Fixed Income Securities

Prof Kaushik Desarkar

PGDM BIFS Programme
Goa Institute of Management
Fixed Income Securities
• TODAY’S SESSION

• SECURITIZATION
• MORTGAGED BACKED SECURITIES
Fixed Income Securities
• SECURITIZATION

• Question: What is Securitization?

• Answer: Process of transforming the illiquid assets of a leading entity – a financial
institution or a corporation – into tradable securities, backed by these (illiquid)
assets.

• The market for securitized assets is called the Securitized Debt Market.

• Question: What are the constituents of the Securitized Debt Market?

• Answer: Mortgage Backed Securities (MBS) & Asset Backed Securities (ABS).
Fixed Income Securities
• SECURITIZATION

• MBS and ABS are

• Collateralized by a pool of loans
• The cash flows from these pool of loans are used to pay the cash flows on the
securities.

• 3 participants involved in the securitization process

1. The Originator
2. The Issuer
3. The Trustee
Fixed Income Securities
• SECURITIZATION
• The 3 participants

1. The Originator – The financial institution or the corporate – the original lender.

• The originator provides loans to various debtors for purchasing houses etc.
Unfortunately, these loans are non-tradable and if there was no securitization,
further loans cannot be provided until a certain level of cash has accumulated
with the institution.
• Thus, securitization provides the liquidity to carry on business without further
debt and/or equity fusion.
Fixed Income Securities
• SECURITIZATION
• The 3 participants

2. The Issuer – also called the conduit.

• The Issuer:
1. The issuer is the investor who buys the loans from the originator.
2. Gathers them into a pool and issues securities guaranteed by the pool.
3. A bankruptcy remote trust – a SPV – is created for holding the pool of loans separately
from other assets of the originator. This to ensure that the CFs from the pool are
dedicated to servicing the securities backed by the pool.
4. In case originator goes bankrupt, the SPV continues to pay the proceeds from the loans
to the security holders.
Fixed Income Securities
• SECURITIZATION
• The 3 participants

3. The Trustee – The entity that manages the SPV created by the Issuer.

• Its main job is to ensure that the rights of the investors, who have purchased the
collateralized backed securities, are protected.
Fixed Income Securities
• SECURITIZATION

• Why are MBS and ABS very popular in the Fixed Income/debt market?

• From Originator/Issuer’s stand point of view?

1. Improves the liquidity of its balance sheet
2. Maintains the size of the balance sheet by transferring a part of its assets - from
illiquid loan assets to highly liquid cash – thus improving the liquidity ratios.
3. A quick and efficient method of refinancing.
Fixed Income Securities
• SECURITIZATION

• Why are MBS and ABS very popular in the Fixed Income/debt market?

• From Investors’ stand point of view?

1. MBS/ABS generally have a high credit quality (AA – AAA).
2. The yields are higher than bonds with comparable quality & maturity.
3. In the west, they are actively traded – hence more liquid than other corporate
debt securities.
4. Historically, they have shown more resilience to downgrades than other issued
debt securities.
Fixed Income Securities
• SECURITIZATION

• Uses of MBS and/or ABS

• From Originator/Issuer’s Standpoint

• Securitization allows maintaining the size of the balance sheet.
• Allows release of capital that can be put back to work thus earning higher
returns.

• From Investors’ standpoint

• Used to capture spread over Treasury bonds
• Yield enhancement without sacrificing credit quality and liquidity
Fixed Income Securities
• SECURITIZATION

• MORTGAGED BACKED SECURITIES

• 3 Main types

1. Mortgage Pass Through Securities

2. Collateralized Mortgage Obligations (CMOs)
3. Stripped Mortgage-backed Securities
Fixed Income Securities
• MORTGAGED BACKED SECURITIES

• Mortgage Pass-Through

1. Simplest form of MBS

2. A pass-through unit represents a share of the underlying mortgage pool
3. The CFs generated by the pool are passed to the security holders.
4. There are 3 payments to security holders
• Interest Payments
• Scheduled principal payments
• Prepayments – (Call option to the Issuer) – another reason why the yld is
high.
Fixed Income Securities
• MORTGAGED BACKED SECURITIES

• Collateralized Mortgage Obligations (CMOs)

1. Cash is distributed to security holders on a priority basis

2. They are structured into maturity classes – Tranches.
3. The first/highest tranche is considered near 100% risk-free (AAA grade).
4. The lowest tranche is “junk” grade – usually considered to be Equity Grade – in
the event of high default, this level suffers the most – like equity share holders
in a default business.
Fixed Income Securities
• MORTGAGED BACKED SECURITIES
• Collateralized Mortgage Obligations (CMOs)

• The Assets are the Mortgages.

• Note the tranches (French for “slicing”) created.
Fixed Income Securities
• MORTGAGED BACKED SECURITIES

• Stripped MBSs

1. Structured into 2 classes – Interest Only Class (IO) and Principal Only Class (PO).
2. The IO class is entitled to all interest payments.
3. The PO class is entitled to the principal payments.
4. These are highly sensitive to prepayment situations and hence riskier than pass-
through.
5. The higher the prepayment rate, the faster the POs are paid off.
6. Hence lesser CFs for the IOs.
7. Question – which security class is valued higher – the PO Class of the IO Class ?
Fixed Income Securities
• MORTGAGED BACKED SECURITIES

• The Prepayment Feature

• Prepayment potentially affects all loans – its effect is higher in residential

mortgages.

• Any early principal payment in excess of the regular amortization schedule. Thus
you can have (1) Partial Prepayment and (2) Total Prepayment.

• There are 5 sources of prepayment in the mortgage lending business …

Fixed Income Securities
• MORTGAGED BACKED SECURITIES
• 5 SOURCES OF PREPAYMENT

1. Home Sale – the mortgagor (borrower) sells his house to buy a bigger property or
change of location due to job change.
2. Refinancing – the mortgagor may have the opportunity to refinance the mortgage at a
lower interest rate if it falls below the current interest rate level.
3. Default – if the mortgagor is unable to make the scheduled payments – “unable to
honor the obligation(s)” – the mortgage is foreclosed and liquidated. The property is
seized and auctioned/sold off.
4. Extra Payment – the mortgagor may wish to pay more than the scheduled payment
each month so as to build up equity in his house (home) faster.
5. Accident – the mortgagor’s house residential property may be destroyed by an
accident or a natural disaster.
Fixed Income Securities
• MORTGAGED BACKED SECURITIES
• 5 SOURCES OF PREPAYMENT
1. Home Sales
2. Refinancings
3. Defaults
4. Extra Payments
5. Accidents

• Question: How are the mortgages paid off in case of 1., 3. & 5.?
• Answer: In case of 1. & 3., the mortgage is paid off with proceeds from house
sales while in case 5., the mortgage is paid off with insurance proceeds.
Fixed Income Securities
• SUMMARY

• Insight into Securitization

• Various terminologies of MBS
• The Prepayment Feature

• Thank you.