Distinguish Asset Backed Securities - Series 65
- What is the primary structural purpose of tranching in ABS and MBS deals?
- To allocate cash flows and credit risk into classes with different priority. Tranching creates tiers of securities with varying risk-return profiles to appeal to different investor preferences.
- What is a special purpose vehicle (SPV) used for in ABS or MBS issuance?
- A bankruptcy-remote entity that holds collateral and issues securities. SPVs isolate assets from the originator's bankruptcy risk, ensuring secure cash flows for security holders.
- What is a support (companion) tranche in a CMO structure?
- A tranche that absorbs prepayment variability to protect PAC tranches. Support tranches shield PACs by taking on excess or deficient prepayments, stabilizing the structure.
- What is an asset-backed security (ABS) in fixed-income terminology?
- A security backed by cash flows from non-mortgage receivables. This definition emphasizes the use of diverse non-mortgage assets like auto loans or credit cards to generate investor cash flows in structured finance.
- What does 'credit enhancement' mean in structured products such as ABS and MBS?
- Structural or third-party support that reduces loss risk to investors. Credit enhancements improve the credit rating and attractiveness of securities by mitigating default risks.
- Identify the collateral type most typical for ABS rather than MBS.
- Auto loans, credit card receivables, student loans, or equipment leases. ABS collateral consists of amortizing consumer debts, differing from MBS's mortgage focus.
- What is a mortgage-backed security (MBS) in fixed-income terminology?
- A security backed by cash flows from pools of mortgage loans. MBS pool residential or commercial mortgages to create securities that pass through principal and interest payments to investors.
- Which underlying loans most directly distinguish MBS from ABS?
- MBS are backed by mortgages; ABS are backed by non-mortgage assets. The core distinction lies in the collateral type, with MBS tied to real estate loans and ABS to consumer or commercial receivables.
- What is a sequential-pay (plain vanilla) CMO structure?
- Tranches receive principal in order; later tranches wait until earlier are paid. Sequential-pay directs principal sequentially to tranches, providing varying maturities and risk levels.
- What does prepayment risk mean for MBS investors?
- Borrowers may repay early, changing timing and reducing expected interest. Prepayment risk arises from borrowers refinancing at lower rates, altering the security's duration and yield.
- Which agency is most associated with 'full faith and credit' support for MBS?
- Ginnie Mae (GNMA). GNMA provides explicit U.S. government backing, ensuring timely payment of principal and interest.
- What is a reserve account in an ABS or MBS transaction?
- A funded account used to cover shortfalls and provide credit support. Reserve accounts build liquidity to offset potential cash flow disruptions from defaults or delinquencies.
- Identify the option that best describes a collateralized mortgage obligation (CMO).
- A tranched MBS that redistributes mortgage cash flows into multiple classes. CMOs restructure MBS cash flows into tranches to manage prepayment risk and cater to investor needs.
- What does 'waterfall' mean in an ABS or MBS cash flow structure?
- Rules that pay interest and principal in a specified priority order. The waterfall mechanism ensures orderly distribution, prioritizing senior tranches to enhance credit protection.
- Which option best defines a Z-tranche (accrual tranche) in a CMO?
- A tranche that accrues interest and receives no cash until earlier tranches are paid. Z-tranches defer cash payments, compounding interest to support earlier tranches' retirement.
- What is overcollateralization as a form of credit enhancement in ABS or MBS?
- Collateral balance exceeds securities issued, creating a loss-absorbing cushion. Overcollateralization provides a buffer against defaults by having more asset value than the securities' principal.
- What is a pass-through MBS structure?
- Investors receive a pro rata share of principal and interest from the pool. Pass-through structures directly transmit mortgage payments, exposing investors to prepayment variability.
- What is excess spread in ABS structures?
- Interest collected minus interest paid and fees, available to absorb losses. Excess spread acts as a first line of defense against losses by retaining surplus interest after expenses.
- What is extension risk in MBS, and when is it most likely to increase?
- Slower prepayments lengthen maturity; it rises when interest rates rise. Extension risk occurs when rising rates reduce refinancing, prolonging the security's life and reinvestment risk.
- What is securitization in the context of ABS and MBS structures?
- Pooling loans and issuing securities backed by the pool cash flows. Securitization transforms illiquid loans into tradable securities by aggregating them and selling claims on their cash flows.
- Which option correctly characterizes Fannie Mae and Freddie Mac MBS support?
- They have credit support from the GSEs, not explicit full faith and credit. Fannie Mae and Freddie Mac offer implicit support through their GSE status, without direct Treasury guarantee.
- What is subordination as a credit enhancement feature in ABS or MBS tranches?
- Junior tranches absorb losses before senior tranches. Subordination protects senior investors by having junior classes bear initial losses in the capital structure.
- Which option best distinguishes a home equity loan ABS from a traditional MBS?
- Home equity loan ABS are backed by second-lien/consumer credit, not agency mortgages. Home equity ABS involve riskier junior liens without agency guarantees, unlike standard MBS pools.
- What is a planned amortization class (PAC) tranche designed to provide?
- More stable principal payments within a defined prepayment range. PAC tranches offer predictability by maintaining scheduled payments assuming prepayments stay within bands.
- What is the key difference between agency MBS and non-agency (private-label) MBS?
- Agency MBS have agency backing; non-agency rely on collateral and structure. Agency MBS benefit from government-sponsored enterprise guarantees, reducing credit risk compared to private issues.