coupon ≈ 4.50%.

1. Annual interest: $100,000,000 × 0.045 = $4,500,000.
2. Monthly interest: $4,500,000 ÷ 12 = $375,000.
3. If 1% monthly prepayment: $100,000,000 × 0.01 = $1,000,000 of principal is prepaid.

C. Prepayment Modeling: CPR, SMM, PSA

• CPR (Constant Prepayment Rate): Annualized percentage of outstanding principal prepaid in a year.
• SMM (Single Monthly Mortality): Monthly prepayment rate. Formula: SMM = 1 − (1 − CPR)^(1/12).
• PSA (Public Securities Association) Benchmark: A standard prepayment model ramping from 0.2% CPR to 6% CPR over 30 months.

D. Negative Convexity

When rates fall, prepayments rise, shortening the MBS life and limiting price appreciation. When rates rise, prepayments slow, lengthening the life and increasing duration. This makes hedging complex.

A. Purpose

CMOs / REMICs split the pool into tranches with differing principal repayment schedules, durations, and prepayment sensitivities, allowing investors to buy specific cashflow profiles.

B. Common Tranche Types

• Sequential (PAC / TAC): Sequential pay (Class A paid off first, then B, etc.). PAC (Planned Amortization Class) provides a stable principal payment collar.
• IO / PO (Interest Only / Principal Only): IOs receive only interest (hurt by faster prepayments). POs receive only principal (helped by faster prepayments).
• Z-tranche (Accrual bond): Receives no cash interest initially; interest accrues to principal.
• Companion tranche (support): Absorbs excess cashflows and prepayment volatility.

C. CMO Sequential Tranche Arithmetic

Pool principal = $100M; Monthly principal payments = $1.2M. Structure: Class A = $60M; Class B = $40M. All principal goes to Class A first.

Months to retire Class A: $60,000,000 ÷ $1,200,000 = 50 months. Class B receives no principal during this time.

D. IO / PO Example

Pool balance = $100M; pass-through coupon = 4.5%. First-month interest = ($100M × 4.5%) / 12 = $375,000. The IO tranche receives this, while the PO tranche receives all principal payments.

REMIC (Real Estate Mortgage Investment Conduit) is a legal/tax structure in the U.S. used to issue multiple classes of mortgage securities. It allows the pool to be treated as a pass-through for tax purposes while enabling complex tranche customization (PAC, TAC, Z, etc.).

A. Asset Classes

Auto loan ABS, credit card ABS (revolving), student loan ABS, equipment leases, royalty/film receivables, etc.

B. Revolving vs. Static Pools

• Static pool: A fixed set of assets where the principal amortizes over time.
• Revolving pool: The originator adds new receivables to replace collected principal during a "revolving period" (common in credit card ABS).

C. Credit Enhancement & Structural Protection

• Subordination (waterfall): Junior tranches absorb losses first.
• Overcollateralization (OC): Excess collateral over issued notes provides a cushion.
• Reserve account: A cash buffer for shortfalls.
• Excess spread: The pool yield minus coupon payments and fees; the first line of defense against defaults.

A. Structure & Lifecycle

• Collateral: Leveraged bank loans (senior secured corporate loans).
• Manager: An active manager buys and sells loans in the pool.
• Reinvestment period (3–5 years): Principal repayments are reinvested in new loans.
• Amortization period: Follows reinvestment; principal repays investors according to the waterfall.
• Tests: OC/IC (overcollateralization/interest coverage) tests can divert cashflows to pay down principal if tests fail.

B. Credit Enhancement & Returns

Senior tranches have low yields, supported by subordination and excess spread. The equity tranche receives residual cashflows and has high potential returns with high risk.

C. Risks

• Manager risk: Selection and trading decisions are critical.
• Credit risk: Leveraged loans' default correlation can spike in downturns.
• Liquidity & covenant deterioration: Covenant-lite loans increase risk.

CDOs package debt into tranches. Synthetic CDOs use credit default swaps instead of actual loans. Pricing requires modeling correlations among underlying assets (historically a key failure point).

• Cashflow modeling: Simulating interest, scheduled principal, and prepayment/default scenarios.
• Discounting: Tranche cashflows are discounted to a yield or curve + spread.
• OAS (Option-Adjusted Spread): Used for MBS/CMOs to account for embedded prepayment options.
• Effective duration & convexity: Option-adjusted measures for interest-rate sensitivity.
• Loss metrics (ABS/CLO): Expected loss = default rate × (1 − recovery).
• Stress testing: Running adverse scenarios to estimate tranche impairment.

• Prepayment / extension risk (MBS): The major driver of MBS performance.
• Credit/default risk (Private RMBS, ABS, CLO mezzanine/equity).
• Liquidity risk (Private-label securities and lower tranches).
• Model risk (Prepayment models, correlation models).
• Counterparty risk (Structures with derivatives or guarantees).
• Operational / servicing risk (Poor servicing reduces recoveries).

• Pooling and servicing agreement (PSA): Defines servicing, payment dates, triggers, and prepayment handling.
• Trust & trustee: The legal structure that holds collateral and enforces the waterfall.
• ISIN / settlement / custodial flows: Requires correct mapping to avoid settlement fails.
• Regulatory capital/treatment: Securitizations affect issuer and investor capital requirements.

Q: How does an MBS investor get hurt when interest rates fall?
A: When rates fall, homeowners refinance, accelerating prepayments. Investors get principal back early and must reinvest at lower yields (reinvestment risk). The MBS also displays negative convexity, limiting price appreciation.

Q: Explain IO vs PO and how prepayments affect them.
A: An IO receives interest only; its value falls with faster prepayments because the interest-generating principal shrinks. A PO receives principal only; its value rises with faster prepayments as cash flows are received sooner.

Q: How do CLOs protect senior tranche investors?
A: Via subordination (equity/mezzanine absorb first losses), excess spread, OC/IC tests that divert cashflows if performance deteriorates, and active management.

Q: What is excess spread and why is it important?
A: Excess spread = pool coupon - fees - tranche coupons. It is the first line of defense against losses and funds reserve accounts.

ABS & MBS are securitizations that transform illiquid loans into marketable securities via tranching and waterfalls. MBS have unique prepayment behavior (CPR/SMM/PSA) that creates negative convexity and makes valuation dependent on prepayment modelling and OAS. ABS use credit enhancement like subordination to create different risk classes; CLOs are actively managed loan pools with reinvestment periods and OC/IC tests. Key investor skills include cashflow modeling, scenario analysis, and managing credit & liquidity risk.