ALL ASSET CLASSES
WA levels for certain portfolio characteristics (LTV, seasoning, loan size etc.) versus the distribution of such characteristics (for instance, are any mortgage loans with LTVs > 100% included in an underlying RMBS pool?); investors bearing the first losses that occur in an underlying portfolio (please refer to the section below that explains how losses are distributed among investors in ABS deals) are typically more interested in the tails of a specific portfolio characteristic's distribution, as these tails generally drive the timing and size of losses (e.g. mortgage loans with higher LTVs generally have higher default probabilities and loss severities)
Eligibility criteria, i.e. how strict are these on a single loan level as well as on a portfolio level (mitigation of potential concentration risks etc.; eligibility criteria typically refer to certain characteristics as of closing, while "portfolio
limits"/"quality tests" typically refer to tests being conducted throughout the deal's life in case of revolving portfolios)
Actual portfolio characteristics versus portfolio limits/portfolio quality tests (in case of non-static portfolios, the latter rather than the portfolio characteristics as of closing are important, as per definition the pool changes continuously)
Arrears levels of portfolio as of closing (incl. distribution of arrears – e.g. bucket of assets < or > 30 days in arrears - and arrears history), which should also be compared to deals that securitized similar/the same assets
Geographic distribution of assets, e.g. concentrations on "problematic" areas with high unemployment rates, weak real estate markets etc. should be avoided (southern versus northern Italy, eastern versus western Germany etc.)
Borrower type, for instance in consumer related deals (employed versus self-employed versus civil servant) or in corporate related deals (industry bucket)
Loan type, for instance amortizing loan versus bullet loan etc.
WA margin/coupon of the underlying assets as an indication of the size of casflows that are generated Î is there possibly a negative carry, i.e. the cashflows generated from the underlying portfolio's assets are lower than the cashflow needed to serve the notes
ALL ASSET CLASSES
Prepayment assumptions, i.e. how fast is the underlying portfolio expected to amortize (prepayments are defined as unscheduled principal payments by borrowers, including early redemptions).
ÎPotential positive effects include:
– Increased relative credit enhancement*
– Shorter WALs of the respective notes, leading to a higher yield compared to notes for which such shorter WAL was already expected upon pricing.
ÎPotential negative effects include:
– Excess spread compression (less assets generate cash going forward, which is typically a problem in case of sequential amortization*, as this leads to higher rated, and hence "cheaper" notes being amortized first, leading to an increase of the WA costs on the liability side and/or in case of high yielding assets being prepayed, leading to a decrease of the WA interest income on the asset side; generally: this is different for revolving pools that are replenished by purchasing new assets after redemptions occured)
– In case of notes trading above par, higher-than-expected prepayments may lead to lower-than-expected total returns for such notes
– Timing mismatches (e.g., in case of pay-through structures: if cash received by the issuer cannot be passed on to the noteholders immediately, but only on the next payment date) that could decrease excess spread levels
– Re-investment risks in a low yield environment
– Assuming that mainly less risky (economically stronger) borrowers prepay as they have the means to do so, the remaining portfolio’s average quality deteriorates
– Notably, prepayment assumptions as of closing are normally not updated in many trading systems, leading to the need to compare actual prepayment rates with originally expected rates in order to quantify a fair price
* Please refer to the pages 52 and 53 for a description of the concept
of credit enhancement (including excess spread) and sequential amortization.
Description of main asset classes – What to look for?
RMBS*
Discounted loans, for instance UK non-conforming RMBS transactions often include mortgage products with "discount-margins/teaser rates", i.e. the respective borrower pays a lower interest rate for a certain time period (normally at the
beginning); the risks that arise from the temporarily reduced cashflow generation of the underlying portfolio consisting of such loans is sometimes mitigated by a specially dedicated reserve fund Îmore importantly, borrowers may have a higher default probability after their discounted margin is increased to a "stabilized level" (payment shock)
RMBS and CMBS
The size of prior ranking mortgages is very important for the calculation of a loss severity Î Generic example:
Value of real estate: EUR 200
1. Example: Size of mortgage loan: EUR 80 and size of prior ranking mortgage loan: EUR 40 2. Example: Size of mortgage loan: EUR 120
– LTV amounts to 60% in both examples, HOWEVER, in case of the borrower's default the loss severity differs signifcantly – Assumption: proceeds from the real estate's forced sale of EUR 55
– 1. Example: 80 – (55 – 40) = 65/80 = 81.3%
– 2. Example: 120 – 55 = 75 Î75/120 = 62.5%
– Loss severity much higher in case of an existing prior ranking mortgage loan, although the LTV was the same for both examples
However, it is the overall size of the prior ranking mortgages (i.e. the WA LTV of prior lien; please refer to page 31 for the definition of the LTV of prior lien) that is important, and not the portion of mortgage loans that have a prior lien, e.g. all mortgage loans of a given pool may have a prior lien, however, as long as the respective prior liens are small, they are not threatening for investors
* In the following, we will not show any areas of potential risk factors for the asset class "ABS", as these are coverered either
CMBS
Rental income distribution, i.e. who are the main tenants of the commercial real estates backing the loan(s), and hence, the main sources of rental income that is needed to pay interest and principal on such loan(s) and finally on the issued notes (assessment of the tenant diversification and credit quality in terms of ratings etc.)
Remaining lease term versus remaining loan term, i.e. it is not only important that the respective loan's ICR/DSCR are large enough, but that the rental income is generated for at least throughout the loan's remaining life (and even if the remaining lease term of the real estates backing a loan is long enough, possible termination rights of tenants have to be taken into account)
Hedging for underlying loans: underlying loans in CMBS transactions often have interest rate and/or currency hedges on the borrower level (as opposed to the issuer, i.e. SPV-level), which may lead to increased risk of swap breakage costs being incurred when compared with transactions where a swap is at the issuer level, which means that breakage costs might be deferred by drawing on the transaction's available liquidity. Hence, it is important to analyze the rank of breakage costs in the transaction's waterfall (please refer to the section "Description of main structures")
A/B structures refers to a commercial mortgage loan that is split into a senior portion, which is securitized, and a junior portion, which is sold or held outside the securitization structure. The senior portion is often referred to as the "A" loan and the junior portion as the "B" loan. Most importantly, both rely on the same collateral. Poorly drafted or implemented A/B structures may delay the recovery process and/or restrict the work-out options available to a special servicer following a loan event of default (hence, inter-creditor arrangements within such A/B structures should be analyzed closely).
Description of main asset classes – What to look for?
CDO
SROC ("Synthetic rated overcollateralization"): this test is used as a monitoring tool by S&P throughout the deal's lifetime (the SROC is not part of the transaction's documentation, but an analytical tool used by S&P) and compares the
– portfolio's respective break even defaultrate, i.e. the max number of defaults the pool could sustain in a certain rating scenario without failing to pay interest and principal on the note of such rating level and the
– portfolio's respective scenario default rate, i.e. the expected number of defaults the underlying pool is expected to suffer in a certain rating scenario
In case the former is lower than the latter, the respective note on the analyzed rating level is considered for a downgrade.
Overcollateralization ("OC") test's (they are part of the overall transaction's documentation based on rating agencies' requirements) generic definition for a given tranche i (at a given point in time)
Interest coverage ("IC") test's (they are part of the overall transaction's documentation based on rating agencies' requirements) generic definition for a given tranche i (at a given point in time):
Par Value of Asset + Cash
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Par Value of Liabilities senior to tranche i + Par Value of tranche i
Total Amount of interest
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Total Amount of interest on Liabilities senior to tranche i + Interest on tranche i
CDO
OC test's rules for asset valuation:
– Are any haircuts (reduction of assets' par value) required for certain assets, e.g. assets rated CCC/Caa or below?
Îhaircuts are bespoke, however a typical rule may be: the OC test looks at the nominal principal balance of the asset, regardless of whether the asset was purchased below or above par. However, a par value haircut is conducted if a rating agency rates a certain amount of assets in the underlying portfolio CCC or below.
Îif this amount exceeds a given limit, the amount of assets that exceed this limit must be subject to either a fixed 30%
par value haircut (i.e. these assets are deemed to have a value of 70% of their nominal amount) OR a floating par haircut equal to their nominal amount multiplied by their market value.
Îthe purpose of these haircuts is to trigger an earlier de-leveraging of senior notes if the credit quality of the portfolio deteriorates beyond expected levels (this is because upon the breach of an OC test, interest income may be used to redeem -parts of- the senior notes, i.e. the liability side of the CDO is decreased)
Îalternatively, par value haircuts may be conducted in case assets were purchased below a given threshold of par (for example: 85% of par).
– The definition of rating-based valuation rules is related to how many ratings, e.g. haircuts are already required
in case one rating agency rates a certain asset CCC/Caa or only in case two rating agencies rate this asset CCC/Caa (problem of split-ratings)?
– Are the valuation rules the same for all different notes (or are there differences between OC tests for senior and mezzanine notes)?
– How are assets valuated that were purchased below par? How are assets valuated that were purchased above par, but currently trade below par?
In case of several IC, OC or other portfolio quality tests being incorporated in the deal's documentation: which test is likely to be breached first, leading to which consequences, e.g. is the OC test for a lower rated tranche or the OC test for the most senior tranche breached first?
Description of main asset classes – What to look for?
CDO
OC test's rules for asset valuation:
– What are the consequences of the breach of an OC test? Typically, re-investments are suspended upon trigger breach and incoming cash is used to pay down notes sequentially until the respective trigger is not breached any more Îdeleveraging of senior notes
– Are the trigger levels/OC test levels reasonable when compared to historical asset performance?
– What is the OC thickness, e.g. after the OC trigger of the note junior to a given tranche i is breached, how many additional defaults have to occur until the OC trigger of the tranche senior to tranche i is breached Îrelative cushion between the two tranches "surrounding" tranche i (relative OC thickness as opposed to absolute OC thickness)
– Comparison of initial OC/IC levels and the respective OC/IC limitsÎif the difference is initially low, it is rather negative for equity investors, as the respectice OC/IC test is breached earlier. In other words, the likelyhood of interest on junior notes being re-directed to senior notes' amortization is higher (hence, reinvestment diversion tests may be more attractive for equity investors, as upon breach of such tests, excess spread is used to buy additional collateral generating additional cashflows going forward, which can be distributed to equity investors as well)
– The amount of cash (<>invested assets) a CDO holds (e.g. because the CDO manager cannot find eligible assets to invest in), as it generates less/no spread
1
Index2
Introduction to ABS3
Description of main asset classes – Overview– Glossary of main terms and definitions – What to look for?
4
Description of main structures – Overview– Glossary of main terms and definitions – What to look for?
5
Rating agencies' approach to rating ABS – General thoughts– Selected methodologies – What to look for?
6
Basel II– General Introduction
– The Standardized Approach – The Ratings Based Approach