auto loans interest rate

Harcourt strategy sheet ABS & MBS Description ABS and MBS strategies fall under the umbrella of structured finance products and include securities that have a claim to all or part of a pool of assets. Such claims can range from payments made by a group of homeowners on commercial or residential properties to payments by car owners on their leases to payments by credit cards. ABS and MBS securities are some of the most complex instruments and include derivative instruments MORTGAGE BACKED SECURITIES MBS is an asset-backed security whose cash flows are backed by the principal and interest payments of a set of mortgage loans. Payments are typically made monthly over the lifetime of the underlying loans. Residential mortgagors in the United States have the option to pay more than the required monthly payment (curtailment) or pay off the loan in its entirety (prepayment). Because curtailment and prepayment affect the remaining loan principal, the monthly cash flow of a MBS is not known in advance, and therefore presents a risk to MBS investors. Overall, value of MBS securities can vary based on the level of interest rates, prepayment speeds (ability to prepay loans at any time) and default risk (credit risk) The US federal government has played a major role in the development of the mortgage market, with three agencies, Ginnie Mae, Fannie Mae and Freddie Mac, being the major payers in issuing and guaranteeing MBS. MBS are not yet very common outside of US, UK, Australia, Denmark and Argentina. Various types of mortgage-backed securities include: Pass-through mortgage-backed security is the simplest type of MBS. A passthrough issuer acquires mortgages either by originating them or by purchasing them in the whole loan market. Mortgages with similar characteristics are collected into a pool, and undivided ownership interests in the pool are sold as pass-through certificates. This undivided interest entitles the owner of the security to a pro rata chare of all interest payments and all scheduled or pre-paid interest payments. These securities can be subdivided further into: • • • Residential mortgage-backed security (RMBS) - a pass-through MBS backed by mortgages on residential property; Commercial mortgage-backed security (CMBS) - a pass-through MBS backed by mortgages on commercial property; Collateralized mortgage obligation (CMO) - a more complex MBS in which the mortgages are ordered into tranches by some quality (such as repayment time), with each tranche sold as a separate security. For more details please see below. Stripped mortgage-backed securities (SMBS): Each mortgage payment is partly used to pay down the loan's principal and partly used to pay the interest on it. These two components can be separated to create SMBSs, of which there are two subtypes: o Interest-only stripped mortgage-backed securities (IO) - a bond with cash flows backed by the interest component of property owner's mortgage payments. Principal-only stripped mortgage-backed securities (PO) - a bond with cash flows backed by the principal repayment component of property owner's mortgage payments. • o Mortgages are also subdivided by varieties of underlying mortgages in the pool: Harcourt strategy sheet ABS & MBS • Prime: conforming mortgages of prime (higher quality) borrowers with full documentation (such as verification of income and assets), strong credit scores, etc. Alt-A: refers generally to prime borrowers, with loans non-conforming in some way, such as lower documentation or purpose of loan (vacation home) Subprime: weaker credit scores, often with no verification of income or assets, etc. Jumbo: the size is bigger than the "conforming loan amount" as set by the US agencies. • • • Collateralized mortgage obligations (CMOs) In order to facilitate protection of investors from interest rate risk as well as credit risk, CMOs are structured such that prepayments are allocated between bonds using a fixed set of rules. The most common schemes for prepayment tranching are described below. 1. Sequential Tranching (or by time): All of the available principal payments go to the first sequential tranche, until its balance is decremented to zero, then to the second, and so on. 2. Parallel Tranching: tranches that pay down pro rata. The coupons on the tranches would be set so that in aggregate the tranches pay the same amount of interest as the underlying mortgages. The tranches could be either fixed rate, or floating rate. If they have floating coupons, they would have formulas that make their total interest equal to the collateral interest. For example, with collateral that pays a coupon of 8%, you could have two tranches that each have half of the principal, one being a floater that pays LIBOR with a cap of 16%, the other being an inverse floater that pays a coupon of 16% minus LIBOR. A special case of parallel tranching is known as the IO/PO split. IO and PO refer to Interest Only and Principal Only. In this case, one tranche would have a coupon of zero (meaning that it would get no interest at all) and the other would get all of the interest. These bonds could be used to speculate on prepayments. A principal only bond would be sold at a deep discount (a much lower price than the underlying mortgage) and would rise in price rapidly if many of the underlying mortgages were prepaid. The interest only bond would be very profitable if few of the mortgages prepaid, but could get very little money if many mortgages prepaid. 3. Schedule bonds (also called PAC or TAC bonds) This type of tranching has a bond (often called a PAC or TAC bond) which has even less uncertainty than a sequential bond by receiving prepayments according to a defined schedule. The schedule is maintained by using support bonds (also called companion bonds) that absorb the excess prepayments. • Planned Amortization Class (PAC) bonds have a principal payment rate determined by two different prepayment rates, which together form a band (also called a collar). Early in the life of the CMO, the prepayment at the lower PSA will yield a lower prepayment. Later in the life, the principal in the higher PSA will have declined enough that it will yield a lower prepayment. The PAC tranche will receive whichever rate is lower, so it will change prepayment at one PSA for the first part of its life, and then switch to the other rate. The ability to stay on this schedule is maintained by a support bond, which absorbs excess prepayments, and will receive less prepayments to prevent extension of average life. However, the PAC is only protected from extension to the amount that prepayments are made on the underlying MBSs. When the principal of that bond is exhausted, the CMO is referred to as a "busted PAC", or "busted collar". Harcourt strategy sheet ABS & MBS • Target Amortization Class (TAC) bonds are similar to PAC bonds, but they do not provide protection against extension of average life. 4. Very Accurately Defined Maturity (VADM) bonds Very Accurately Defined Maturity (VADM) bonds are similar to PAC bonds in that they protect against both extension and contraction risk, but their payments are supported in a different way. Instead of a support bond, they are supported by accretion of a Z bond. Because of this, a VADM tranche will receive the scheduled prepayments even if no prepayments are made on the underlying. 5. Z bonds - This type of tranche supports other tranches by not receiving an interest payment. The interest payment that would have accrued to the Z tranche is used to pay off the principal of other bonds, and the principal of the Z tranche increases. The Z tranche starts receiving interest and principal payments only after the other tranches in the CMO have been fully paid. This type of tranche is often used to customize sequential tranches, or VADM tranches. 6. Non-Accelerating Senior (NAS) NAS bonds are designed to protect investors from volatility and negative convexity resulting from prepayments. NAS tranches of bonds are fully protected from prepayments for a specified period, after which time prepayments are allocated to the tranche using a specified step down formula. For example, an NAS bond might be protected from prepayments for five years, and then would receive 10% of the prepayments for the first month, then 20%, and so on. 7. NASquential NASquentials were introduced in mid 2005 and represented an innovative structural twist, combining the standard NAS (Non-Accelerated Senior) and Sequential structures. Similarly to a sequential structure, the NASquentials are tranched sequentially. However, each tranche has a NAS-like hard lockout date associated with it. Unlike with a NAS, no shifting interest mechanism is employed after the initial lockout date. ASSET-BACKED SECURITIES (ABS) ABS is a type of bond or Note that is based on pools of assets, or collateralized by the cash flows from a specified pool of underlying assets. Assets are pooled to make otherwise minor and uneconomical investments worthwhile, while also reducing risk by diversifying the underlying assets. These asset pools can be made of any type of receivable from the common, like credit card payments, auto loans, and mortgages, or esoteric cash flows such as aircraft leases, royalty payments and movie revenue. Typically, the securitised assets might be highly illiquid and private in nature. Common types of ABS include: 1. Home Equity Loans - Securities collateralized by home equity loans (HELs) are currently the largest asset class within the ABS market. Investors typically refer to HELs as any nonagency loans that do not fit into either the jumbo or alt-A loan categories. While early HELs were mostly second lien subprime mortgages, firstlien loans now make up the majority of issuance. In addition to first and second-lien loans, other HEL loans can consist of high loan to value (LTV) loans, re-performing loans, or open-ended home equity lines of credit (HELOC), which homeowners use as a method to consolidate debt. 2. Auto Loans - The second largest sub sector in the ABS market is auto loans. Auto finance companies issue securities backed by underlying pools of auto-related loans. Auto ABS are classified into three categories: prime, nonprime, and subprime. Prime auto ABS are collateralized by loans made to borrowers with strong credit histories. Nonprime auto ABS consist of loans made to lesser credit quality consumers, which may have higher cumulative losses. Finally subprime borrowers will typically have lower incomes, tainted credited histories, or both. Harcourt strategy sheet ABS & MBS Owner trusts are the most common structure used when issuing auto loans and allow investors to receive interest and principal on sequential basis. Deals can also be structured to pay on a pro-rata or combination of the two. 3. Credit Card Receivables - Securities backed by credit card receivables have been benchmark for the ABS market since they were first introduced in 1987. Credit card holders may borrow funds on a revolving basis up to an assigned credit limit. The borrowers then pay principal and interest as desired, along with the required minimum monthly payments. Because principal repayment is not scheduled, credit card debt does not have an actual maturity date and is considered a non-amortizing loan. ABS backed by credit card receivables are issued out of trusts that have evolved over time from discrete trusts to various types of master trusts of which the most common is the de-linked master trust. Discrete trusts consist of a fixed or static pool of receivables that are tranched into senior/subordinated bonds. A master trust has the advantage of offering multiple deals out of the same trust as the number of receivables grows, each of which is entitled to a pro-rata share of all of the receivables. The delinked structures allow the issuer to separate the senior and subordinate series within a trust and issue them at different points in time. The latter two structures allow investors to benefit from a larger pool of loans made over time rather than one static pool 4. Student Loans - ABS collateralized by student loans. Federal Family Education Loan Programs or FFELP loans are the most common form of loans and almost entirely guaranteed by the U.S. Government. 5. Other - There are many other cash-flow-producing assets, including manufactured housing loans, equipment leases and loans, aircraft leases, trade receivables, dealer floor plan loans, and royalties. Harcourt strategy sheet ABS & MBS Categories Return Drivers • • • Risks Risk Return Profile Correlations Relative value trades between tranches, vintages, originators Government agency guaranteed MBS vs. privately issued MBS and ABS) Complexity, i.e. many market participants with insufficient know how, resulting in wide spreads and lots of arbitrage opportunities. • Inherent market inefficiency, i.e. homeowner decisions are often irrational and based on non-financial reasons. • Institutional investors might be eligible to buy only certain securities, resulting in the risky bits trading at deep discounts. • Market participants all buy different securities, hedge differently and use different prepayment models with different assumptions => low correlation among hedge funds. • Prepayment risk • Liquidity risk: securities are fairly illiquid, especially in uncertain markets • Short volatility except for long convexity positions (e.g. short MBS + long bond) • Mark-to-market risk: securities can be difficult to price • Complexity and basis risk: hedging extremely difficult given complexity of valuation models and assumptions on factors, such as interest rates, prepayments, etc. • Overall macro outlook, including a view on the real estate market and employment • Some interest rate and yield curve risk, e.g. more prepayments if flat yield curve • Leverage • Credit risk, especially for sub-prime mortgages Expected return p.a.: 12-15% Standard deviation p.a.: 3-8% Correlation to stocks: 0.0 to +0.5 Correlation to bonds: sometimes negative if lower rates cause prepayments An investment in an alternative investment carries substantial risks. The nature and extent of some of these risks differ from traditional investments in stocks and bonds. There can be no assurance that the advice or information provided above will lead to superior performance. In particular, the performance of an alternative investment may vary substantially over time. Investors bear the risk of losing all or part of their investment and thus should carefully consider the appropriateness of such investments for their portfolio. While the information contained in this document has been obtained from sources deemed reliable, no representation is made as to its accuracy or completeness, and it should not be relied on as such. Past performance is not necessarily indicative of future performance.