24. Asset Backed Securities
Asset Backed Security (ABS): Financial securities issued to the public market that are backed (securitized) by
pledging a specific asset.
Mortgage Backed Security (MBS) is the subset of the ABS market, but is by far the largest
Other assets used to back securities issued:
1. Auto loans
2. Credit card receivables
3. Home equity loans (HELs)
4. Manufactured housing
5. Royalties (Music, Movies)
6. Student loans
7. Parking receivables (backed by parking garage tickets)
8. Manufacturing Equipment
9. Commercial real-estate
Q: Why issue an ABS instead of straight secured debt?
A: Potentially a lower cost debt issuance.
Assets and liabilities are removed from the balance sheet.
Once off balance sheet, a higher credit rating can be achieved for the issued security, making it
lower cost (lower yield).
Q: How is this accomplished?
Firms sell pledged assets to a special purpose vehicle (SPV). The SPV is not owned or affiliated
with the firm, so this is a “real” sale
The SPV issues debt to public markets, using the pledged assets to securitize the offering.
The yield of the issue is based the quality of the pledged assets, and not the firm, so it is possible
for a higher credit rating to be received – lower yield or higher price.
The increased revenue is passed on to the firm – taking advantage of a higher credit rating than
what could be achieved if straight secured debt were issued.
Q: What are the risk associated with this type of securitization?
Since assets are removed from the firm, there is less security available for straight secured debt
(Risk to current secured debt holders)
If the pledged assets are “necessary” for the continuation of firm operations, then the SPV holds
immense negotiating power in the event of distress (Risk to firm)
Although assets are sold to SPV, bankruptcy courts can (and have) ruled that the pledged assets still
belong to the firm (Risk to SPV). LTV steel is an example.
Feature of Asset Backed Securities
1. Amortization: The schedule of Principal and interest payments.
If principal is paid simultaneous to interest, then it is an amortizing security. Otherwise, if interest
only is paid, then it is non amortizing.
Prepayment may occurs (as in Mortgage Backed Securities), with early principal payments made,
shortening the life of the security. Prepayment does not apply for non-amortizing structures.
Non amortizing securities include those backed by receivables, or non physical assets (Credit cards,
royalties, future cashflow streams).
2. Fixed v. Floating rates: The ABS coupon rate is generally tied to the rate paid by the underlying
assets. Credit card rates are floating, so the ABS backed by these receivables is likely to be floating.
3. Credit enhancement: SPVs “support” the assets used in the securitization of the debt issuance, either
internally from the SPV itself, or from an external source.
All ABSs are rated, and the rating is based on the risk of the pledged assets, not the risk of the firm
who is selling the assets.
Given sufficient enhancement, any credit rating can be obtained, including AAA. The SPV need
only increase the level of insurance.
Credit rating agencies anticipate expected losses, and assign a credit rating based on the amount of
“support” pledged in relation to this expectation.
Credit rating support relationship might look like:
AAA for support = 4 times expected loss, AA for support = 3 times expected loss, etc.
External credit enhancement: Enhancement provisions are provided by 3rd parties (not the SPV).
• Corporate guarantees: Backed by an affiliated firm
• Bank letter of credit: A bank agrees to back SPV in the event of payment difficulty.
• Bond insurance: Insurance policy issued from a 3rd party who agrees to pay XX% of any
realized losses, up to $YY.
Internal credit enhancement: Enhancement provisions are provided by the SPV.
• Reserve funds:
Excess servicing: Underlying assets support a higher level of payment than that promised to
If gross WAC (weighted average coupon) is 8.00%, and after service fee is 7.75% (25bp
for servicing the security) then the SPV may set up the ABS to pay 7.25%, using the 50bp
spread to fund a reserve for expected losses.
cash reserve: SPV sets aside a cash reserve, independent of underlying assets, to cover
The higher the reserve, the higher the credit rating.
• Overcollateralization: Set the par value of the collateralized assets greater than the liabilities of
If ABS is issued for a face value of $200 million (total liability), then if the SPV backed
this with $214 million of pledged assets, there would be a built-in $14 million reserve.
The overcollateralized portion is used to absorb any potential losses.
• Senior subordinated structure: Similar to how a MBS separates out prepayment risk into
different tranches, the ABS separates out the credit risk
Cashflows from Senior security
asset Class receives first 90% of
- loans A cashflow
receives 10% of
B cashflow, if any
Q: What is the credit rating of the Class A shares?
Depends on the expected losses…
The disaggregation of cashflows are set according to what will make the Class A security
Q: At what price (or yield) do the class B shares sell?
Major Asset classes
1. Home equity loans (HELs)
Backed by residential property, usually a second lien if property already has a
prepayment speed is calculated in the same manner as an MBS (measured by CPR).
This is listed in the prospectus – prospectus prepayment curve (PPC).
HEL floater: When the HEL is backed by variable rate loans, typically a spread over
2. Auto loans
Finance companies of auto manufacturers (GMAC, FMC), Commercial banks, small
Maturity 3 – 6 years, fixed or variable rates.
prepayment risk due to (repossession, early payoff, insurance settlement from wreck,
sale of vehicle, or refinancing (rare).
Absolute prepayment speed (ABS) expressed in monthly prepayment rates (calculated
similar to SMM for MBSs)
3. Student loans: Most common securitization is under Federal Family Education Loan Program
Student loans are subsidized both explicitly (interest deferment) and implicitly (credit
enhancement for otherwise risky borrowers)
Government makes loans through private institutions (lenders), and these loans ARE NOT
based on the ability of the borrower to repay. Government guarantees up to 98% of P&I
• Subsidized and unsubsidized Stafford loans
• Parental student loans (PLUS)
• Supplemental loans to students (SLS)
Timing of loans:
• Deferment period – loans are not repaid until graduation
• Grace period – students have 6 months to find job and source of loan repayment
• Loan repayment period – begins after the grace period, lasts up to 10 years.
Loan rates: reference rate based on treasury securities,
The rate is determined by the 3 month treasury according to the following formula.
Alternative loans ARE based on the ability of the borrower to repay – consumer loans.
Generally made by parents or mature/working students.
Sallie Mae (Student Loan Marketing Association – SLMA)
• created by government in the same spirit as Fannie Mae and Freddie Mac, to securitize
student loans and create a liquid secondary market.
• SLMA created in 1995, is a GSE
• Issues SLABS – securitized student loans
Q: Why is the benefit of the government subsidizing student loans to the extent that they are?
4. Manufactured housing
Issued by GNMA (Ginnie Mae)
Typical maturity is 10-20 years.
Refinancing is not as prevalent for manufactured home loans compared to convential
mortgages, so prepayment speeds are more stable.
5. SBA loans (Small Business Administration)
6. Credit Card receivables
Banks – Chase, Citibank
Retailers – Sears, JC Penny
Travel Co’s – AMEX
Credit card securitizations are organized into master trusts
Firms/Institutions issuing credit card receivables pool accounts and specify the following:
• Underlying principal amount of debt held by borrowers with card
• Average credit limit (eg. $3,000)
• Seasoning of account (eg. 60% of accounts are at least 5 years old)
• Account selection process (random or other)
• Type of credit enhancement
• Credit rating of issue
Cashflows come from:
• Finance charges (interest on credit card balances)
• Principal (credit card balance)
• Fees (late payments etc.)
Lockout period: Amount of time that principal repayments are reinvested in new receivables
rather than returned to security holders.
Principal amortizing period: From the end of the lockout period through the end
The following is an example of a Master Trust issue of credit card receivables.
Fitch Expects To Rate Household Master Note Tr I, Ser 2000-1
Business Wire, Nov 8, 2000
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NEW YORK--(BUSINESS WIRE)--Nov. 8, 2000
Household Credit Card Master Note Trust I (HCCMNT I, or the trust), series 2000-1, class A floating-
rate, asset-backed notes are expected to be rated 'AAA' by Fitch and the class B notes are expected to
be rated 'A+'.
The trust has been established and consists of accounts originated under Household Bank (Nevada)
N.A.'s Union Plus program affinity relationship with Union Privilege. The trust will initially consist of
approximately $3.0 billion in receivables generated under MasterCard International Inc. and VISA
International credit card accounts originated by Household Bank (Nevada) under the Union Plus
program. Household Finance Corp. (HFC; rated 'A+/F1' by Fitch) will act as the servicer and
administrator for the trust and will engage Household Credit Services, Inc. (HCSI), an affiliate, as a
subservicer. HCSI currently services all the HFC and affiliate-managed credit card portfolio.
The expected ratings are based on the quality of the underlying collateral, the strong servicing of HFC
and HCSI and origination capabilities of Household Bank (Nevada), the required 7% minimum seller's
interest, the sound legal and cash flow structures, and the available credit enhancement.
When sizing credit enhancement, Fitch applied various stress scenarios to the trust's key performance
variables -- chargeoffs, monthly payment rate (MPR), yield and purchase rate -- to determine the
amount of losses needed to be covered during the payout period. Under the various stress scenarios,
available credit enhancement is commensurate with the rating assigned. Available credit
enhancement for the class A notes totals 17.25%, consisting of subordination of the class B
notes (7.25%) and the overcollateralization (OC) amount of 10.0%, while the required credit
enhancement for the class B notes totals 10.0%, consisting of the OC amount. The expected ratings
address the likelihood of payment of timely interest and the ultimate payment of principal by the series
final maturity date.
Noteholders will receive interest payments, based on the one-month London Interbank Offered Rate
plus a spread, on the 15th of each month, beginning Dec. 15, 2000. Unless an early amortization event
occurs, the noteholders will be paid interest only during the revolving period and a variable
accumulation period. Following the variable accumulation period, principal is expected to be paid to
noteholders on the series expected principal payment date, which is the November 2005 distribution
date. The series final maturity date is the August 2008 distribution date. During an early amortization
period, on each distribution date, principal collections will be used to pay down the notes sequentially.
7. CBO (Collateralized Bond Obligations): A diversified pool of different types of debt
• High yield (non investment grade) bonds
• Emerging market bonds
• Distressed, non-performing bonds
• Unsecured bonds
• Bank loans to corporate entities CLO
Class A: Senior notes
bond 2 Class B: Senior notes
bond 3 8.50% Baa2
bond 4 Weighted
bond 5 Average Mezzanine Notes
bond 6 Coupon 9.00% B1
bond 7 = 10.0%
Baa rated Subordinated notes
bond n 0% - 30%
Above diagram from smartpros.com Jason Nelson, Sept 11 2000.
John Hancock Bond and Corporate Finance Group, CBO offerings:
Our Competitive Advantage In our CBO program, we seek to build optimal structures for both debt and
equity investors. Each transaction reflects the character of the Bond & Corporate Finance Group and our long-
term commitment to this business. Our CBO's contain unique features, which are designed to provide
diversification and relative value opportunities for investors in structured finance. Special characteristics of
our CBO's include:
• A core position in private placement bonds, which typically have strong covenants and represent a wider
variety of issuer/industry types than is commonly found with high-yield public bonds.
• Our CBO collateral is BA or BB average quality with allocations along the credit spectrum, including
investment-grade assets and mezzanine transactions with equity participation rights.
• With a long-term view, our CBO structures generally reinvest all gains (trading gains, make-wholes,
mezzanine gains) back into the portfolio in order to add stability and durability.
• We believe transparency and information flow are very important to investors, and thus we produce a
monthly portfolio advisor report for all investors which analyzes our CBO portfolios on a market value
Our first CBO was launched in 1996, and we currently manage six cash flow CBO's. The Signature 3,
Signature 4, Signature 5, Signature 6, Signature QSPE and Signature 7 transactions are CBO products which
leverage the skills of over 41 credit analysts with access to high-value corporate bonds in the public and
private placement markets. In each case, John Hancock serves as the collateral manager and also participates,
directly or indirectly, in the equity tranche as an investor.
Summary of Signature CBO Portfolios as of December 31, 2004:
Signature 3 Signature 4 Signature 5 Signature 6 Signature 7
Inception/Completion September December December December December
of Offering 1998 1999 2000 2001 2003
Original Capitalization $300,000,000 $500,000,000 $500,000,000 326,600,000 275,700,000
Asset Quality* (excluding
BA2/BA3 BA3/B1 BA2/BA3 BA2/BA3 BA2 BA2
Private Placement Assets 26% 38% 19% 50% 32% 71%
Senior Assets 99% 95% 97% 100% 97% 95%
Senior Secured Assets 41% 37% 43% 46% 55% 69%
EM Assets 12% 0% 7% 6% 8% 9%
Risk inherent in CDOs: A story from American Express Co.
American Express Company took a pretax charge of $826 Million – Q2 2001
For losses resulting from defaults on high yield investments, a strategy started in 1997.
1. $3.0 Billion in directly owned high grade bonds
2. $745 million of investment grade structured loan trusts.
3. $900 million of high grade CDOs
4. $400 million of low grade CDOs
5. $90 million o f CDO residuals
10-12% of investments by AEFA (American Express Financial Advisors) were in CDOs, many of
the underlying investments were AEFA products.
CDOs were the larges source of loss, according to AEFA, including the investment grade CDOs
($40-$60 million loss)