Uni_4_Structured_Investment_Products.pptx

Inversión de productos estructurados

1. Global Structured Finance Topic 4: Structured Investment Products

2. 2 | Securitized and collateralized debt instruments Mortgage-Backed Securities (MBS) Auto- Loans ABS Credit Card Receivables ABS Asset- Backed Commercial Paper (ABCP) Collateralized Debt Obligations ( CDOs ) How do rating agencies rate structured products? Structured Notes Table of Contents

3. 1. Securitized and collateralized debt instruments 3 | Mortgage-Backed Securities (MBS) These are securities whose collateral pool of assets is composed of mortgage loans . Most are Residential Mortgage-Backed Securities (RMBS), but there is also a significant market for Commercial Mortgage-Backed Securities (CMBS).

4. 1. Securitized and collateralized debt instruments 4 | Mortgage-Backed Securities (MBS) Homogenous type of asset in the pool, but diversified – mortgage pools can contain many mortgages, e.g. 200 or 200 000 mortgages Long-maturity loans (recourse, e.g. RMBS, and non-recourse, e.g. CMBS) Generally secured by collateral (the real estate asset) Regular and predictable payments Credit risk of the underlying loans is measured by calculating the borrower’s credit score , called FICO score in the U.S.:

5. 1. Securitized and collateralized debt instruments 5 | Mortgage-Backed Securities (MBS) There are two primary types of MBS: Pass-through Mortgage-Backed Securities are trusts that collect mortgage payments and distribute them (pass through) directly to investors. They have maturities of 5, 15, or 30 years. They include mortgage pools filled with fixed-rate mortgages mostly. Collateralized Mortgage-Backed Securities are composed of multiple tranches, each governed by a separate set of rules that determine how the principal and interest are distributed. Most MBS in the U.S. are issued or guaranteed by a U.S. government agency such as Ginnie Mae (Government National Mortgage Association) or by a government-sponsored enterprise (GSE) such as Freddie Mac (Federal Home Loan Mortgage Corporation) or Fannie Mae (Federal National Mortgage Association). Watch this video from 1:05: https://www.youtube.com/watch?v=t1V7H5pJY4U

6. 1. Securitized and collateralized debt instruments 6 | Auto-Loans ABS When consumers buy a car, they can get an auto loan from a car company or a bank . Hence, car loans are originated by banks or other financial institutions (including the finance units of car manufacturers). Loans normally secured by collateral (the vehicle) . Can be new or used car. Underlying asset depreciates significantly over time. Short to medium maturities (1-6 years). Monthly repayments. Very stable cash flows. Repayment type: amortizing and balloon loans (large final payment to retain the car, or sale of the car using the proceeds to pay down the loan, or return car to the dealer) Generally low prepayment speed and limited relation between prepayment and interest rates. Prepayments linked to ageing of car, desire to trade up, thefts, incidents Performance indicators/collateral characteristics indicators: New vs used; private vs commercial; credit/FICO score; prime vs subprime Arrears; defaults; recovery rates Constant Prepayment Rate (CPR) and Absolute Prepayment Speed (APS)

7. 1. Securitized and collateralized debt instruments 7 | Auto-Loans ABS Car companies that offer loans typically want to sell their loans. They want to sell them for the best price possible. The best price is achieved through securitization. A car company can hire an underwriter to help structure the securitization and find investors to buy the securities which will be issued. Investment banks ( underwritters ) are in charge of finding interested investors .

8. 1. Securitized and collateralized debt instruments 8 | Credit Card Receivables ABS Credit Card Asset-Backed Securities are fixed-income securities that are backed by the cash flow from credit card debt repayments . As lenders collect on credit card payments, interest and fees, these cash flows are used to fund the principal and interest payments to the ABS investors. New loans can be added to the pool at any time, and repayments do not have scheduled amounts . The popularity of these securities began in the 198 0s as credit card use became more widespread.

9. 1. Securitized and collateralized debt instruments 9 | Asset-Backed Commercial Paper (ABCP) An Asset-Backed Commercial Paper (ABCP) is a short-term investment vehicle with a maturity date typically between 90 and 270 days. The notes are backed by a company's trade receivables and other assets (t he pool of assets can include assets under repos, receivables, but also longer-term assets like structured finance securities, commercial loans, residential mortgages, car loans, or credit card receivables). This market lies at the crossroads between the cash money market and the structured credit markets.

10. 1. Securitized and collateralized debt instruments 10 | Asset-Backed Commercial Paper (ABCP) Conduit structure : A bank or other financial institution is typically the sponsor and provides support.

11. 1. Securitized and collateralized debt instruments 11 | Asset-Backed Commercial Paper (ABCP) Maturity mismatches between assets and liabilities in the structure: ABCP conduits fund themselves solely in the Commercial Paper market, usually with short-term issues of notes, exposing them to liquidity risks in the event of disruption in the functioning of the short end of the Commercial Paper market. These issuances are rolled-over continuously . ABCP structures depend totally on liquidity provision to solve any funding problems: This is available in several forms, such as credit lines, letters of credit, cash-reserve accounts or swaps, and is usually provided by the sponsor of the vehicle which is often a bank with a high credit rating.

12. 1. Securitized and collateralized debt instruments 12 | Collateralized Debt Obligation (CDO) These are securities whose collateral pool is composed, among others, by bonds, loans, or other types of debt, as well as by asset-backed securities. They are much broader than simple ABSs. The term 'CDO' encompasses such securities as collateralized bond obligations (CBO) and collateralized loan obligations (CLO). Similar to other structured products, a senior CDO security is paid before a mezzanine CDO.

13. 1. Securitized and collateralized debt instruments 13 | Collateralized Debt Obligation (CDO) The first CDOs comprised cash flow CDOs as opposed to synthetic CDOs (a newer product). However, by the mid-2000s during the lead up to the 2008 recession, marked-to-market CDOs made up the majority of CDOs. A fund manager actively managed the CDOs. Actively managed CDOs : The “CDO manager” or “collateral manager” is allowed a degree of discretionary trading . There are restrictions imposed (i.e., restrictive covenants) as to what the CDO manager can and cannot do, and certain tests must be satisfied for the CDO securities to maintain the credit rating assigned at the time of issuance. A CDO only redistributes the total credit risk of the initial pool of assets among the newly created securities. The structure itself neither increases nor reduces the total credit risk. The ability of the CDO to make payments to the tranches depends on the performance of the underlying assets. Income is derived from: (1) interest income from the underlying assets, (2) principal repayments from maturing assets in the underlying pool, and (3) capital appreciation and sale of underlying assets.

14. 1. Securitized and collateralized debt instruments 14 | Collateralized Debt Obligation (CDO) There are three distinct periods in the life of a CDO: The first is the ramp-up period . This period usually begins two to six months before the closing date of the transaction and usually ends fewer than six months afterwards when the CDO manager completes the purchase of the CDO’s initial portfolio. The reinvestment period or revolving period is when principal proceeds are reinvested in new collateral assets and usually is five to seven years long. In the final period , the portfolio assets mature or are sold, and the note holders are paid off.  Unlike a traditional asset-backed security, a collateralized debt obligation involves active management because the CDO manager buys and sells debt obligations in the pool with the objective of paying off different classes of bondholders as well as generating a high return for the subordinated/equity tranche and a % fee for himself.

15. 1. Securitized and collateralized debt instruments 15 | Collateralized Debt Obligation (CDO) Advantages of CDOs for investors : Diversification opportunities Varying risk/return profiles: The senior notes are ideal for a low-risk, fixed-income portfolio. The investment-grade mezzanine classes are suited for a credit-risk portfolio. The speculative-grade notes and equity tranche compete with alternative investments and PE funds for customers willing to risk capital for high returns. Exposure to asset classes that are often difficult to invest in directly Risks of CDOs for investors : CDOs’ performance can vary greatly depending on the collateral, the structure, the manager, and the specific CDO note’s position in the capital structure. When the collateral performs well, the CDO market works like a well-oiled machine as it distributes the underlying asset risk around the globe. When the collateral performs poorly, investors (particularly of the subordinated notes) feel the stress.

16. 1. Securitized and collateralized debt instruments 16 | Who has a role to play in structured finance transactions? Trust : it is the SPV Manager (in the case of a CDO) : runs the collateral (assets) portfolio Underwritter : structures and places the transaction among investors Servicer : collects payments from borrowers in the underlying pool of assets and transfers the collected funds to investors Lawyer : creates deal documents Rating Agencies : rate the issued securities Trustee : “safe-keep” the assets, and monitor the manager’s trading activities (in the case of a CDO) Monoline insurer : in transactions where the strength of the collateral pool is not sufficient, an insurer may provide extra assurance that their cash flows will not be impaired Depositor : central repository for the collection and pooling of the assets to be securitized. Assets are often acquired from multiple originators, and subsequently sold by the depositor to the issuer of the ABSs. The depositor is also known as the "intermediate SPE" (ISPE), or multi-seller conduit. The depositor is created by the transaction's sponsor solely for the purpose of undertaking a particular securitization transaction, and conducts no other business.

17. 1. Securitized and collateralized debt instruments 17 | Who has a role to play in structured finance transactions?

18. 1. Securitized and collateralized debt instruments 18 | Collateralized Debt Obligation (CDO) Distribution of income in a CDO transaction: Income is derived from interest income and capital appreciation on underlying assets. Income is distributed as follows (Waterfall structure): Trustees and CDO manager are paid Compliance tests need to be passed before other payments are made: Interest Coverage tests (IC) Once compliance tests are passed, Senior and Mezzanine tranches are paid Compliance tests are passed again Then, payment to equity (junior) tranche is made

19. 1. Securitized and collateralized debt instruments 19 | Collateralized Debt Obligation (CDO) Distribution of principal cash flow in a CDO transaction: Cash Flows from principal repayments are used as follows (Waterfall structure): Trustees and CDO manager are paid (those that are based on performance) Compliance tests need to be passed before other payments are made: Overcollateralization tests (OC) Once compliance tests are passed, the principal promised to Senior and Mezzanine tranches is paid, and additional proceeds from principal cash flows may cover interest payments Compliance tests are passed again Then, payment of principal is made to equity (junior) tranche

20. 1. Securitized and collateralized debt instruments 20 | CDO Squared The collateralized debt obligation squared is backed by the pool of collateralized debt obligation (CDO) tranches and payments to investors are made from payments made into the various tranches. It is basically a CDO where the underlying portfolio is made of CDOs. Long story short: It is the CDO of a CDO

21. 1. Securitized and collateralized debt instruments 21 | CDO Squared Watch this clip: https://www.youtube.com/watch?v=A25EUhZGBws

22. 1. Securitized and collateralized debt instruments 22 | CDO Squared When CDOs default…

23. 1. Securitized and collateralized debt instruments 23 | The use of interest rate swaps : Interest rate swaps allow the SPV to hedge against a mismatch between cash flows generated by the asset pool and coupon promised to investors. Example : Imagine that the income stream from the pool of assets is 30 years fixed rate mortgages delivering 7.5% But the payment to senior CDO holders is variable rate (LIBOR + 70 bp) What happens if LIBOR GOES UP? - > The structure is incurring in basis risk, namely, it has to deliver a higher “variable” return to Senior investors Solution: Interest rate swap

24. 2. How do rating agencies rate structured products? 24 | Credit quality of the collateral (i.e., pool of assets) When a rating agency needs to rate a structured product, one of the factors it looks at is the ability of the issuer to pay and the borrower’s equity in the asset (e.g., if mortgages fund 80% of the houses, equity is 20%). By the “borrower” we mean the individual or business entity that is the obligor for the financial asset which is used as the collateral for the securitization. In addition to default rates , rating agencies look at historical recovery rates . Concentration of loans is also examined by rating agencies. The underlying principle of asset securitization is that the large number of borrowers in the collateral pool will reduce the credit risk via diversification. If there are a few borrowers included in the collateral pool that are significant in size relative to the entire pool balance, this diversification benefit can be lost, resulting in a higher level of default risk.

25. 2. How do rating agencies rate structured products? 25 | 2. Quality of the servicer When rating a structured product, rating agencies also look at the ability of a servicer to perform all the activities for which the servicer will be responsible. The job of the servicer in a structured transaction is to collect payments from borrowers in the underlying pool of loans and transfer the collected funds to investors in the ABS tranches. The servicer may also be responsible for advancing payments when there are delinquencies in payments. The servicer can be the originator.

26. 2. How do rating agencies rate structured products? 26 | 3. Cash flow stress and payment structure Rating agencies also analyze the extent to which the cash flows from the collateral pool can satisfy all of the obligations of the ABS transaction. The cash flows from the collateral pool consist of interest payments and principal repayment . The cash flow payments that must be made are interest and principal to investors, servicing fees, and any other expenses for which the issuer is liable. Rating agencies analyze the structure to test whether the collateral’s cash flows match the payments that must be made to satisfy the issuer’s obligations . This requires that the rating company make assumptions about losses and delinquencies under various interest rate scenarios. Based on its analysis of the collateral and the stress testing of the structure to assess the risk that the investors will not be repaid in full, a rating agency determines the amount of credit enhancement necessary for an issue to receive a particular credit rating.

27. 3. Structured Notes 27 | Structured Notes There are bonds with embedded options that have much more complicated provisions than plain-vanilla bonds for one or more of the following: interest rate payable, redemption amount, and timing of principal repayment. The interest or redemption amount can be tied to the performance or the level of one or more interest rates or noninterest rate benchmarks. As a result, the potential performance (return and risk) of such securities will be substantially different from those offered by plain vanilla bond structures. Examples: Interest rate linked Structured Notes Leveraged/Deleveraged Floaters Step-up notes Dual-Indexed Floaters Range Notes Inverse Floaters Equity-Linked Structured Notes See page 193 of the “Introduction to Structured Finance” textbook.

28. Exercise 1 : CDO 28 | Consider the following $100 Million CDO structure for 1 year: Suppose that the pool of assets consist of high-yield bonds with F = 100 Mill., maturity in 10 years, and coupon rate fixed at the 10-year Treasury rate = 7% plus 400 basis points. To hedge the interest rate risk of the senior tranche payments, the CDO enters into an interest rate swap with 80 Mill. nominal: the CDO pays a fixed rate equal to the 10-year Treasury rate plus 100 basis points, and receives LIBOR . The fees to different providers amount to $614 000. Do the following: Compute interest generated by the collateral pool of assets Compute the payment received from the swap counterparty Compute the payment to the swap counterparty Determine the interest paid to the senior tranche Determine the interest paid to the mezzanine tranche Determine the amount available to compensate the equity tranche

29. Exercise 2 : CDO – In the shoes of a CDO manager 29 | Consider the following $100 Million CDO structure. Assume a 3-years structure: You are the manager and need to determine how much interest income the collateral pool of assets needs to generate. To hedge the interest rate risk, the CDO enters into an interest rate swap with 80 Mill. nominal: the CDO pays a fixed rate of 3.5% annually and receives LIBOR . The fees to different providers amount to 15 bps of the total principal of the collateral (F = $100 Mill.). Do the following: Compute the cash inflows received by the structure Compute the cash outflow paid by the structure Determine how much the interest obtained by the collateral pool of assets should be in order to provide the equity tranche with a 10% rate of return Without doing any calculations, how much is the minimum return the equity tranche investors will be willing to accept?

30. Readings 30 | Required : Chapters 6, 7, 8, and 10: FRANK J. FABOZZI, HENRY A. DAVIS, MOORAD CHOUDHRYG. – “Introduction to Structured Finance” Wiley Chapters 3, 4, 5, 9, 10 and 11: BRIAN P. LANCASTER, GLENN M. SCHULTZ, FRANK J. FABOZZI– “ Structured Products and Related Credit Derivatives ” Wiley Fitch ratings (2001): Asset Backed Commercial Paper Explained ECB (2007) UNDERSTANDING ASSET BACKED COMMERCIAL PAPER STRUCTURES https://www.ecb.europa.eu/pub/financial-stability/fsr/focus/2007/pdf/ecb~d11e423a5b.fsrbox200712_08.pdf Complementary ( not required , but interesting for those who want to know more about structured notes) : Moodys (2001) Fundamentals of Asset-Backed Commercial Paper https://pages.stern.nyu.edu/~igiddy/ABS/moodysabcp.pdf SCOTT Y. PENG, RAVI E. DATTATREYA – “The Structured Note Market ” Probus