Asset Backed Sector of a Bond Market

Summaries

Distinguish:

1)      Seller

2)      Servicer

3)      Issuer/Trust

Waterfall: Borrower => Servicer (charge service fee) => Seller => Lender (investor)

For agency MBS, sequential-pay and PAC are pre-payment tranching. In ABS, we also need credit tranching because of the credit risk involved in ABS (e.g. Senior/Sub-ordinated Structure).

Non-amortization asset: Minimum payment is applied to accrued interest. Excess payment applied to principal reduction. Short fall increases the loan balance. (e.g. Revolving credit card loan)

ABS on non-amortization asset, there is a lock-out period. Principal payment in the lock out period is used to re-invest new loans to replace the amount paid off instead of passing to investors. => revolving structures.

Call Provisions in Revolving Structures:

1)      Option-clean up call provision (collateral fells below a certain level)

2)      Latter of percent or date call

3)      Insurer call (cumulative loss reaches a specific level)

4)      A specific date is reached

Credit Enhancement:

1)      External

a.      Corporate Guarantee

b.      Letter of Credit

c.      Bond insuance

2)      Internal –

a.      Cash Reserve Fund (from issuance proceeds)

b.      Excess Service Spread Fund

c.      Over collateralization

d.      Senior/subordinate structure

Subordinate tranches absorb credit and prepayment risk. But if prepayment increases, it increases the credit risk of the senior tranche (because subordinate is being paid-off faster). So need shifting interest mechanism, in which senior tranches receive higher proportion of prepayment in the early years.