Mortgage-Backed Securities by zhangyun


									Nonagency Residential MBSs,
Commercial MBSs, and Other
  Asset-Backed Securities

                     Other Securitized Assets

   Agency MBSs represent the largest and most extensively developed
    asset-backed security.

   Since 1985, a number of other asset-backed securities have been

   The most common types are nonagency residential MBS, commercial
    MBSs, and asset-backed securities backed by automobile loans, credit
    card receivables, and home equity loans.

   These asset-backed securities are structured as pass-through and many
    have prepayment tranches.

   Different from agency MBSs, though, the collateral backing these
    asset-backed securities are subject to credit and default risk.

Nonagency Residential MBS

          Nonagency Residential MBS

 MBS created by one of the agencies are collectively
  referred to as agency MBSs, and those created by
  private conduits are called nonagency MBSs or
  private labels.

            Nonagency Residential MBS
 Agency residential MBSs are created from conforming

 All other mortgages that are securitized are nonagency

 Nonagency residential MBSs can, in turn, be classified as
  either prime MBSs, in where the underlying mortgages
  are all prime, or subprime MBSs, where the underlying
  mortgage pool consists of subprime mortgages.

 In grouping the different types of securitized assets
  (residential mortgages, commercial mortgages, and other
  assets) nonagency subprime MBSs are typically grouped
  with asset-backed securities and not mortgage-backed
           Default Loss and Credit Tranches

 Nonagency MBSs or nonagency CMOs are subject to
  default losses.

 A portfolio of 30-year, 8% mortgages with a 100 standard
  default assumption (SDA) has a cumulative default rate
  after 120 months of 3.59% and one with a 300 SDA has a
  cumulative default rate of 10.46%.

 Different from agency MBSs, investors of nonagnecy
  MBS need to taken into account the expected default losses
  in determining the credit spread for pricing such securities.

Projected Cash Flows with Default Loss
     Mortgage Portfolio = $100,000,000,
WAC = 8%, WAM = 360 Months, 100 SDA Model

  Cumulative Default Rates
 100, 200, and 300 SDA Models
Mortgage Portfolio = $100,000,000,
WAC = 8%, WAM = 360 Months

       Default Loss and Credit Tranches

 MBS conduits address credit risk on nonagency MBSs by
  providing credit enhancements designed to absorb the
  expected losses from the underlying mortgage pool
  resulting from defaults.

 For nonagency MBSs or CMOs, credit enhancement
   1. Senior-Subordinate Structures
   2. Excess Spreads
   3. Overcollateralization
   4. Monoline Insurance

            Senior-Subordinate Structures

 A MBS issue with a senior-subordinate structure is formed
  with two general bond classes: a senior bond class and a
  subordinated bond class, with each class consisting of one
  or more tranches.

 The next slide shows a $500 million senior-subordinate
  structured MBS with one senior bond class with a principal
  of $400 million and six subordinate or junior classes with a
  total principal of $100 million.

         Senior-Subordinate Structures

Bond Class    Tranche     Principal      Credit Ratings
  Senior         1       $400 million        AAA
Subordinate      2       $40 million          AA
Subordinate      3       $20 million           A
Subordinate      4       $10 million         BBB
Subordinate      5       $10 million          BB
Subordinate      6       $10 million           B
Subordinate      7       $10 million       Not Rated

             Senior-Subordinate Structures

 For this MBS issue, the default losses are absorbed first by
  Tranche 7 (starting at the bottom) and ascend up.
    If losses on the collateral are less than $10 million, then
     only Tranche 7 will experience a loss
    If losses are $30 million, then Tranches 7, 6, and 5 will
     realize losses

 The senior-subordinated structured MBS spreads the credit
  risk amongst the bond classes. This is referred to as credit

            Senior-Subordinate Structures

 The rules for the distribution of the cash flows that include
  the distribution of losses are referred to as the cash flow
  waterfalls or simply waterfalls.

 Because of the different levels of default risk, each of the
  subordinate tranches created in a senior-subordinate
  structured MBS are separately rated by Moody’s or
  Standard and Poor’s, with the lower tranches receiving
  lower ratings.

                Senior-Subordinate Structures

  Senior Interest
 The proportion of the mortgage balance of the senior bond class to the
  total mortgage deal is referred to as senior interest (initial senior
  interest = $400m/$500m = .80).

  Subordinate Interest
 The proportion of the mortgage balance of the subordinated bond
  classes to the total mortgage deal is referred to as subordinate interest
  (initial subordinate interest = $100m/$500m = .20).

 The greater the subordinate interest, the greater the level of credit
  protection for the senior bond.

              Senior-Subordinate Structures

  Shifting Interest Schedule
 Over the life of the MBS deal, the level of credit protection
  will change as principal is prepaid.

 In general, with prepayment, senior interest will increase
  and the subordinate interest will decrease over time.

 Because of this, most senior-subordinate structured MBS
  deals have a shifting interest schedule designed to
  maintain the credit protection for the senior bond class.

            Senior-Subordinate Structures

  Shifting Interest Schedule
 Shifting interest schedule is used to determine the
  allocation of prepayment that goes to the senior and
  subordinate tranches.
 Example:
                     Shifting Interest Schedule
           Years after Issuance        Shifting Interest Percentage
                   1-5                             100%
                     6                              70%
                     7                              60%
                     8                              40%
                     9                              20%
                    10                              10%
                 After 10                            0

              Senior-Subordinate Structures

  Shifting Interest Schedule
 In determining the allocation to the senior holders, their
  percentage of prepayment is equal to their initial senior
  interest (for example, 80% = $400m/$500m) plus the
  shifting interest (based on the schedule) times the
  subordinate interest (20% = ($100m/$500m):

                     Initial           Initial          Shifting
                     Senior                             Interest
 prepayment      =               +    Subordinate   x
                     Interest                           Proportion
 Percentage                           Interest

                  Senior-Subordinate Structures
      Shifting Interest Schedule
      Senior                   Initial                  Initial                     Shifting
      prepayment               Senior            +     Subordinate            x     Interest
                       =       Interest                Interest                     Proportion
           Initial senior interest = $400m/$500m = .80
           Initial subordinate interest = $100m/$500m = .20
                      Years after Issuance                  Shifting Interest Percentage
                             1-5                                       100%
                               6                                        70%
                               7                                        60%
                               8                                        40%
                               9                                        20%
                              10                                        10%
                           After 10                                      0

 Based on the above schedule:
     100% of the prepayment would go to the senior class for the first five years (= 80% + (1)(20%) =
     96% in year 6 (= 80% + (20%)(.70)
     92% in year 7, and so on.
     After year 10, the allocation of principal between senior and subordinate classes would match
      their initial senior and subordinate interest proportions of 80% and 20%.                   18
            Senior-Subordinate Structures

  Step-Down Provision
 The shifting-interest schedule from 100% to 70% in year 6,
  to 60% in year 7, to finally 0% after year 10 is known as a
  step-down provision; such a provision allows for
  reductions in the credit support over time.

             Senior-Subordinate Structures

 In many senior-subordinated structured MBS deals,
  provisions are included that allow for changes in the
  shifting interest schedule if credit conditions related to the
  underlying collateral deteriorate.

 Typically, the provisions prohibit the step-down provision
  in the shifting interest schedule from occurring if certain
  performance measures are not met.

 For example, if the cumulative default losses exceed a
  certain limit of the original balance or if the 60-day
  delinquency rate exceeds a specified proportion of the
  current balance, then step downs would not be allowed.
                      Excess Interest

 Excess interest (or excess spread) is the interest from the
  collateral that is not being used to pay MBS investors and
  fees (mortgage servicing and administrative services).

 The excess spread can be used to offset any losses.

 If the excess interest is retained, it can be accumulated in
  an account and used to offset futures default losses.

 When this is done, the excess interest can be set up similar
  to a notional interest-only (IO) class, with the proceeds
  going to a reserve account and paid out to IO holders at
  some future date if there is an excess.

 Overcollateralization is having the par value of the
  collateral exceeds the value of the MBS issued.

 For example, if the MBS issue of $500 million had $550
  million in collateral.

 The $50 million excess would then be used to absorb
  default losses.

           Monoline Insurance Companies

 Some Nonagency MBSs also have external credit
  enhancements in the form of insurance provided by
  Monoline insurance companies.

 Monoline insurance companies: Finance Guarantee
  Insurance Corporation, the Capital Markets Insurance
  Corporation, or the Financial Security Assurance

 The guarantees provided by monoline insurers, in turn,
  shifts the default risk to the insurer.

Commercial MBS

                   Commercial Mortgages
  Commercial Mortgage Loans
 Real estate property can be either residential or nonresidential.

 Residential includes houses, condominiums, and apartments; it is
  classified as either single-family or multiple-family.

 Nonresidential includes commercial and agricultural property.

 Commercial real estate loans are for income-producing properties.
  They are used to finance the purchase of the property or to refinance
  an existing one.

              Commercial Mortgages

 Commercial property can include:
  1.   Shopping centers
  2.   Shopping strips
  3.   Multifamily apartment buildings
  4.   Industrial properties
  5.   Warehouses
  6.   Hotels
  7.   Health care facilities

               Commercial Mortgages

 In contrast to residential mortgages where the interest
  and principal payments come from borrowers’ income-
  generating ability or wealth, commercial mortgage
  loans come from income produced from the property.

 As such, commercial mortgage loans are referred to as
  non-recourse loans.

               Commercial Mortgages

  Assessing Credit Quality
 Lenders in assessing the credit quality of commercial
  loans look at
    The debt-to-service ratio (= Rental Income –
     operating expenses)/ Interest Payments)
    The loan-to-value ratios, where value is equal to
     the present value of expected cash flows or the
     appraised value.

               Commercial Mortgages

  Prepayment Protection
 Commercial mortgage loans also differ from residential
  mortgage loans in that they typically have prepayment

 Prepayment protection can take the form of prepayment
  penalties, provisions prohibiting prepayment for a
  specified period, and defeasance.

 Note: Defeasance is an agreement whereby the borrower
  agrees to invest funds in risk-free securities in an amount
  that would match the cash flows of a prepayment
                 Commercial Mortgages

  Balloon Risk
 Unlike residential mortgage loans in which the principal
  is amortized over the life of the loan, commercial
  mortgage loans are typically balloon loans.

 At the balloon date, the borrower is therefore obligated to
  pay the remaining balance. This is typically done by

 As a result, the lender is subject to balloon risk: The risk
  that the borrower will not be able to make the balloon
  payment because they either cannot refinance or sell the
  property at a price that will cover the loan.
                Commercial Mortgages

  Special Servicer
 With many commercial property loans, there is a special
  servicer who takes over the loan when default is

 These servicers have the responsibility to try modify the
  loan terms to avert default.

        Commercial Mortgage-Backed Security

 Commercial Mortgage-Backed Security (CMBS) is a
  security backed by one or more commercial mortgage

 Some CMBSs are backed by Fannie Mae, Freddie Mac,
  and Ginnie Mae. These agency CMBSs are limited to
  multifamily mortgages and healthcare facilities.

 Most CMBSs are private labels formed by either a single
  borrower with many properties or by a conduit with
  multiple borrowers.

         Commercial Mortgage-Backed Security

 Similar to nonagency residential MBSs, many CMBSs
    Credit tranches (senior-subordinated structures)

    Credit enhancements (overcollaterialization, excess
     interests, and monocline insurance)

    Prepayment tranches (sequential-pay, PACs, notional
     interest-only (NIO), floaters, etc.)

         Commercial Mortgage-Backed Security

 One feature common to residential and commercial
  mortgage-backed securities is cross-collateralization:
  property used to secure one loan is also used to secure the
  other loans in the pool.

 Cross-collateralization prevents the MBS
  investors/lenders from calling the loan if there is a
  default, provided there is sufficient cash flows from the
  other loans to cover the loan’s default loss. Such
  protection is called cross-default protection.

             Commercial Mortgage-Backed Security

 Commercial MBS can be formed with a fewer number of loans than
  residential MBS and with some loans being more important to the
  pool than others.

 As a result, commercial MBSs often have less cross-default

 To redress this, some commercial MBSs include a property release
  provision that requires the borrower of a commercial loan to pay a
  premium (e.g. 105% of par) if the property is removed from the pool.

 The provision is aimed at averting potential deterioration in the
  overall credit quality of the collateral when the best property in the
  pool is prepaid.
        Commercial Mortgage-Backed Security

  Single Borrower with Multiple Properties
 CMBSs can be formed from a single borrower with
  multiple properties.

 These deals are often set up by large real estate
  developers who use commercial MBSs as a way to
  finance or refinance their numerous projects: shopping
  malls, office buildings, hotels, apartment complexes, and
  the like.

         Commercial Mortgage-Backed Security

  Conduit Deals
 The other type of commercial MBS deal is one in which
  there are multiple borrowers or originators with the MBS
  set up through a conduit—a conduit deal.

 When the deal has one large borrower or property
  combined with a number of smaller borrowers, the deal is
  referred to as a fusion conduit deal.

         Commercial Mortgage-Backed Security

  Conduit Deals
 Conduit deals are often structured by large banks such as
  Bank of America, Well Fargo, or J.P, Morgan.

 Note: It is not uncommon for the conduit deal to be used
  to finance properties totaling as much as $1 billion, with
  as many as 200 property loans, varying in type (office,
  multi, warehouses, etc.,), geographical distributions, and
  credit enhancements.

          Commercial Mortgage-Backed Security

  Conduit Deals
 With such large deals, there are different servicing levels.

 For example, there may be subservicing by the local
  originators who are required to collect payments and
  maintain records, a master servicer responsible for
  overseeing the commercial MBS deal, and a special
  servicer responsible for taking action if a loan becomes
  past due.

         Commercial Mortgage-Backed Security

  CMBS Investors
 Commercial MBS investors include institutional

 These investors, in turn, evaluate a commercial MBS
  issue not only in terms of issue’s general sensitivity to
  economic conditions and interest rates, but also assess
  each income-producing property on an ongoing basis.

Asset-Backed Securities

               Asset-Backed Securities

 Asset-Backed Securities (ABSs) are securities created
  from securitizing pools of loans other than residential
  prime mortgage loans and commercial loans; as noted,
  residential subprime MBS are included in the ABS

                Asset-Backed Securities

 Loans used to create ABSs include
   1. Home Equity Loans
   2. Credit Card Receivables
   3. Home Improvement Loans
   4. Trade Receivables
   5. Franchise Loans
   6. Small Business Loans
   7. Equipment Leases
   8. Operating Assets
   9. Subprime Mortgages

                  Asset-Backed Securities

 Like most securitized assets, ABS can be structured with
  different prepayment and credit tranches and can include
  different credit enhancements.

 The three most common types of ABSs are those backed
   1. Automobile Loans
   2. Credit Card Receivables
   3. Home Equity Loans

         Automobile Loan-Backed Securities

 Automobile loan-backed securities are often referred to
  as CARS (certificates for automobile receivables).

 They are issued by the financial subsidiaries of auto
  manufacturing companies, commercial banks, and
  finance companies specializing in auto loans.

         Automobile Loan-Backed Securities

 The automobile loans underlying these securities are similar to
  mortgages in that borrowers make regular monthly payments that
  include interest and a scheduled principal.

 Also like mortgages, automobile loans are characterized by
  prepayment. For such loans, prepayment can occur as a result of
   1. Car sales
   2. Trade-ins
   3. Repossessions
   4. Wrecks
   5. Refinancing when rates are low

         Automobile Loan-Backed Securities

 CARS differ from MBSs in that they have
   1. Shorter maturities

   2. Their prepayment rates are less influenced by
      interest rates than mortgage prepayment rates

   3. They are subject to greater default risk


 The prepayment for auto loans is typically measured in
  terms of the absolute prepayment speed (APS).

 APS measures prepayment as a percentage of the
  original collateral amount, instead of the prior period’s

 The relation between APS and the monthly prepayment
  rate (single monthly mortality rate maturity, SMM) is

   where M = month.                                           48

 If the absolute prepayment speed is 2%, then the
  monthly prepayment rate in month 25 is 3.8462%:

             Installment Sales Contracts

 A large part of auto manufacturers’ sales are sold from
  installment sales contracts, with the company’s credit
  department (often a financial subsidiary) making:
    Administrative decisions on extending credit
    Setting underwriting standards
    Originating loans
    Later servicing the loans

               Special Purpose Vehicles

 Automobile loan-backed securities are often created
  from installment sales loans and typically issued by
  special purpose vehicles (SPV) created by the
  manufacturer or its financial subsidiary; the financial
  subsidiary may also be set up as a special purpose

              Special Purpose Vehicles

 A car manufacturer might have $500 million of
  installment loans resulting from monthly car sales.

 The manufacturer could set up (or may already have set
  up) an SPV to sell the installment loans for $500
  million cash.

 The SPV would then sell the $500 million in securities
  backed by the loans as ABSs.

                Special Purpose Vehicles

  Advantage of SPV over Issuing Debt
 Instead of securitizing the installment loans as ABS
  through an SPV, the auto manufacturer could have
  alternatively raised $500 million by issuing corporate
  notes, either as a debenture or collateralized by the
  installment loans.

 If the manufacturer were to default, though, all of its
  creditors would be able to go after all of its assets.

                Special Purpose Vehicles

  Advantage of an SPV over Issuing Debt
 If the manufacturer sells the installment loans to its
  SPV, though, the SPV owns the loans/assets and not the

 Thus, if the manufacturer were forced into bankruptcy,
  its creditors would not be able to recover the installment
  loans of the SPV.

                Special Purpose Vehicles

  Advantage of an SPV over Issuing Debt
 Thus, when the SPV issues ABS, the investors only
  look at the credit risk associated with the installment
  loans and not the manufacturer.

 As a result, by financing with securitization via an SPV,
  the ABS issue often has a better credit rating and a
  lower rate than the manufacturer’s notes.

                 Two-Step Securitization

 In practice, a manufacturer often uses a two-step
  securitization process whereby it first sells the loans to
  its financial subsidiary (an intermediate SPV) who then
  sells the loans to the SPV who creates the ABS.

 This two-step securitization process is done to ensure
  that the transaction is considered a true sale for tax

 If the manufacturer’s financial subsidiary is considered
  a wholly owned subsidiary, then it may only be allowed
  to engage in purchasing, owning, and selling

 ABSs are characterized by having a number of features:
   1. Credit tranches
   2. Overcollateralization
   3. Excess interest
   4. Sequential-pay tranches
   5. Derivative positions

                   ABS Example

 ABS deal of a representative U.S. auto manufacturer’s
  financial subsidiary in which car loans are securitized.
 The key features of the deal include:
   1. Car loans totaling $1.1 billion purchased from the
      car manufacturer’s financial subsidiary by a special
      purpose vehicle.

   2. $1 billion of CARDS (auto-loan-backed securities)
      issue (overcollateralization).

   3. A senior-subordinated structure consisting of $800
      million senior class bond (A) and $200 million
      subordinate class bonds (B, C, and D).
                       ABS Example

 The key features of the deal:
   4. Bond classes Aa (A1a, 2a, A3a) are fixed rate

   5. Bond classes Ab (A1b and A2b) are floating rate

   6. Senior bond classes A are sequential pay: 1, 2,
      and 3

   7. Principal amount for senior fixed-rate is $600
       1.   A1a = $300 million
       2.   A2a = $200 million
       3.   A3a = $100 million

                      ABS Example

 The key features of the deal:

   8. Principal amount for senior floating-rate is $200
       1. A1b = $100 million
       2. A2b = $100 million

   9. Principal amount for subordinate fixed-rate is $200
       1. B = $100 million
       2. C = $50 million
       3. D = $50 million

                     ABS Example

 The key features of the deal include:

   10. The SPV entered into an interest rate swap with a
       financial institution for each of the floating rate
       bonds to fix the rate (swaps are discussed in
       Chapter 20).

   11. Each month the cash flows from the collateral are
       used to pay the service fee and the payments to
       the swap.

   12. Bank A is the Trustee.


          Home Equity Loan-Backed Securities

 Home-equity loan-backed securities are referred to as

 They are similar to MBSs in that they pay a monthly
  cash flow consisting of interest, scheduled principal, and
  prepaid principal.

 In contrast to mortgages, the home equity loans securing
  HELS tend to have a shorter maturity and different
  factors influencing their prepayment rates.

        Home Equity Loan-Backed Securities

 The home equity loans forming the pool backing a
  HEL issue are also subject to default.

 Like nonagency MBS, commercial MBS, and
  CARDS, HEL deals are often structured with different
  prepayment tranches, credit tranches, and credit

         Credit-Card Receivable-Backed Securities

 Credit-card receivable-backed securities are
  commonly referred to as CARDS (certificates for
  amortizing revolving debts).

          Credit-Card Receivable-Backed Securities

  Nonamortized Loans
 Securitized asset formed with home equity loans, residential
  mortgages, and auto loans are backed by loans that are amortized.
    ABSs with amortizing assets are sometime referred to as self-
     liquidating structures.

 In contrast, CARDS investors do not receive an amortized
  principal payment as part of their monthly cash flow.
     That is, the credit card receivables backing a CARD are
      nonamortizing loans where there is not a schedule of periodic
      principal payments.
     As such, prepayment does not apply for a pool of credit card
      receivable loans.

            Credit-Card Receivable-Backed Securities

 Credit cards are issued by banks (VISA and MasterCard),
  retailers, and global payment and travel companies (American

 Credit card borrowers usually make a minimum principal
  payment, in which if the payment is less than the interest on the
  debt, the shortfall is added to the principal balance, and if it
  greater, it is used to reduce the balance.

 The cash flow from a pool of card receivables comes from
    1. Finance charges (interest charges based on unpaid balance)
    2. Principal collected
    3. Fees

           Credit-Card Receivable-Backed Securities

 The CARDS formed from a pool of credit card
  receivables are often structured with two periods.
   1. In one period, known as the lockout period (or revolving
      period) all principal payments made on the receivables are
      retained and either reinvested in other receivables or invested
      in other securities.
        When new assets are added to an ABS deal, the structure
          is called a revolving structure.

   2.   In the other period, known as the principal-amortization
        period (or amortizing period), all current and accumulated
        principal payments are distributed to the CARD holders.

         Credit-Card Receivable-Backed Securities

 In structuring an ABS secured by credit card
  receivable, the issuer often sets up a master trust
  where the credit card accounts meeting certain
  eligibility requirement are pledged.

 The master trust is very large, including millions of
  credit card accounts, totaling billions of dollars.

         Credit-Card Receivable-Backed Securities

 Numerous credit card deals or series are then issued
  from the master trust.

 Each series is, in turn, identified by a year and a

         2007 -1         2008-1            2009-1
         2007-2          2008-2            2009-2
         2007 -3         2008-3            2009-3
         2007-4          2008-4

           Credit-Card Receivable-Backed Securities

 Each series has a lockout period where, as noted, the principal
  payments made by the credit card borrowers are retained by the
  trustee and reinvested in additional receivables or securities.
     During the lockout period, the cash flow to CARD investors comes
      from finance charges and fees.
     This period can last a number of years.

 The lockout period is followed by the principal amortizing
  period when principal received by the trustee is paid to CARD

 There can also be an early amortizing provision in some series
  that requires early amortization of principal if certain events

           Credit-Card Receivable-Backed Securities

  Evaluating CARD
 In evaluating a CARD series, investors often monitor the monthly
  payment rate (MPR): the monthly payment of finance charges,
  fees, and principal repayment from the credit card receivable
  portfolio (e.g., $50 million) as a percentage of the credit card debt
  outstanding (e.g. , $500 million; MPR = 10%).

 For a CARD series with low or declining MPRs, there is a chance
  there may not be sufficient cash to pay off the principal.

 If there is an early amortization provision, an MPR falling below
  a threshold MPR would be the trigger for early amortization.

            Credit-Card Receivable-Backed Securities

  Evaluating CARD
 Other important rate measures for evaluating CARDs include:
    1. Gross Portfolio Yield: finance charges collected and fees as a
       proportion of the credit card debt outstanding

    2. Charge-offs: the accounts charged off as uncollectable as a
       proportion of the credit card debt outstanding

    3. Net portfolio Yield: gross profit yield minus charge-offs as a
       proportion of the credit card debt outstanding; this is the return
       CARD holders receive.

    4. Delinquency Rate: Proportion of receivables that are past due—30,
       60, or 90 days

            Credit-Card Receivable-Backed Securities

 Like many ABS, CARDs are characterized by having a number
  of features. Slide 77 shows an example of a CARD deal of a
  representative credit card issuer.

 Key features of the series include:
  1. The issuing entity is the credit card issuer’s master trust
         The depositors is the card issuer’s finance corporation
         The sponsors and originators are the credit card issuer’s bank
         The service is the credit card company
         The CARD is identified as 2008 Series 1

            Credit-Card Receivable-Backed Securities

 Key features of the series include:
   2.   Total CARDS issue is $600 million.

   3.   There is a senior-subordinate structure with $550 million issued to
        the Senior A Class and $50 million to Subordinate B Class.

   4.   Interest payment to each class is equal to the monthly LIBOR +

   5.   The final payment date of the series is anticipated to be 2015.

   6.   Principal collected during the lockout period is to be used to invest
        in additional receivables. Principal is to be accumulated in a
        ―principal funding account.‖

           Credit-Card Receivable-Backed Securities

 Key features of the series include:
  7. In January 2012, the Trust will begin accumulating
       collection of receivables for principal repayment and begin
       distributing principal to Bond Class A and Bond Class B.

   8.   Early amortization is triggered if the MPR for any three
        consecutive months is less than a specified base level.

   9.   If the collection of receivables is less than expected,
        principal may be delayed.

                     Credit-Card-Backed Security Deal
                                      Credit Card Bank


                                     Credit Card Master Trust

                                                                $50 million
                      $600 million         2008-1

                   Class A                                       Class B

                                        CARDS Holders

1. Interest payment to each class is equal to the monthly LIBOR + spread.
2. The final payment date of the series is anticipated to be 2015.
3. Principal collected during the lockout period is to be used to invest in additional receivables.
    Principal is to be accumulated in a ―principal funding account.‖
4. In January 2012, the Trust will begin accumulating collection of receivables for principal
    repayment and begin distributing principal to Bond Class A and Bond Class B.
5. Early amortization is triggered if the MPR for any three consecutive months is less than 10%.
6. If the collection of receivables is less than expected, principal may be delayed.                  77
Collateralized Debt Obligations

             Collateralized Debt Obligations

 Collateralized Debt Obligations (CDOs) are securities
  backed by a diversified pool of one or more fixed-
  income assets or derivatives.
 Assets from which CDOs are formed include:
   1. Investment Grade Corporate Bonds
   2. Asset-backed Securities
   3. High-yield Corporate Bonds
   4. Leveraged Bank Loans
   5. Distressed Debt
   6. Residential Mortgage-Backed Securities
   7. Commercial Loans
   8. Commercial Mortgage-Backed Securities
   9. Real Estate Investment Trusts
   10. Municipal Bonds
   11. Emerging Market Bonds
              Collateralized Debt Obligations

 The issuance of CDOs grew from the 1990s to 2007, but stopped
  in 2008 in the aftermath of the 2008 financial crisis. There are
  still, though, a number of issues outstanding.

 CDOs deals are set up with a collateral manager who is
  responsible for purchasing the debt obligation and managing the
  portfolio of debt obligations.

 CDOs can vary in terms of their objectives.

 CDOs are often structured with different tranches and credit

             Collateralized Debt Obligations

 There are four types of CDOs:
  1. Cash Flow CDOs that make periodic payment of
     interest and principal.

  2. Market Value CDOs that are characterized by total
     returns generated from the collateral: interest income,
     capital gains, and principal.

  3. Synthetic CDOs that are formed with derivatives

  4. Balance Sheet CDOs consisting of bank loans in which
     the objective is to sell or remove the loans from the
     balance sheet.
              Collateralized Debt Obligations

 Before the financial crisis of 2008, synthetic CDOs were one
  of the fastest growing segments of the CDO market.

 A common structure for a synthetic CDS was the issuance of
  the CDOs to finance the purchase of high quality bonds with
  the CDO manager then entering into credit default swap
  contracts as the seller to enhance the return
    That is, from the swap position the fund would receive
     premiums for providing default protection against a bond
     or bond portfolio.

              Collateralized Debt Obligations

 Slide 84 shows a CDO with
    Four tranches
    Backed by a $200 million collateral investment consisting
       1. Fixed-rate, investment-grade bonds with a par value
          of $200 million
       2. Weighted average maturity of five years
       3. Yielding a return 200 basis points over the five-year

                   Tranche                                 Par                 Coupon         Coupon Rate
                   Senior A1                             $100m                 Fixed          5-year T-note Rate + 150bp
                   Senior A2                              $60m                Floating        LIBOR + 100bp
                   Junior B                               $20m                 Fixed          5-year T-note Rate + 200bp
                   Subordinate/Equity                     $20m                   --                           --
                     Collateral Requirements:
 Collateralized     Investment-grade bonds
                    Weight average maturity of 5 years
Debt Obligations    Average quality rating of A
   Example            Swap
                   Manager will enter interest rate swap contracts to
                   fix the rate on the A2 Tranche
                      Senior-Subordinate Structure
                    Tranche B is subordinate to A1 and A2
                        Initial Collateral Investment:
                    $200 million investment in investment-grade portfolio yielding 8%
                   T-note rate at time of initial investment of 6%
                   Initial spread on portfolio of 200 basis points
                      Initial Swap Agreement:
                    CDO manager agrees to pay 6% on $60m notional principal in return for a payment of LIBOR on $60m.

                                                             Projected First-Year Cash Flow

                   1.  Interest from collateral = (.08)($200m)                                         $16m
                   2.  Payment to A1 tranche: ($100m)(.06 + .015)($100m)                              − $7.5m
                   3.  Payment to A2 tranche: (LIBOR + .01)($60m)                              − (LIBOR + .01)($60m)
                   4.  Interest paid to swap counterparty:
                       (.06)($60M) = $3.6m                                                              −$3.6m
                   5.  Interest received from swap counterparty:
                        (LIBOR)($60m)                                                             + (LIBOR)($60m)
                   6.  Payment to B Tranche: ((.06 + .02)($20m)                                        − $1.6m
                   ____________________________________________                                  ________________
                   Net                                                                                  $2.7m
                   ____________________________________________                                 _________________
                   7.  Payment to Subordinate/Equity Tranche                                            $2.7m

                  Collateralized Debt Obligations

 The CDO’s four tranches consist of:
   1.   A senior A1 trance with a par value of $100 million, paying a fixed
        rate equal to the five-year T-note rate plus 150 basis points

   2.   A senior A2 tranche with a par value of $60 million and paying a
        floating rate equal to LIBOR plus 100 basis points

   3.   A subordinate B Tranche with a par value of $20 million and
        paying a fixed rate equal to the five-year T-note rate plus 200 basis

   4.   A subordinate/equity tranche with a par value of $20 million that
        receives the excess return: return from collateral minus returns paid
        to the other tranches.
               Collateralized Debt Obligations

 Since Tranche A2 pays a floating rate and the underlying
  collateral is to consist of fixed-rate bonds, the CDO deal
  allows the manager to take a derivative position to fix the
  rate on the A2 tranche.

 In this deal, the manager enters an interest rate swap
  contract to pay a fixed rate of 6% on a $60 million notional
  principal in return for the receipt of a floating rate payment
  equal to the LIBOR on a $60 million notional principal.

                Collateralized Debt Obligations

 The interest rate swap contract when combined with the
  floating rate loan obligation on Tranche A2 serves to fix the
  rate on the tranche at 7%:

   Tranche A2      Pay LIBOR + 100 basis point   − (LIBOR + 1%)
      Swap         Pay 6%                        − 6%
      Swap         Receive LIBOR                 + LIBOR
       Net         Pay 6% + 1%                   − 7%

            Collateralized Debt Obligations

 If the initial investment of collateral were in
  investment-grade bonds yielding 8% when five-year
  Treasuries were yielding 6%, then the CDO deal
  would be expected to yield an excess return of $3.1
  million in the first year, with the $3.1 million going
  to the Equity/Subordinate Tranche.

 As a rule, managers in structuring a cash flow CDO
  will estimate the expected return to the
  subordinate/equity tranche investors, as well as the
  return and risk of the Tranches to determine the
  feasibility of the CDO deal.
          Collateralized Debt Obligations

  CDO Restrictions
 Restrictions are imposed on what the collateral
  manager can do.

 In the above example, the manager was required to
  invest the collateral in investment-grade bonds with
  an average maturity of five years.

          Collateralized Debt Obligations

  CDO Restrictions
 In general, the restrictions on CDOs include:
   1. Constraints on the payment of interest and
      principal to the CDO investors

   2. The credit management of the portfolio

   3. The lengths of investment periods

          Collateralized Debt Obligations

  CDO Restrictions
 Example
 Rules for the distribution of interest and principal
  could specify that the manager distribute all interest
  and principal to senior tranches but restrict the
  payment of principal to subordinate tranches if
  certain credit conditions are not met (e.g. a coverage
  ratio not being met).

           Collateralized Debt Obligations

  CDO Restrictions
 Example
 There could also be credit restrictions that prohibit
  the manager from making certain investments if the
  asset fails to meet certain quality tests as it relates to
  the collateral’s diversification, maturity, and average
  credit quality.

               Collateralized Debt Obligations

   CDO Restrictions
 Credit restrictions are often specified in terms of a par value
  test that requires that the value of the underlying collateral be
  equal to a certain percentage (e.g., 110%) of the par value of
  the CDOs or the par value of the senior CDO class.
     If the collateral value were to drop below the par value test, then
      the manager would be required to take certain actions such as
      making all principal payments to senior tranche holders.

 Similarly, the restriction might be defined in terms of an
  interest coverage tests that requires the collateral’s return to
  meet interest payments.

                Collateralized Debt Obligations

    Event Of Default
 Most CDO deals also have an early termination requirement if an
  event of default occurs.

 Such an event relates to conditions that could significantly impact
  the performance of the collateral.

 This could include a failure to comply with certain coverage ratios,
  the bankruptcy of an issuing credit, or the departure of the collateral
  management team.

 Many of the CDOs that were based on subprime mortgage loans
  resulted in the CDOs issuing events of default notices.


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