. 6
( 10)


the period.
2. For disbursement of principal payments: Disburse principal payments to tranche
P based on its schedule of principal repayments. Tranche P has priority with respect
to current and future principal payments to satisfy the schedule. Any excess principal
payments in a month over the amount necessary to satisfy the schedule for tranche
P are paid to tranche S. When tranche S is completely paid off, all principal payments
are to be made to tranche P regardless of the schedule.

The greater certainty of the cash ¬‚ow for the PAC bonds comes at
the expense of the non-PAC classes, called the support or companion
tranches. It is these tranches that absorb the prepayment risk. Because
PAC bonds have protection against both extension risk and contraction
risk, they are said to provide “two-sided” prepayment protection.
Exhibit 9.7 shows a CMO structure, Deal 4, created from the $400
million 7.5% coupon passthrough with a WAC of 8.125% and a WAM
of 357 months. There are just two tranches in this structure: a 7.5%
coupon PAC bond created assuming 90 to 300 PSA with a par value of
$243.8 million, and a support bond with a par value of $156.2 million.
The two speeds used to create a PAC bond are called the initial PAC col-
lars (or initial PAC bands). For Deal 4, 90 PSA is the lower collar and
300 PSA the upper collar.
Exhibit 9.8 reports the average life for the PAC bond and the support
bond in Deal 4 assuming various actual prepayment speeds. Notice that
between 90 PSA and 300 PSA, the average life for the PAC bond is stable at
7.26 years. However, at slower or faster PSA speeds the schedule is broken
and the average life changes, lengthening when the prepayment speed is less
than 90 PSA and shortening when it is greater than 300 PSA. Even so, there
is much greater variability for the average life of the support bond.
Most CMO PAC structures have more than one class of PAC bonds.
Exhibit 9.9 shows six PAC bonds created from the single PAC bond in
Deal 4. We will refer to this CMO structure as Deal 5. Information
about this CMO structure is provided in Exhibit 9.9. The total par
value of the six PAC bonds is equal to $243.8 million, which is the
amount of the single PAC bond in Deal 4.
Short-Term Mortgage-Backed Securities

EXHIBIT 9.8 Average Life for PAC Bond and Support Bond in Deal 4 Assuming
Various Prepayment Speeds

Prepayment rate (PSA) PAC Bond (P) Support Bond (S)

0 15.97 27.26
50 9.44 24.00
90 7.26 18.56
100 7.26 18.56
150 7.26 12.57
165 7.26 11.16
200 7.26 8.38
250 7.26 5.37
300 7.26 3.13
350 6.56 2.51
400 5.92 2.17
450 5.38 1.94
500 4.93 1.77
700 3.70 1.37

EXHIBIT 9.9 Deal 5: Structure with Six PAC Bonds and One Support Bond

Tranche Par amount Coupon rate (%)

P-A $85,000,000 7.5
P-B 8,000,000 7.5
P-C 35,000,000 7.5
P-D 45,000,000 7.5
P-E 40,000,000 7.5
P-F 30,800,000 7.5
S 156,200,000 7.5
Total $400,000,000

Payment rules:
1. For payment of periodic coupon interest: Disburse periodic coupon interest to
each tranche on the basis of the amount of principal outstanding at the beginning of
the period.
2. For disbursement of principal payments: Disburse principal payments to tranches
P-A to P-F based on their respective schedules of principal repayments. Tranche P-A
has priority with respect to current and future principal payments to satisfy the
schedule. Any excess principal payments in a month over the amount necessary to
satisfy the schedule for tranche P-A are paid to tranche S. Once tranche P-A is com-
pletely paid off, tranche P-B has priority, then tranche P-C, etc. When tranche S is
completely paid off, all principal payments are to be made to the remaining PAC
tranches in order of priority regardless of the schedule.

EXHIBIT 9.10 Average Life for PAC Bond and Support Bond in Deal 5 Assuming
Various Prepayment Speeds

PAC Bonds
rate (PSA) P-A P-B P-C P-D P-E P-F

0 8.46 14.61 16.49 19.41 21.91 23.76
50 3.58 6.82 8.36 11.30 14.50 18.20
90 2.58 4.72 5.78 7.89 10.83 16.92
100 2.58 4.72 5.78 7.89 10.83 16.92
150 2.58 4.72 5.78 7.89 10.83 16.92
165 2.58 4.72 5.78 7.89 10.83 16.92
200 2.58 4.72 5.78 7.89 10.83 16.92
250 2.58 4.72 5.78 7.89 10.83 16.92
300 2.58 4.72 5.78 7.89 10.83 16.92
350 2.58 4.72 5.94 6.95 9.24 14.91
400 2.57 4.37 4.91 6.17 8.33 13.21
450 2.50 3.97 4.44 5.56 7.45 11.81
500 2.40 3.65 4.07 5.06 6.74 10.65
700 2.06 2.82 3.10 3.75 4.88 7.51

Exhibit 9.10 shows the average life for the six PAC bonds and the
support bond in Deal 5 at various prepayment speeds. From a PAC
bond in Deal 4 with an average life of 7.26, we have created six PAC
bonds with an average life as short as 2.58 years (P-A) and as long as
16.92 years (P-F) if prepayments stay within 90 PSA and 300 PSA.
As expected, the average lives are stable if the prepayment speed is
between 90 PSA and 300 PSA. Notice that even outside this range the
average life is stable for several of the shorter PAC bonds. For example,
PAC P-A is stable even if prepayment speeds are as high as 400 PSA. For
the PAC P-B, the average life does not vary when prepayments are
between 90 PSA and 350 PSA. Why is it that the shorter the PAC, the
more protection it has against faster prepayments?
To understand why this is so, remember that there are $156.2 mil-
lion in support bonds that are protecting the $85 million of PAC P-A.
Thus, even if prepayments are faster than the initial upper collar, there
may be suf¬cient support bonds to assure the satisfaction of the sched-
ule. In fact, as can been from Exhibit 9.10, even if prepayments are 400
PSA over the life of the collateral, the average life is unchanged.
Now consider PAC P-B. The support bonds are providing protection
for both the $85 million of PAC P-A and $93 million of PAC P-B. As
Short-Term Mortgage-Backed Securities

can be seen from Exhibit 9.10, prepayments could be 350 PSA and the
average life is still unchanged. From Exhibit 9.10 it can be seen that the
degree of protection against extension risk increases the shorter the
PAC. Thus, while the initial collar may be 90 to 300 PSA, the effective
collar is wider for the shorter PAC tranches.

PAC Floaters Given a series of PAC bonds, any of the tranches can be
carved up to make a ¬‚oater and an inverse ¬‚oater. The advantage of the
PAC ¬‚oater compared to a sequential-pay ¬‚oater is that there is two-
sided prepayment protection and therefore the uncertainty of the aver-
age life is less. The trade-off is that this greater prepayment protection is
not free. All other factors constant, the margin over the same reference
rate offered on a PAC ¬‚oater will be less than that on a sequential-pay
¬‚oater and/or the cap will be the lower.

Effective Collars and Actual Prepayments As we have emphasized, the creation
of an MBS cannot make prepayment risk disappear. This is true for both
a passthrough and a CMO. Thus, the reduction in prepayment risk
(both extension risk and contraction risk) that a PAC bond offers must
come from somewhere.
The prepayment protection comes from the support bonds. It is the
support bonds that have principal payments deferred if the collateral
prepayments are slow; support bonds do not receive any principal until
the PAC bonds receive the scheduled principal repayment. This reduces
the risk that the PAC bonds will extend. Similarly, it is the support
bonds that absorb any principal payments in excess of the scheduled
principal payments that are made. This reduces the contraction risk of
the PAC bonds. Thus, the key to the prepayment protection offered by a
PAC bond is the amount of support bonds outstanding. If the support
bonds are paid off quickly because of faster-than-expected prepayments,
then there is no longer any protection for the PAC bonds. In fact, in
Deal 5, if the support bond is paid off, the structure is effectively
reduced to a sequential-pay CMO. In such cases, the schedule is unlikely
to be maintained, and the structure is referred to as a busted PAC.
The support bonds can be thought of as bodyguards for the PAC
bondholders. When the bullets ¬‚y”i.e., prepayments occur”it is the
bodyguards that get killed ¬rst. The bodyguards are there to absorb the
bullets. Once all the bodyguards are killed off (i.e., the support bonds
paid off with faster-than-expected prepayments), the PAC bonds must
fend for themselves: they are exposed to all the bullets.
With the bodyguard metaphor for the support bonds in mind, let™s
consider two questions asked by buyers of PAC bonds:

1. Will the schedule of principal repayments be satis¬ed if prepayments
are faster than the initial upper collar?
2. Will the schedule of principal repayments be satis¬ed as long as pre-
payments stay within the initial collar?

Let™s address the ¬rst question. The initial upper collar for Deal 4 is
300 PSA. Suppose that actual prepayments are 500 PSA for seven con-
secutive months. Will this disrupt the schedule of principal repayments?
The answer is: it depends!
There are two pieces of information we will need to answer this ques-
tion. First, when does the 500 PSA occur? Second, what has been the
actual prepayment experience up to the time that prepayments are 500
PSA? For example, suppose six years from now is when the prepayments
reach 500 PSA, and also suppose that for the past six years the actual pre-
payment speed has been 90 PSA every month. What this means is that
there are more bodyguards (i.e., support bonds) around than was
expected when the PAC was structured at the initial collar. In establishing
the schedule of principal repayments, it is assumed that the bodyguards
would be killed off at 300 PSA. But the actual prepayment experience
results in them being killed off at only 90 PSA. Thus, six years from now
when the 500 PSA is assumed to occur, there are more bodyguards than
expected. Thus, a 500 PSA for seven consecutive months may have no
effect on the ability of the schedule of principal repayments to be met.
In contrast, suppose that the actual prepayment experience for the
¬rst six years is 300 PSA (the upper collar of the initial PAC collar). In
this case, there are no extra bodyguards around. As a result, any pre-
payment speeds faster than 300 PSA, such as 500 PSA in our example,
jeopardize satisfaction of the principal repayment schedule and increase
contraction risk. What this means is that the prepayment protection is
It should be clear from these observations that the initial collars are
not particularly useful in assessing the prepayment protection for a sea-
soned PAC bond. This is most important to understand, as it is common
for CMO buyers to compare prepayment protection of PACs in different
CMO structures, and conclude that the greater protection is offered by
the one with the wider initial collars. This approach is inadequate
because it is actual prepayment experience that determines the degree of
prepayment protection going forward, as well as the expected future
prepayment behavior of the collateral.
The way to determine this protection is to calculate the effective col-
lar for a PAC bond. An effective collar for a PAC is the lower and the
upper PSA that can occur in the future and still allow maintenance of
the schedule of principal repayments.
Short-Term Mortgage-Backed Securities

The effective collar changes every month. An extended period over
which actual prepayments are below the upper range of the initial PAC col-
lar will result in an increase in the upper range of the effective collar. This is
because there will be more bodyguards around than anticipated. An
extended period of prepayments slower than the lower range of the initial
PAC collar will raise the lower range of the effective collar. This is because
it will take faster prepayments to make up the shortfall of the scheduled
principal payments not made plus the scheduled future principal payments.
It is important to understand that the PAC schedule may not be satis-
¬ed even if the actual prepayments never fall outside of the initial collar.
This may seem surprising since our previous analysis indicated that the
average life would not change if prepayments are at either extreme of the
initial collar. However, recall that all of our previous analysis has been
based on a single PSA speed for the life of the structure. If we vary the
PSA speed over time rather than keep it constant over the life of the
CMO, we can see what happens to the effective collar if the prepayments
are at the initial upper collar for a certain number of months. For exam-
ple, if one computed the average life two years from now for the PAC
bond in Deal 4 assuming that prepayments are 300 PSA for the ¬rst 24
months, one would ¬nd that the average life is stable at six years if the
prepayments for the following months are between 115 PSA and 300 PSA.
That is, the effective PAC collar is no longer the initial collar. Instead, the
lower collar has shifted upward. This means that the protection from year
2 on is for 115 PSA to 300 PSA, a narrower band than initially, even
though the earlier prepayments did not exceed the initial upper collar.

Support Bonds
The support bonds are the bonds that provide prepayment protection
for the PAC tranches. Consequently, support tranches expose investors
to the greatest level of prepayment risk. Because of this, investors must
be particularly careful in assessing the cash ¬‚ow characteristics of sup-
port bonds to reduce the likelihood of adverse portfolio consequences
due to prepayments.
To see this, consider a short-term, 7% coupon support bond issued
by Freddie Mac (Class BA, Series 2279) in January 2001. Exhibit 9.11
presents a Bloomberg Security Description screen for this security. This
support bond makes coupon payments monthly on the ¬fteenth day of
each month. Let™s analyze this support bond™s exposure to prepayment
risk using Bloomberg™s PT (Price Table) function in Exhibit 9.12. Suppose
at current interest rates, the underlying mortgage collateral prepays at
210 PSA and the security™s current price is 100-07. Note at the bottom of
the screen, given a prepayment speed of 210 PSA, the average life is 0.22
years. If we shock the current U.S. Treasury yield curve by ±100, 200,

300 basis points, respectively, and feed those shocks into a prepayment
model, what will happen to the prepayment speed of the collateral and
the average life of this support bond? As can be seen from the Price Table,
if interest rates rise, prepayment speeds will decrease and the security™s
average life will extend from 0.22 years to 7.17 years for a 100 basis
point upward parallel shift in the yield curve. Of course, this is a concern
to an investor who thought that they were purchasing a money market-
type instrument. Correspondingly, if interest rate decline, prepayment
speeds will increase such that the security™s average life will shorten.
The support bond typically is divided into different tranches. All the
tranches we have discussed earlier are available, including sequential-pay
support tranches and ¬‚oater and inverse ¬‚oater support tranches. The sup-
port bond can even be partitioned so as to create support tranches with a
schedule of principal payments. That is, support tranches that are PAC
bonds can be created. In a structure with a PAC bond and a support bond
with a PAC schedule of principal payments, the former is called a PAC I
bond or Level I PAC bond and the latter a PAC II bond or Level II PAC
bond or scheduled bond. While PAC II bonds have greater prepayment pro-
tection than the support tranches without a schedule of principal repay-
ments, the prepayment protection is less than that provided PAC I bonds.

EXHIBIT 9.11 Bloomberg Security Description Screen for a
Freddie Mac Support Bond

Source: Bloomberg Financial Markets
Short-Term Mortgage-Backed Securities

EXHIBIT 9.12 Bloomberg Price Table Screen

Source: Bloomberg Financial Markets

There is more that can be done with the PAC II bond. A series of
PAC IIs can be created just as we did with the PACs in Deal 5. PAC IIs
can also be used to create any other type of bond class, such as a PAC II
¬‚oater and inverse ¬‚oater, for example. The support bond without a
principal repayment schedule can be used to create any type of bond
class. In fact, a portion of the non-PAC II support bond can be given a
schedule of principal repayments. This bond class would be called a PAC
III bond or a Level III PAC bond. While it provides protection against
prepayments for the PAC I and PAC II bonds and is therefore subject to
considerable prepayment risk, such a bond class has greater protection
than the support bond class without a schedule of principal repayments.

There are short-term ¬xed-rate bonds and ¬‚oaters created in CMO
deals in which the issuer is a private entity rather than Ginnie Mae, Fan-
nie Mae, or Freddie Mac. These securities are called nonagency mort-
gage-backed securities (referred to as nonagency securities hereafter).
Other mortgage-backed products that are separately classi¬ed in the

industry as asset-backed securities are home equity loan-backed securi-
ties and manufactured housing-backed securities. These products are
discussed in the next chapter. Since all of these mortgage-related securi-
ties expose an investor to credit risk, these securities are sometimes
referred to as credit-sensitive mortgage-backed securities.
For agency CMOs, the concern is with the redistribution or “tranching”
of prepayment risk. For nonagency CMOs, the bonds issued are not guaran-
teed by a federally related agency or a government sponsored enterprise.
Consequently, there is concern with credit risk. As a result, nonagency
CMOs expose the investor to both prepayment risk and credit risk. The same
types of tranches are created in nonagency CMO structures as described ear-
lier for agency CMO structures. What is unique is the mechanisms for
enhancing the credit of a nonagency CMO so that an issuer can obtain any
credit rating desired for a tranche in a deal. The same credit enhancement
mechanisms are used for ABS structures discussed in the next chapter.
Agency CMOs are created from pools of passthrough securities. In
the nonagency market, a CMO can be created from either a pool of
passthroughs or unsecuritized mortgage loans. It is uncommon for non-
conforming mortgage loans to be securitized as passthroughs and then the
passthroughs carved up to create a CMO. Instead, in the nonagency mar-
ket a CMO is carved out of mortgage loans that have not been securitized
as passthroughs. Since a mortgage loan is commonly referred to as a
whole loan, nonagency CMOs are also referred to as whole-loan CMOs.
The underlying loans for agency securities are those that conform to
the underwriting standards of the agency issuing or guaranteeing the
issue. That is, only conforming loans are included in pools that are col-
lateral for an agency mortgage-backed security. The three main under-
writing standards deal with (1) the maximum loan-to-value ratio, (2)
the maximum payment-to-income ratio, and (3) the maximum loan
amount. A nonconforming mortgage loan is one that does not conform
to the underwriting standards established by any of the agencies.

Credit Enhancement Mechanisms
Typically a double A or triple A rating is sought for the most senior
tranche in a nonagency CMO. The amount of credit enhancement nec-
essary depends on rating agency requirements. There are two general
types of credit enhancement mechanisms: external and internal. We
describe each type below.

External Credit Enhancements
External credit enhancements come in the form of third-party guaran-
tees that provide for ¬rst protection against losses up to a speci¬ed level,
Short-Term Mortgage-Backed Securities

for example, 10%. The most common forms of external credit enhance-
ment are (1) a corporate guarantee, (2) a letter of credit, (3) pool insur-
ance, and (4) bond insurance.
Pool insurance policies cover losses resulting from defaults and fore-
closures. Policies are typically written for a dollar amount of coverage that
continues in force throughout the life of the pool. However, some policies
are written so that the dollar amount of coverage declines as the pool sea-
sons as long as two conditions are met: (1) the credit performance is better
than expected and (2) the rating agencies that rated the issue approve.
Since only defaults and foreclosures are covered, additional insurance
must be obtained to cover losses resulting from bankruptcy (i.e., court
mandated modi¬cation of mortgage debt”“cramdown”), fraud arising in
the origination process, and special hazards (i.e., losses resulting from
events not covered by a standard homeowner™s insurance policy).
Bond insurance provides the same function as in municipal bond
structures. The major insurers are AMBAC, MBIA, FSA, and FGIC.
A nonagency CMO with external credit support is subject to the
credit risk of the third-party guarantor. Should the third-party guarantor
be downgraded, the issue itself could be subject to downgrade even if the
structure is performing as expected. This is based on the “weak link” test
followed by rating agencies. According to this test, when evaluating a
proposed structure, the credit quality of the issue is only as good as the
weakest link in credit enhancement regardless of the quality of the
underlying loans. This is the chief disadvantage of third-party guaran-
tees, sometimes referred to as “event risk.” Therefore, it is imperative
that investors monitor the third-party guarantor as well as the collateral.
External credit enhancements do not materially alter the cash ¬‚ow
characteristics of a CMO structure except in the form of prepayments.
In case of a default resulting in net losses within the guarantee level,
investors will receive the principal amount as if a prepayment has
occurred. If the net losses exceed the guarantee level, investors will real-
ize a shortfall in the cash ¬‚ows.

Internal Credit Enhancements
Internal credit enhancements come in more complicated forms than exter-
nal credit enhancements and may alter the cash ¬‚ow characteristics of the
loans even in the absence of default. The most common forms of internal
credit enhancements are reserve funds and senior/subordinated structures.
Reserve funds come in two forms, cash reserve funds and excess ser-
vicing spread. Cash reserve funds are straight deposits of cash generated
from issuance proceeds. In this case, part of the underwriting pro¬ts from
the deal are deposited into a fund which typically invests in money mar-

ket instruments. Cash reserve funds are typically used in conjunction with
letters of credit or other kinds of external credit enhancements.
Excess servicing spread accounts involve the allocation of excess spread
or cash into a separate reserve account after paying out the net coupon, ser-
vicing fee, and all other expenses on a monthly basis. For example, suppose
that the gross WAC is 7.75%, the servicing and other fees are 0.25%, and
the net WAC is 7.25%. This means that there is excess servicing of 0.25%.
The amount in the reserve account will gradually increase and can be used
to pay for possible future losses. This form of credit enhancement relies on
the assumption that defaults occur infrequently in the very early life of the
loans but gradually increase in the following two to ¬ve years.
The most widely used internal credit enhancement structure is the
senior/subordinated structure. Today a typical structure will have a senior
tranche and several junior tranches. The junior tranches represent the
subordinated tranches of the structure. The issuer will seek a triple A or
double A rating for the senior tranche. The junior tranches will have
lower ratings”investment grade and non-investment grade. Typically, the
most junior tranche”called the ¬rst loss piece”will not be rated.
Exhibit 9.13 shows a hypothetical $200 million structure with a senior
tranche representing 92.25% of the deal and ¬ve junior tranches represent-
ing 7.75% of the deal. Note that all that has been done in this structure is
“credit tranching.” The senior or any of the junior tranches can then be
carved up to create other CMO tranches such as sequential pays.
The ¬rst loss piece in this hypothetical deal is tranche X5. The sub-
ordination level in this hypothetical structure is 7.75%. The junior
classes will absorb all losses up to $15.5 million and the senior tranche
will start to experience losses thereafter. So, if there is a $10 million
loss, no loss will be realized by the senior tranche. If, instead, there is a
$20 million loss, the senior tranche will experience a loss of $4.5 mil-
lion ($20 million minus $15.5 million) or a 2.4% loss ($4.5/$184.5).

EXHIBIT 9.13 Hypothetical $200 Million Senior/Subordinated Structure

Bond Rating Amount ($ in millions) Percent of deal(%)

Senior AAA $184.50 92.25
X1 AA 4.00 2.00
X2 A 2.00 1.00
X3 BBB 3.00 1.50
X4 BB 4.00 2.00
X5a Not rated 2.50 1.25
First loss piece.
Short-Term Mortgage-Backed Securities

In the case where the loss is $10 million, the ¬rst loss piece (tranche
X5), tranche X4, and tranche X3 absorb $9.5 million. These tranches
will realize a loss experience of 100%. Tranche X2 will realize a loss of
$0.5 million, thereby having a loss experience of 25% ($0.5/$2.0).
Tranche X1 will not realize any loss. If the loss is $20 million, all junior
bonds will have a loss experience of 100%.
The junior tranches obviously would require a yield premium to
take on the greater credit risk exposure relative to the senior tranche.
This setup is a form of self-insurance wherein investors in the senior
tranche are giving up yield spread to the investors in the junior tranches.
This form of credit enhancement still does not affect the cash ¬‚ow char-
acteristics of the senior tranche except in the form of prepayments. To
the extent that losses are within the subordination level, investors in the
senior tranche will receive principal as if a prepayment has occurred.
The basic concern is that while the subordinate tranche provides a
certain level of credit protection for the senior tranche at the closing of
the deal, the level of protection changes over time due to prepayments
and certain liquidation proceeds. The objective is to distribute these
payments of principal such that the credit protection for the senior
tranche does not deteriorate over time.
To accomplish this, almost all existing senior/subordinated struc-
tures incorporate a shifting interest structure. A shifting interest struc-
ture redirects prepayments disproportionally from the subordinated
classes to the senior class according to a speci¬ed schedule. An example
of such a schedule would be as follows:

Months Percentage of prepayments directed to senior class

1-60 100%
61-72 70%
73-84 60%
85-96 40%
97-108 20%
109+ pro rata

The rationale for the shifting interest structure is to have enough
insurance outstanding to cover future losses. Because of the shifting
interest structure, the subordination amount may actually grow in time
especially in a low default and fast prepayment environment. Using the
same example of our previous $200 million deal with 7.75% initial sub-
ordination and assuming a cumulative paydown (prepayments at 165
PSA and regularly scheduled repayments) of $40 million by year 3, the

subordination will actually increase to 10.7% [$15.5/($184.50 ’ $40)]
without any net losses. Even if the subordinated classes have experi-
enced some losses, say, $1 million, the subordination will still increase
to 9.3% [($15.5 ’ $1)/($184.50 ’ $40)].
While the shifting interest structure is bene¬cial to the senior
tranche from a credit standpoint, it does alter the cash ¬‚ow characteris-
tics of the senior tranche even in the absence of defaults.
As an illustration, consider a short-term, nonagency CMO with a
7% coupon issued by Citigroup Mortgage Securities, Inc. (Class A2,
Series CMSI 2000-1) issued in January 2000. Exhibit 9.14 presents the
Bloomberg Security Description screen for this security. As can be seen
from the screen, this senior security is designated as an accelerated secu-
rity (AS) which means it receives principal payments at a faster rate than
the underlying collateral. This is an example of the shifting interest
structure. Note also this security is rated AAA by Standard & Poor™s
which is indicated in the upper right-hand corner of the screen.
Once again, let™s analyze this security™s exposure to prepayment risk
using Bloomberg™s PT (Price Table) function in Exhibit 9.15. We consider
interest rate shocks of ±100, 200, and 300 basis points. The “BWP”
beside each interest rate shock is a Bloomberg-de¬ned prepayment rate
notation. For example, ’100 BWP generates a prepayment vector using
the Bear Stearns Whole Loan Prepayment Vectors model given a parallel
interest rate shift of minus 100 basis points. The other interest rate
shocks are interpreted similarly. So, as before, the interest rate shock is
fed into a prepayment model that tells us how prepayments change when
interest rates change. At current interest rates and prepayment speed rep-
resented by +0 BWP, the security™s average life is 0.47 years. For shocks
of +100, +200, and +300, prepayment speeds decrease and the average
life increases. However, note the average life does not extend as much as
the agency support bond analyzed earlier. The reason is that even though
slowing prepayments extend tranche A2™s average life, this security still
receives prepayments at a faster rate than the underlying collateral.
Thus, accelerated securities have greater protection from extension risk
even when prepayments slow. For shocks of ’100, ’200, and ’300, pre-
payments increase and the average life shortens.
Panels A and B of Exhibit 9.16 present a Bloomberg screen of this
tranche™s paydown history from issuance in January 2000 through
August 2001. In particular, this screen indicates the original principal
balance is $49,672,000 and details how the principal balance has
changed each month as the principal pays down. Note the principal
payments vary considerably due to prepayments but the monthly inter-
est payments decline each month as expected.
Short-Term Mortgage-Backed Securities

EXHIBIT 9.14 Bloomberg Security Description Screen for a Nonagency CMO

Source: Bloomberg Financial Markets

EXHIBIT 9.15 Bloomberg Price Table Screen

Source: Bloomberg Financial Markets

EXHIBIT 9.16 Bloomberg CMO/ABS Class History Screen
Panel A

Panel B

Source: Bloomberg Financial Markets

Short-Term Asset-Backed

hile residential mortgage loans are by far the most commonly secu-
W ritized asset type, securities backed by other assets (consumer and
business loans and receivables) have also been securitized. In this chap-
ter we discuss the various asset-backed securities products.
Just as with collateralized mortgage obligations (CMOs), structures
with multiple tranches can be created from a pool of loans or receiv-
ables to create short-term average life tranches. Floating-rate asset-
backed securities are typically created where the underlying pool of
loans or receivables pay a ¬‚oating rate. The most common are securities
backed by credit card receivables, home equity line of credit receivables,
closed-end home equity loans with an adjustable rate, student loans,
Small Business Administration loans, and trade receivables. As demon-
strated in the previous chapter, ¬xed-rate loans also can be used to cre-
ate a structure that has one or more ¬‚oating-rate tranches. For example,
there are closed-end home equity loans with a ¬xed rate that can be
pooled to create a structure with one or more ¬‚oating-rate tranches.

Asset-backed securities (ABS) expose investors to credit risk. The three
nationally recognized statistical rating organizations rate asset-backed
securities. In analyzing credit risk, all three rating companies focus on
similar areas of analysis: (1) credit quality of the collateral, (2) the qual-
ity of the seller/servicer, (3) cash ¬‚ow stress and payment structure, and
(4) legal structure.


The credit enhancements”internal and external”that were
described in the previous chapter for nonagency CMOs are also used for
all ABS products. The amount of enhancement necessary to obtain a
speci¬c rating for each tranche in an ABS deal is determined by a rating
agency after analysis of the collateral and the structure.

A ¬‚oating-rate ABS is often exposed to basis risk. This risk is de¬ned as
any mismatch between adjustments to the coupon rate paid to bond-
holders and the interest rate paid on the ¬‚oating-rate collateral. Two
common sources of basis risk are index risk and reset risk.
Index risk is a type of yield curve risk that arises because the ABS
¬‚oater™s coupon rate and the interest rate of the underlying collateral
are usually determined at different ends of the yield curve. Speci¬cally,
the ¬‚oater™s coupon rate is typically spread off the short-term sector of
the yield curve (e.g., U.S. Treasury) while the collateral™s interest rate is
spread off a longer maturity sector of the same yield curve or in some
cases a different yield curve (e.g., LIBOR). This mismatch is a source of
risk. For example, for home equity loan-backed securities in which the
collateral is adjustable-rate loans, the reference rate for the loans may
be 6-month LIBOR while the reference rate for the bonds is usually 1-
month LIBOR. Both the collateral and the bonds are indexed off
LIBOR, but different sectors of the Eurodollar yield curve. The refer-
ence rate for some home equity loans is a constant maturity Treasury.
Thus, the collateral is based on a spread off the 1-month sector of the
Eurodollar yield curve while the bonds are spread off a longer maturity
sector of the Treasury yield curve. As another example, for credit card-
backed ABS the interest rate paid is usually a spread over the prime rate
(a spread over the Treasury yield curve) while the coupon rate for the
bonds is usually a spread over 1-month LIBOR (a spread over the Euro-
dollar yield curve).
Reset risk is the risk associated with the mismatch between the fre-
quency of the resetting of the interest rate on the ¬‚oating-rate collateral
and the frequency of reset of the coupon rate on the bonds. This risk is
common for ABS. For home equity loan-backed securities, for example,
the underlying collateral for the adjustable-rate loans is either reset semi-
annually or annually. However, the coupon rate on the bonds is reset
every month. For credit card-backed securities, the coupon rate for the
bonds is set monthly, while the ¬nance charges on the outstanding credit
card balances are computed daily at a ¬xed spread over the prime rate.
Short-Term Asset-Backed Securities

Basis risk has an impact on the cap of an ABS ¬‚oater. For a non-ABS
¬‚oater, the coupon rate has a ¬xed cap (typically, for the life of the
¬‚oater). In contrast, the cap for an ABS ¬‚oater depends on the perfor-
mance of the underlying collateral. For ABS ¬‚oaters, basis risk affects the
excess spread available to pay the coupon rate for the bondholders. In
the case of home equity loan-backed ABS and student loan ABS, the cap
on the bondholder™s coupon is called the available funds cap. Typically,
the large spread on the collateral loans compared to the spread offered
on the bonds provides protection for ABS investors against basis risk.
Where there is an available funds cap, typically there is a provision
for carrying any interest shortfall resulting from the cap forward to
future months. So, for example, suppose that in one month the full cou-
pon rate would be 6.5% but the available fund cap restricts the coupon
rate for that month to 6.2%. The 30 basis point difference between the
full coupon rate and the rate due to the available funds cap is capital-
ized and paid in a subsequent month (or months) when the funds are
available to pay the bondholder. As a result, the presence of an available
funds cap does not have the same impact on cash ¬‚ow as a typical cap
which does not have a catch-up provision.

The collateral for an ABS can be classi¬ed as either amortizing or non-
amortizing assets. Amortizing assets are loans in which the borrower™s
periodic payment consists of scheduled principal and interest payments
over the life of the loan. The schedule for the repayment of the principal
is called the amortization schedule. The standard residential mortgage
loan falls into this category. Auto loans and certain types of home equity
loans (speci¬cally, closed-end home equity loans discussed later in this
chapter) are amortizing assets. Any excess payment over the scheduled
principal payment is called a prepayment. Prepayments can be made to
pay off the entire balance or a partial prepayment, called a curtailment.
In contrast to amortizing assets, non-amortizing assets do not have
a schedule for the periodic payments that the borrower must make.
Instead, a non-amortizing asset is one in which the borrower must make
a minimum periodic payment. If that payment is less than the interest
on the outstanding loan balance, the shortfall is added to the outstand-
ing loan balance. If the periodic payment is greater than the interest on
the outstanding loan balance, then the difference is applied to the reduc-
tion of the outstanding loan balance. There is no schedule of principal
payments (i.e., no amortization schedule) for a non-amortizing asset.

Consequently, the concept of a prepayment does not apply. Credit card
receivables and certain types of home equity loans described later in this
chapter are examples of non-amortizing assets.
For an amortizing asset, projection of the cash ¬‚ows requires pro-
jecting prepayments. One factor that may affect prepayments is the pre-
vailing level of interest rates relative to the interest rate on the loan. In
projecting prepayments it is critical to estimate the extent to which bor-
rowers are expected to take advantage of a possible decline in interest
rates below the loan rate by re¬nancing the loan.
Modeling defaults for the collateral is critical in estimating the cash
¬‚ow of an ABS. Proceeds that are recovered in the event of a default of a
loan prior to the scheduled principal repayment date of an amortizing
asset represent a prepayment. Projecting prepayments for amortizing
assets requires an assumption of the default rate and the recovery rate.
For a non-amortizing asset, while the concept of a prepayment does not
exist, a projection of defaults is still necessary to project how much will
be recovered and when.

Below we review major sectors of the asset-backed securities market.
Exhibit 10.1 presents a Bloomberg screen that summarizes ABS issuance
for the period January 1, 1999 through August 22, 2001. The box
labeled “Collateral” indicates the dollar amount (billions of dollars) of
ABS by type of underlying collateral, which includes credit card receiv-
ables (CARD), auto loans (AUTO), home equity loans (HOMEQ), man-
ufactured housing loans (MANUF), and student loans (STDLN).
Second, the box labeled “Deal Structure” indicates the dollar amount of
ABS by the payment structure and includes sequential (SEQ), controlled
amortization structure (CAM), hard bullet and soft bullet (HB/SB), sub-
ordinated (SUB), and all others. These different types of payment struc-
tures will be discussed later in the chapter. The next box is labeled
“Interest Method” and indicates the dollar amount of ¬‚oating-rate ABS
issued versus all other types (e.g., ¬xed-rate). The ¬nal box labeled
“Class Rating” shows dollar amount of ABS issuance by credit rating.

Auto Loan-Backed Securities
Auto loan-backed securities are issued by (1) the ¬nancial subsidiaries
of auto manufacturers (domestic and foreign), (2) commercial banks,
and (3) independent ¬nance companies and small ¬nancial institutions
specializing in auto loans.
Short-Term Asset-Backed Securities

EXHIBIT 10.1 Bloomberg Screen of ABS Issuance

Source: Bloomberg Financial Markets

Cash Flow and Prepayments
The cash ¬‚ow for auto loan-backed securities consists of regularly sched-
uled monthly loan payments (interest and scheduled principal repay-
ments) and any prepayments. For securities backed by auto loans,
prepayments result from (1) sales and tradeins requiring full payoff of the
loan, (2) repossession and subsequent resale of the automobile, (3) loss or
destruction of the vehicle, (4) payoff of the loan with cash to save on the
interest cost, and (5) re¬nancing of the loan at a lower interest cost.
Prepayments due to repossessions and subsequent resale are sensi-
tive to the economic cycle. In recessionary economic periods, prepay-
ments due to this factor increase. While re¬nancings may be a major
reason for prepayments of mortgage loans, they are of minor impor-
tance for automobile loans. Moreover, the interest rates for the automo-
bile loans underlying several issues are substantially below market rates
if they are offered by manufacturers as part of a sales promotion.
Prepayments for auto loan-backed securities are measured in terms
of the absolute prepayment speed (ABS). The ABS is the monthly pre-
payment expressed as a percentage of the original collateral amount.
Recall that the SMM (monthly CPR) expresses prepayments based on

the prior month™s balance. There is a mathematical relationship between
the SMM and the ABS measures.1

Payment Structure
There are auto loan-backed deals that are passthrough structures and
paythrough structures. A typical passthrough structure for an auto loan-
backed deal is as follows:2

Tranche Amount ($) Average Life (Years) Coupon Rate

A $187,050,000 1.87 Fixed
B 18,499,000 1.87 Fixed
IO 6,000,000 1.46 Fixed

In this typical passthrough structure there is a senior tranche (A) and a
subordinated tranche (B). There is also an interest-only class. While
more deals are structured as passthroughs, this structure is typically
used for smaller deals.
Larger deals usually have a paythrough structure. As an illustration,
consider auto-loan backed securities issued from the Chase Manhattan
Auto Owner Trust 2001-A displayed in the Bloomberg screen in Exhibit
10.2. Note in this typical paythrough structure, the senior pieces are
tranched to create a range of average lives. The subordinated piece typi-
cally is not tranched.

Credit Card Receivable ABS
Credit cards are originated by banks (e.g., Visa and MasterCard), retail-
ers (e.g., JCPenney and Sears), and travel and entertainment companies
(e.g., American Express). Deals are structured as a master trust. With a
master trust the issuer can sell several series from the same trust. Each
series issued by the master trust shares the cash ¬‚ow and therefore the
credit risk of one pool of credit card receivables of the issuer.

Letting M denote the number of months after loan origination, the SMM rate can
be calculated from the ABS rate using the following formula:
SMM = ---------------------------------------------
1 “ ABS — ( M “ 1 )

where the ABS and SMM rates are expressed in decimal form.
Thomas Zimmerman and Leo Burrell, “Auto Loan-Backed Securities,” Chapter 4
in Anand K. Bhattacharya and Frank J. Fabozzi (eds.) Asset-Backed Securities (New
Hope, PA: Frank J. Fabozzi Associates, 1996).
Short-Term Asset-Backed Securities

EXHIBIT 10.2 Bloomberg Screen of Auto Loan-Backed Paythrough Structure

Source: Bloomberg Financial Markets

For a pool of credit card receivables, the cash ¬‚ow consists of ¬nance
charges collected, fees, interchange, and principal. Finance charges col-
lected represent the periodic interest the credit card borrower is charged
based on the unpaid balance after the grace period. Fees include late pay-
ment fees and any annual membership fees. For Visa and MasterCard, a
payment is made to originators. This payment is called interchange and is
made to the originator for providing funding and accepting risk during
the grace period. The principal is the amount of the borrowed funds
repaid. Interest to security holders is paid periodically (e.g, monthly,
quarterly, or semiannually). The interest rate may be ¬xed or ¬‚oating.
A credit card receivable-backed security is a non-amortizing secu-
rity. For a speci¬ed period of time, referred to as the lockout period or
revolving period, the principal payments made by credit card borrowers
comprising the pool are retained by the trustee and reinvested in addi-
tional receivables. The lockout period can vary from 18 months to 10
years. So, during the lockout period, the cash ¬‚ow that is paid out is
based on ¬nance charges collected and fees. After the lockout period,
the principal is no longer reinvested but paid to investors. This period is
referred to as the principal-amortization period.
There are three different amortization structures that have been used in
credit-card receivable-backed security structures: (1) passthrough structure,
(2) controlled-amortization structure, and (3) bullet-payment structure.

In a passthrough structure, the principal cash ¬‚ows from the credit
card accounts are paid to the security holders on a pro rata basis. In a
controlled-amortization structure, a scheduled principal amount is estab-
lished. The scheduled principal amount is suf¬ciently low so that the
obligation can be satis¬ed even under certain stress scenarios. The inves-
tor is paid the lesser of the scheduled principal amount and the pro rata
amount. In a bullet-payment structure, the investor receives the entire
amount in one distribution. Since there is no assurance that the entire
amount can be paid in one lump sum, the procedure is for the trustee to
place principal monthly into an account that generates suf¬cient interest
to make periodic interest payments and to accumulate the principal to be
repaid. The time period over which the principal is accumulated is called
the accumulation period. There are two basic types of bullet payments
(i.e., soft versus hard) that differ according to steps taken by the issuer to
insure investors will receive full payment of principal on the maturity
date.3 With a soft bullet payment, investors rely exclusively on the
underlying portfolio™s payment speed for full payment of the principal at
maturity. So, while the principal funding account is structured to have
sufficient funds to pay the entire principal on the bond™s expected matu-
rity date, there is no guarantee. Conversely, with a hard bullet payment,
the issuer purchases a maturity guarantee to ensure there will be suffi-
cient funds to pay the entire principal on the expected maturity date.
There are provisions in credit card receivable-backed securities that
require early amortization of the principal if certain events occur. Such
provisions, which are referred to as early amortization or rapid amorti-
zation provisions, are included to safeguard the credit quality of the
issue. The only way that the cash ¬‚ows can be altered is by the trigger-
ing of the early amortization provision. When early amortization
occurs, the credit card tranches are retired sequentially (i.e., ¬rst the
AAA bond, then the AA rated bond, and so on).
Exhibit 10.3 presents a Bloomberg screen displaying a credit card
receivable structure. The deal consists of two securities (A and B) issued
from the Citibank Credit Card Master Trust I, Series 1999-7. Exhibit 10.4
presents a Bloomberg Security Description screen for the senior tranche A.
This tranche is rated Aaa and carries a 6.65% coupon rate paid semiannu-
ally. Note also that next to WAL (weighted average life) in the center of
the screen is an “n.a.” or not applicable. This is so because credit card
receivables are non-amortizing assets so the concept of a prepayment does
not apply. Hence, WAL does not apply. The amortization structure used is

Robert Karr, Greg Richter, R. J. Shook, and Lireen Tsai, “Credit-Card Receiv-
ables” Chapter 3 in Anand K. Bhattacharya and Frank J. Fabozzi (eds.), Asset-
Backed Securities (New Hope, PA: Frank J. Fabozzi Associates, 1996).
Short-Term Asset-Backed Securities

a soft bullet with the principal expected to be paid in a single payment on
November 15, 2004. Exhibit 10.5 presents a Bloomberg Security Descrip-
tion screen for the subordinated tranche B. Note that B is rated A2 by
Moody™s and carries a higher coupon rate of 6.9%.

EXHIBIT 10.3 Bloomberg Screen of a Credit Card Receivable Deal

Source: Bloomberg Financial Markets

EXHIBIT 10.4 Bloomberg Security Description Screen of Credit Card Receivable
ABS, Senior Tranche A

Source: Bloomberg Financial Markets

EXHIBIT 10.5 Bloomberg Security Description Screen of
Credit Card Receivable ABS, Subordinated Tranche B

Source: Bloomberg Financial Markets

There are several concepts that must be understood in order to assess
the performance of the portfolio of receivables and the ability of the
issuer to meet its interest obligation and repay principal as scheduled.
We begin with the concept of gross portfolio yield. This yield
includes ¬nance charges collected and fees. Some issuers include inter-
change in the computation of portfolio yield. Charge-offs represent the
accounts charged off as uncollectible. Net portfolio yield is equal to
gross portfolio yield minus charge-offs. Delinquencies are the percent-
age of receivable that are past due a speci¬ed number of months.
The monthly payment rate (MPR) expresses the monthly payment
(which includes ¬nance charges, fees, and any principal repayment) of a
credit card receivable portfolio as a percentage of debt outstanding in the
previous month. For example, suppose a $500 million credit card receiv-
able portfolio in January realized $50 million of payments in February.
The MPR would then be 10% ($50 million divided by $500 million).
The MPR is an important statistic that is presented to investors in
monthly credit card portfolio performance reports. An example is pre-
sented in Exhibit 10.6 for four series (1999-A, 1999-B, 1999-C, and 2001-
A) from the BA Master Credit Card Trust for July 2001 using Bloomberg™s
Short-Term Asset-Backed Securities

CCR function. Bloomberg displays monthly credit card portfolio perfor-
mance reports for the leading credit card ABS issuers. Investors use the data
to make assessments about how the underlying collateral is performing and
to determine the likelihood that early amortization will be triggered.
MPR is an important indicator for two reasons. With a low level of
MPR, extension risk with respect to the principal payments may
increase. Also a low MPR, indicating low cash ¬‚ows to satisfy principal
payments, may trigger early amortization of the principal.

Closed-End Home Equity Loan-Backed Securities
A home equity loan (HEL) is a loan backed by residential property. At one
time, the loan was typically a second lien on property that has already been
pledged to secure a ¬rst lien. In some cases, the lien may be a third lien. In
recent years, the character of a home equity loan has changed. Today, a
home equity loan is often a ¬rst lien on property where the borrower has an
impaired credit history so that the loan cannot qualify as a conforming loan
for Ginnie Mae, Fannie Mae, or Freddie Mac. Typically, the borrower uses
a home equity loan to consolidate consumer debt using the current home as
collateral rather than to obtain funds to purchase a new home. Borrowers
are segmented into four general credit quality groups, A, B, C, and D.
There is no standard industrywide criteria for classifying a borrower.

EXHIBIT 10.6 Bloomberg Screen of Monthly Credit Card Portfolio
Performance Report

Source: Bloomberg Financial Markets

Home equity loans can be either open end or closed end. An open-
end home equity loan is discussed in the next section. A closed-end HEL
is structured the same way as a fully amortizing residential mortgage
loan. That is, it has a ¬xed maturity and the payments are structured to
fully amortize the loan by the maturity date. There are both ¬xed-rate
and variable-rate closed-end HELs. Typically, variable-rate loans have a
reference rate of 6-month LIBOR and have periodic caps and lifetime
caps, just as the adjustable-rate mortgages discussed in the previous
chapter. The cash ¬‚ow of a pool of closed-end HELs is comprised of
interest, regularly scheduled principal repayments, and prepayments, just
as with mortgage-backed securities. Thus, it is necessary to have a pre-
payment model and a default model to forecast cash ¬‚ows. The prepay-
ment speed is measured in terms of a conditional prepayment rate (CPR).

Cash Flow
The monthly cash ¬‚ow for a security backed by closed-end HELs is the
same as for mortgage-backed securities. That is, the cash ¬‚ow consists of
(1) net interest, (2) regularly scheduled principal payments, and (3) pre-
payments. The uncertainty about the cash ¬‚ow arises from prepayments.
Borrower characteristics must be kept in mind when trying to assess
prepayments for a particular deal. In the prospectus of an offering, a base
case prepayment assumption is made”the initial speed and the amount of
time until the collateral is expected to season. Thus, the prepayment bench-
mark is issue speci¬c and is called the prospectus prepayment curve or PPC.

Payment Structure
There are passthrough and paythrough home equity loan-backed struc-
tures. Typically, home equity loan-backed securities are securitized by
both closed-end ¬xed-rate and adjustable-rate (or variable-rate) HELs.
The securities backed by the latter are called HEL ¬‚oaters. The reference
rate of the underlying loans is typically 6-month LIBOR. The cash ¬‚ow
of these loans is affected by periodic and lifetime caps on the loan rate.
To increase the attractiveness of home equity loan-backed securities
to short-term investors, the securities typically have been created in
which the reference rate is 1-month LIBOR. Because of (1) the mismatch
between the reference rate on the underlying loans and that of the HEL
¬‚oater and (2) the periodic and lifetime caps of the underlying loans,
there is an available funds cap on the coupon rate for the HEL ¬‚oater.
Exhibit 10.7 presents a Bloomberg Security Description screen HEL
¬‚oater issued from the Advanta Mortgage Loan Trust, Series 2000-2.
This ¬‚oating-rate tranche has a coupon formula of 1-month LIBOR plus
14 basis points with a ¬‚oor of 14 basis points. This ¬‚oater also has an
available funds cap.
Short-Term Asset-Backed Securities

EXHIBIT 10.7 Bloomberg Security Description Screen of a HEL Floater

Source: Bloomberg Financial Markets

Tranches have been structured in HEL deals so as to give some
senior tranches greater prepayment protection than other senior
tranches. The two types of structures that do this are the planned amor-
tization class (PAC) tranche and non-accelerating senior (NAS) tranche.
In our discussion of CMOs issued by the agencies in the previous chap-
ter we explained how a planned amortization class tranche can be cre-
ated. These tranches are also created in HEL structures.
A NAS tranche receives principal payments according to a schedule.
The schedule is not a dollar amount. Rather, it is a principal schedule
that shows for a given month the share of pro rata principal that must
be distributed to the NAS tranche. A typical principal schedule for a
NAS tranche is as follows:

Months Share of pro rata principal

1 through 36 0%
37 through 60 45%
61 through 72 80%
73 through 84 100%
After month 84 300%

EXHIBIT 10.8 Bloomberg Screen of a HEL-Backed Deal

Source: Bloomberg Financial Markets

The average life for the NAS tranche is stable for a large range of pre-
payments because for the ¬rst three years all prepayments are made to the
other senior tranches. This reduces the risk of the NAS tranche contracting
(i.e., shortening) due to fast prepayments. After month 84, 300% of its pro
rata share is paid to the NAS tranche thereby reducing its extension risk.
As an illustration, Exhibit 10.8 presents a Bloomberg screen that
presents a HEL-backed deal issued by the Advanta Mortgage Loan
Trust, Series 2000-2. Note that tranche A6 is the NAS tranche. More-
over, tranches A2 through A5 are accelerated securities (AS) which
means simply these tranches receive principal payments faster than the
underlying collateral.

Open-End Home Equity Loan-Backed Securities
With an open-end home equity loan (HELOC) the homeowner is given a
credit line and can write checks or use a credit card for up to the
amount of the credit line. The amount of the credit line depends on the
amount of the equity the borrower has in the property.
The revolving period for a HELOC is the period during which the bor-
rower can take down all or part of the line of credit. The revolving period
can run from 10 to 15 years. At the end of the revolving period, the
HELOC can specify either a balloon payment or an amortization schedule
(of up to 10 years). Almost all HELOCs are ¬‚oating-rate loans. The interest
rate paid by HELOC borrowers is typically reset monthly to the prime rate
as reported in The Wall Street Journal plus a spread.
Short-Term Asset-Backed Securities

EXHIBIT 10.9 Bloomberg Security Description Screen of a HELOC Floater

Source: Bloomberg Financial Markets

The securities created in HELOC deals are ¬‚oating-rate tranches.
While the underlying loans are priced based on a spread over the prime
rate, the securities created are based on a spread over 1-month LIBOR.
Exhibit 10.9 presents a Bloomberg Security Description screen of a
HELOC ¬‚oating-rate tranche issued from the Advanta Revolving Home
Equity Loan Trust, Series 2000-A. This ¬‚oater has a coupon formula of
1-month LIBOR plus 25 basis points with a ¬‚oor of 25 basis points. The
coupon payments are delivered and reset monthly.
Because HELOCs are for revolving lines, the deal structures are quite
different for HELOCs and closed-end HELs. As with other ABS involv-
ing revolving credit lines such as credit card deals, there is a revolving
period, an amortization period, and a rapid amortization period.

Manufactured Housing-Backed Securities
Manufactured housing-backed securities are backed by loans for manu-
factured homes. In contrast to site-built homes, manufactured homes
are built at a factory and then transported to a manufactured home
community or private land. The loan may be either a mortgage loan (for
both the land and the home) or a consumer retail installment loan.

Manufactured housing-backed securities are issued by Ginnie Mae
and private entities. The former securities are guaranteed by the full
faith and credit of the U.S. government. Loans not backed by the FHA
or VA are called conventional loans. Manufactured housing-backed
securities that are backed by such loans are called conventional manu-
factured housing-backed securities.
The typical loan for a manufactured home is 15 to 20 years. The
loan repayment is structured to fully amortize the amount borrowed.
Therefore, as with residential mortgage loans and HELs, the cash ¬‚ow
consists of net interest, regularly scheduled principal, and prepayments.
However, prepayments are more stable for manufactured housing-
backed securities because they are not sensitive to re¬nancing.
There are several reasons for this. First, the loan balances are typically
small so that there is no signi¬cant dollar savings from re¬nancing. Second,
the rate of depreciation of manufactured homes may be such that in the
earlier years depreciation is greater than the amount of the loan paid off.
This makes it dif¬cult to re¬nance the loan. Finally, typically borrowers are
of lower credit quality and therefore ¬nd it dif¬cult to obtain funds to re¬-
nance. As with residential mortgage loans and HELs, prepayments on man-
ufactured housing-backed securities are measured in terms of CPR.
The payment structure is the same as with nonagency mortgage-
backed securities and home equity loan-backed securities.
As an illustration, Exhibit 10.10 presents a Bloomberg screen of
manufactured housing-backed securities issued by Green Tree Financial
Corporation, Series 1999-5. In the last column labeled “Description”,
there may be some abbreviations that require explanation. SEQ means
the security is a sequential-pay tranche. AFC means that tranche has an
available funds cap, as discussed earlier in the chapter. MEZ stands for
a mezzanine bond that provides credit support for the senior tranches
but has a higher credit rating than the subordinated (SUB) bonds.
Finally, EXE stands for Excess bond, this type of bond receives any cash
¬‚ows in excess of the amount of principal and interest obligated to all
other securities in the structure. Exhibit 10.11 presents a Bloomberg
Security Description screen of shortest maturity security (A1). A1 car-
ries a coupon rate of 6.27% and makes payments monthly. Note this
security carries a AAA credit rating from Standard & Poor™s.

Student Loan-Backed Securities
Student loans are made to cover college costs (undergraduate, graduate, and
professional programs such as medical school and law school) and tuition
for a wide range of vocational and trade schools. Securities backed by stu-
dent loans, popularly referred to as SLABS (student loan asset-backed securi-
ties), have similar structural features as the other ABS products we discussed.
Short-Term Asset-Backed Securities

EXHIBIT 10.10 Bloomberg Screen of Manufactured Housing-Backed Deal

Source: Bloomberg Financial Markets

EXHIBIT 10.11Bloomberg Security Description Screen Manufactured
Housing-Backed Security, Tranche A1

Source: Bloomberg Financial Markets

The student loans that have been most commonly securitized are
those that are made under the Federal Family Education Loan Program
(FFELP). Under this program, the government makes loans to students
via private lenders. The decision by private lenders to extend a loan to a
student is not based on the applicant™s ability to repay the loan. If a
default of a loan occurs and the loan has been properly serviced, then
the government will guarantee up to 98% of the principal plus accrued
interest. The federal government has a direct lending program”the Fed-
eral Direct Student Loan Program (FDSLP)”in which the Department
of Education (DOE) makes loans directly to students; however, these
loans are retained by the DOE and not securitized. Loans that are not
part of a government guarantee program are called alternative loans.
These loans are basically consumer loans and the lender™s decision to
extend an alternative loan will be based on the ability of the applicant
to repay the loan. Alternative loans have been securitized.
As Congress did with the creation of Fannie Mae and Freddie Mac
to provide liquidity in the mortgage market by allowing these entities to
buy mortgage loans in the secondary market, it created the Student
Loan Marketing Association (“Sallie Mae”) as a government-sponsored
enterprise to purchase student loans in the secondary market and to
securitize pools of student loans. Its ¬rst issuance was in 1995. Sallie
Mae is now the major issuer of SLABS and its issues are viewed as the
benchmark issues. Other entities that issue SLABS are traditional corpo-
rate entities (e.g., PNC Bank) and non-pro¬t organizations (Michigan
Higher Education Loan Authority and the California Educational Facil-
ities Authority). The SLABS of the latter are typically issued as tax-
exempt securities and therefore trade in the municipal market.
Let™s ¬rst look at the cash ¬‚ow for the student loans themselves.
There are different types of student loans under the FFELP, including
subsidized and unsubsidized Stafford loans, Parental Loans for Under-
graduate Students (PLUS), and Supplemental Loans to Students (SLS).
These loans involve three periods with respect to the borrower™s pay-
ments”deferment period, grace period, and loan repayment period.
Typically, student loans work as follows. While in school, no payments
are made by the student on the loan. This is the deferment period. Upon
leaving school, the student is extended a grace period of usually six
months when no payments on the loan need to be made. After this
period, payments are made on the loan by the borrower.
Prior to July 1, 1998, the reference rate for student loans originated
under the FFELP program was the 3-month Treasury bill rate plus a mar-
gin of either 250 basis points (during the deferment and grace periods) or
310 basis points (during the repayment period). Since July 1, 1998, the
Higher Education Act changed the reference rate to the 10-year Treasury
Short-Term Asset-Backed Securities

note. The interest rate is the 10-year Treasury note plus 100 basis points.
The spread over the reference rate varies with the cycle period for the loan.
As with other ABS, the reference rate need not be the same as that
of the underlying loans. For investors in non-Sallie Mae issues, there is
exposure to collateral performance due to basis risk discussed earlier in
this chapter. Typically, non-Sallie Mae issues have been LIBOR-based
¬‚oaters. For Sallie Mae issues, there is an indirect government guaran-
tee. Sallie Mae has typically issued SLABS indexed to the 3-month Trea-
sury bill rate. However, late in the second quarter of 1999, Sallie Mae
issued bonds in which the buyer of the 2-year tranche had the choice of
receiving either LIBOR plus 8 basis points or the 3-month Treasury bill
rate plus 87 basis points. There are available funds caps in ABS deals
because of the different reference rates.
Exhibit 10.12 presents a Bloomberg screen for SLABS issued by Sallie
Mae from the SLM Student Loan Trust 2001-3. As can be seen from the
screen, all four tranches are ¬‚oaters. However, investors have a choice of
reference rates in the ¬‚oater™s coupon formula. Speci¬cally, the ¬rst
tranche A1 is divided into two securities A1T and A1L. Panels A and B of
Exhibit 10.13 presents the Bloomberg Security Description screens for
these two securities. From the “Floater Formula” box in Panel A, we see
that A1T™s coupon formula is the 3-month Treasury bill rate plus 65 basis
points with a ¬‚oor of 65 basis points. The coupon is paid quarterly and
reset weekly. Conversely from Panel B, we see that A1L™s coupon formula
is 3-month LIBOR plus 4 basis points with a ¬‚oor of 4 basis points. The
coupon is paid and reset quarterly. The remaining two securities in the
deal”A2L and B”both have coupon formulas tied to 3-month LIBOR.

EXHIBIT 10.12 Bloomberg Screen of a SLABS Deal

Source: Bloomberg Financial Markets

EXHIBIT 10.13 Bloomberg Security Description Screen of a Sallie Mae SLABS
Panel A: Tranche A1T

Panel B: Tranche A1L

Source: Bloomberg Financial Markets
Short-Term Asset-Backed Securities

Prepayments typically occur due to defaults or loan consolidation.
Even if there is no loss of principal faced by the investor when defaults
occur, the investor is still exposed to contraction risk. This is the risk
that the investor must reinvest the proceeds at a lower spread and in the
case of a bond purchased at a premium, the premium will be lost. Stud-
ies have shown student loan prepayments are insensitive to the level of
interest rates. Consolidations of loans occur when the students who
have loans over several years combine them into a single loan. The pro-
ceeds from the consolidation are distributed to the original lender and,
in turn, distributed to the bondholders.

SBA Loan-Backed Securities
The Small Business Administration (SBA) is an agency of the federal
government empowered to guarantee loans made by approved SBA
lenders to quali¬ed borrowers. The loans are backed by the full faith
and credit of the U.S. government. Most SBA loans are variable-rate
loans where the reference rate is the prime rate. The rate on the loan is
either reset monthly on the ¬rst of the month or quarterly on the ¬rst of
January, April, July, and October. SBA regulations specify the maximum
coupon allowable in the secondary market. As of this writing, the maxi-
mum coupon rate is equal to the prime rate plus 1.625%. SBA loans
typically do not have caps. Newly originated loans have maturities
between 5 and 25 years.
The Small Business Secondary Market Improvement Act passed in
1984 permitted the pooling of SBA loans. When pooled, the underlying
loans must have similar terms and features. The maturities typically
used for pooling loans are 7, 10, 15, 20, and 25 years. Loans without
caps are not pooled with loans that have caps.
Most variable-rate SBA loans make monthly payments consisting of
interest and principal repayment. The amount of the monthly payment
for an individual loan is determined as follows. Given the coupon for-
mula of the prime rate plus the loan™s quoted margin, the interest rate is
determined. Given the interest rate, a level payment amortization sched-
ule is determined. It is this level payment that is paid for the months
until the coupon rate is reset. When variable-rate SBA loans are pooled,
the amortization schedule is based on the net pool rate and the rate is
recomputed either every month or every quarter.
Prepayments for SBA-backed securities are measured in terms of
CPR. Voluntary prepayments can be made by the borrower without any
penalty. Exhibit 10.14 presents a Bloomberg screen of the historical
CPR for SBA pools (all variable rate pools) for the period January 1991
until August 2001. Even a cursory glance suggests that prepayments

vary considerably over time and across pools established in different
years. There are several factors contributing to the prepayment speed of


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