Fixed Income I
Reading 45. Introduction to Asset-Backed Securities
Learning Outcome Statements
b. describe securitization, including the parties involved in the process and the roles they play;
c. describe typical structures of securitizations, including credit tranching and time tranching;
CFA Curriculum, 2020, Volume 5
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Subject 2. The Securitization Process
- A lender originates loans, such as to a homeowner or corporation.
- The lender sells certain assets (e.g., loans) to a special purpose vehicle (SPV). The structure is legally insulated from management.
- The SPV issues debt, dividing up the benefits and risks among investors.
- Payments from borrowers are deposited into the SPV, then transferred to investors.
The parties to a securitization transaction:
- Originator: the seller of the collateral
- The SPV: the issuer of the securities, also called the trust
- The third parties: the loan servicer, attorneys, trustees, underwriters, rating agencies, and guarantors
The SPV is a bankruptcy-remote vehicle that plays a pivotal role in the securitization process. It issues securities backed by the underlying assets. The underlying assets are used as collateral for the securities. Cash flows generated from the underlying assets are used to service the debt obligations on the securities.
The SPV separates the assets used as collateral from the corporation seeking financing.
- It makes it possible that the asset-backed securities have a higher credit rating than the parent company.
- If bankruptcy occurs, the SPV can shield assets from the parent company's creditors.
Prepayment tranching refers to dividing cash flows from securitized assets among different classes of securities so that some receive repayment of principal before others. It is used to reallocate the prepayment risk of the underlying loans among different classes of securities. In the simplest cases, a deal might offer several classes of serially maturing securities. Some investors might prefer the securities with shorter maturities while others might favor the ones with longer maturities. Collateralized mortgage obligations (CMOs) are the most ubiquitous examples of time tranching.
Credit tranching refers to the creation of a multi-layered capital structure that includes senior and subordinated tranches (classes). The structure is designed so that any losses caused by defaults will be passed on to the subordinated tranches first. Credit tranching is thus used to reallocate the credit risk associated with the collateral.