MODULE 18: Asset-Backed Security (ABS) Instrument and Market Features

Source module: /home/karma/CFAPractice/mcq/quiz/AI/PDF/FixedIncome/module_18_asset_backed_security_abs_instrument_and_market_features.txt

1. Compared to ordinary bank bonds, covered bonds are safer because your repayment isn’t riding on just “the bank stays healthy.” You also have a legally protected pile of assets sitting behind the bond. If assets fail to pay, you can lay claim on the assets of the originator. The covered bonds have a recourse to the originator.
2. In a covered bond, the bank still owns the loans (they stay on its balance sheet), so regulators still treat them as the bank’s assets/risk. So the bank must still hold the same capital buffer against them-unlike securitization, where selling/isolating the loans can reduce required capital.
3. There is no tranching in covered bonds and the collateral pool cannot contain non performing assets.
4. Hard Bullet Suppose issuer misses Year 2 coupon Under hard bullet, this is immediate default. Acceleration happens immediately. The bondholders’ claim becomes: “pay me everything outstanding now."
5. Soft-bullet: if the issuer can’t pay at maturity, default/acceleration is delayed by extending the maturity (e.g., up to a year) to give time to pay, and only if still unpaid after the extension does default kick in.
6. Conditional pass-through: if anything is still unpaid at maturity, the bond switches to pass-through, meaning investors get paid only as cash is later collected from the cover pool (e.g., 60 now, then 25, then 15), with repayment timing driven by recoveries rather than a fixed date.

WATERFALL STRUCTURE IN ABS

ORIGINATOR (BANK)
   |
   | Sells loans to. 
   | This is a true sale including 
   | claim on collateral
   v
SPECIAL PURPOSE VEHICLE (SPV)
    |
    | Issues ABS to investors 
    v
    Flow of Funds works like this:
    --------
    SENIOR TRANCHE (AAA)
    FV = 300
    MRR + 0.5%
    --------
    MEZZANINE TRANCHE (BBB)
    FV = 80
    MRR + 1.5%
    --------
    JUNIOR TRANCHE (BB)
    FV = 30
    Variable

1. The senior tranche has the first claim on cash flows from the underlying assets, so it has the lowest risk and lowest yield. **It can have a higher credit rating than originator"
2. Suppose I have 10 of Mezzanine tranche and MRR is 4%. In no default case; I get 10 * 0.055 = 0.55.
3. Suppose there is a default in the pool that amounts to 50, then the Junior tranche will be wiped off (30). I have to pay for remaining 20 from Mezzanine tranche. So I get 80 - 20 = 60. My return is 60/80 = 75% of 0.55 = 0.4125.
4. Credit card ABS has two phases because credit cards don’t have a fixed “repay schedule” like a mortgage. So the deal first runs a revolving/lockout period where principal coming in is re-lent (investors get only interest/fees), then switches to an amortization period where principal is returned to investors. (Very similar to a Z-Tranche)

COLLATERALISED DEBT OBLIGATION

1. A CDO is an SPE-issued box that owns a portfolio of debt and then slices the cashflows into tranches (senior/mezz/equity). What makes many CDOs different from plain ABS is that the portfolio is often actively managed: a collateral manager can buy/sell/reinvest the collateral to keep the deal generating enough cash to pay investors.