Temp_store

LO 36.7: Explain the implications o f the subprime mortgage meltdown on portfolio management.
Currently, the rating agencies collectively monitor approximately 10,000 mortgage pools. It would be impractical to monitor each pool on a monthly basis in detail. It is current practice to annually review each individual pool. An important performance measure used during this review is the loss coverage ratio (LCR), defined as: (current credit enhancement for tranche) / (estimated unrealized losses). An example of a credit enhancement is excess spread. If the LCR is breached (i.e., falls below what is acceptable), a full review is warranted.
P r e d a t o r y L e n d i n g a n d B o r r o w i n g

LO 36.6: Describe the relationship between the credit ratings cycle and the housing cycle.
The goal of the rating system is to rate through-the-cycle, meaning that there should not be excessive upgrades (downgrades) if the housing market heats up (slows down). A problem may arise if the agency assigns, say, an AAA rating during a boom period. As the housing market slows down, the probability of default increases and the security has migrated to AA even though the agency has not made a public pronouncement. The problem is further exacerbated if new deals are based on the credit enhancements from the AAA rating in the boom period.
As economic conditions change, it is expected to see some upgrades or downgrades in mortgage-backed securities. However, the effect may amplify up and down markets. For example, in a downward trending market, additional enhancements are needed to maintain the highest ratings. This crowds out the credit available for lower rated borrowers increasing the required loan rate or raising qualification standards. The opposite is true for housing upturns freeing up credit for lower rated borrowers.
2018 Kaplan, Inc.
Page 305
Topic 36 Cross Reference to GARP Assigned Reading – Ashcroft & Schuermann
Cash Flow Analysis o f Excess Spread
In the ratings process it is necessary to simulate the cash flows of the structure to forecast the degree of excess spread used for credit enhancement. As you can imagine, the forecasts are complex and depend on several interrelated factors including credit enhancement, timing of losses, prepayment rates, interest rates, trigger events, weighted average loan rate decrease, prepayment penalties, pre-funding accounts, and hedging instruments. The more important factors are discussed as follows.
First, the credit enhancement identifies the amount of collateral that can be impaired before the tranche suffers an economic loss. The timing of losses is also important because as losses accumulate, less excess spread will be available. A more conservative approach would front-load the losses. Prepayments will directly impact the excess spread. Prepayments may be voluntary (refinance, sales) or involuntary (default) so the prepayment assumption directly impacts the cash flow analysis. Prepayments typically follow the CPR (conditional prepayment rate) convention. However, it is important to note that hybrids will have higher than predicted defaults on or about the reset date due to the sudden change in rates and financial condition of the subprime borrower. A more conservative view would accelerate prepayments reducing further interest collections. Finally, the path of interest rates introduces uncertainty into the projected cash flow stream. Interest rates determine the adjustments (i.e., cash inflows), and influence refinancing.

LO 36.3: Explain the im plications o f credit ratings on the emergence o f subprime related m ortgage backed securities.
Assigning credit ratings for securitized assets presents additional challenges. Credit ratings for subprime securities, and more generally asset-backed securities (ABS), differ from corporate ratings in several important ways. First, corporate bond ratings are based on the firm-specific characteristics of the issuer where as ABS is a claim on a portfolio. Hence, systematic risk and degree of correlation between assets is important in the latter but not the former. ABS represents claims on a static pool and cannot infuse additional capital or restructure as a corporation can. In addition, the forecasts for ABS incorporate future economic conditions since the cash flow stream is tied to the macro environment. Finally, while corporates and ABSs with the same rating may indicate similar default probabilities, the ABS will exhibit much wider variation in losses.

LO 36.4: Describe the credit ratings process with respect to subprime mortgage backed securities.
A credit rating is defined as an opinion on the creditworthiness of the specific bond issue. Note that the assigned rating is specific to the security and in no way a reflection on the originator. The ratings represent an unconditional view of the rating agency as they rate through-the-cycle.
The rating process involves two steps: (1) estimation of loss distribution and (2) simulation of the cash flows. Once the estimates are obtained, the agency indicates the level of credit enhancement necessary to achieve the desired rating. If the projected rating is too low, the originator can provide additional enhancement to raise the rating.

LO 36.3: Describe the characteristics o f the subprime mortgage market, including the creditworthiness o f the typical borrower and the features and performance o f a subprim e loan.
Subprime borrowers have a history of either default or strong indicators of possible future default. Past incidents include 30- or 60-day delinquencies, judgments, foreclosures, repossessions, charge-offs, or bankruptcy filings. Low FICO scores (660 or below) or a high debt service ratio of 30% or more are likely indicators of future default.
The vast majority of subprime loans are adjustable rate mortgages. The loan offers a teaser rate for a short period of time, and then adjusts each year relative to a floating rate index (usually LIBOR). The 2- and 3-year teaser rates are called 2/28 and 3/27 hybrid arms denoting the fixed and floating terms, respectively (e.g., fixed term is 2 years, floating term is 28 years). Since the majority of the term of the mortgage is floating, the borrower is bearing the interest rate risk in contrast to a traditional fixed rate mortgage where the lender bears the interest rate risk.
The performance of subprime pools indicates defaults and foreclosures way above historical levels. As a point of reference, the authors of the assigned reading analyze a New Century pool originating in May 2006 and estimate a 23% cumulative default rate through August 2007.
Securitized pools incorporate structures to provide protection to investors from losses in the collateral including subordination, excess spread, shifting interest, performance triggers, and interest rate swaps.
Subordination involves creating tranches of differing priority levels. Losses are applied first to the most subordinated tranche, the equity tranche. The equity tranche is usually created from overcollateralization (i.e., assets in excess of face value). If the losses exceed the size of this tranche then losses will reach the next highest subordinated level called the mezzanine. Credit ratings on mezzanine debt typically vary from AA to B. In this fashion, the most senior tranche is protected by all the junior tranches and offers the lowest return.
Mortgages pools are typically constructed so that the weighted average coupon (less servicing, hedging, and other expenses) exceeds the weighted average payout. The difference is called the excess spread which is paid to equity tranche investors when available. Thus, the excess spread protects all tranches.
Under shifting interest, the senior investors receive all principal in the pool while the mezzanine investors receive only interest. The senior holders may receive the principal for a set period of time (lockout period) or until a cutoff ratio is reached.
Performance triggers denote the release of overcollateralizion which is applied from the bottom of the capital structure up.
Since the first few years of the pool are fixed, the pool faces interest rate risk. As protection, interest rate swaps are used where the pool will pay a fixed rate and receive a floating rate.
Page 304
2018 Kaplan, Inc.
Topic 36 Cross Reference to GARP Assigned Reading – Ashcroft & Schuermann
T h e C r e d i t R a t i n g s P r o c e s s

LO 36.8).
Friction 3: Arranger and third-parties. The arranger of the pool of mortgages will possess
better information about the borrower than third parties including rating agencies, asset managers, and warehouse lenders. The adverse selection problem gives the arranger the opportunity to retain the higher quality mortgages and securitize the lower quality mortgages (i.e., lemons).
The warehouse lender temporarily holds and finances the underlying purchases. As a precaution, the warehouse will fund less than 100% of its estimated collateral value forcing the arranger to retain a equity position on its balance sheet.
The asset portfolio manager purchases the assets for the pool from the arranger. Once again, the arranger has superior information about the creditworthiness of the mortgage pool. To minimize the potential adverse selection problem, the asset manager must use adequate due diligence, use reputable arrangers, and force credit enhancements from the arranger.
Similarly, the rating agencies determine the amount of credit enhancement necessary to achieve the desired credit rating. Thus, the rating agency is dependent on the information provided by the arranger. Typically, the due diligence on the arranger and originator is rushed.
Friction 4:
Servicer and mortgagor. The servicers role is to manage the cash flows of the pool and follow up on delinquencies and foreclosures. A conflict of interest arises for delinquent loans. The homeowner in financial difficulty does not have the incentive to upkeep tax payments, insurance, or maintenance on the
Page 302
2018 Kaplan, Inc.
Topic 36 Cross Reference to GARP Assigned Reading – Ashcroft & Schuermann
property. Escrowed funds can minimize this problem but ultimately efficient foreclosure must comply with federal regulations.
Friction 5:
Servicer and third-parties. The servicer faces a moral hazard problem because their (lack of) effort can impact the asset manager and credit rating agencies without directly affecting their own cash flow distribution. In delinquency, the servicer is responsible for the property taxes and insurance premiums. These funds are reimbursable upon foreclosure so there is a temptation to exaggerate the fees and expenses particularly with high recovery rates.
The servicer also has an incentive to keep the problem loan on its books by modifying loan terms rather than foreclose (investor preference). Since most of the costs are unrecoverable (escrow analysis, payment set up, etc.) the property needs to be active to generate any additional funds to the servicer.
It is apparent that the quality of the servicer can directly impact the cash flows of the pool which in turn affects the credit rating. Changes in credit ratings reflect poorly on the agency. Therefore, the credit rating agencies must use due diligence in analyzing the servicer as well as the underlying collateral.
Friction 6:
Asset manager and investor. The investor relies on the asset managers expertise to identify and analyze potential investments. It is difficult for the investor to comprehend the investment strategy and the investor will not be able to observe the effort of the management team (same moral hazard problem as shareholder-manager). Investment mandates and proper benchmarking can mitigate some of the distortion.
Friction 7:
Investor and credit rating agencies. Rating agencies are compensated by the arranger and not the end user, the investor. To the extent that the rating agencies are beholden to the fee structure of the arranger, a conflict of interest arises. In addition, it is very difficult to judge the accuracy of their models particularly with complex products and rapid financial innovation.
Five of these factors are direct contributors to the recent subprime crisis. First, the complexity of the product and naive nature of the borrower led to inappropriate loans (friction 1). Second, managers sought the additional yield from structured mortgage products without fully assessing the associated risks (friction 6). Third, the problem became more expansive as underperforming managers made similar investments with less due diligence on the arranger and originator (friction 3). Fourth, as the asset managers reduced their oversight, it was natural that the arranger would follow suit (friction 2). This left the credit rating agencies as the last line of defense but they operated at a significant informational disadvantage. Finally, the assigned ratings were hopelessly misguided (friction 7).
2018 Kaplan, Inc.
Page 303
Topic 36 Cross Reference to GARP Assigned Reading – Ashcroft & Schuermann
C h a r a c t e r i s t i c s o f t h e S u b p r i m e M o r t g a g e M a r k e t

LO 36.2: Identify and describe key frictions in subprime mortgage securitization, and assess the relative contribution o f each factor to the subprime mortgage problems.
In general, when two parties do not have the same information (which is usually the case), a sub-optimal outcome results. The two broad classes of information problems we will discuss here are moral hazard and adverse selection. Moral hazard denotes the actions one party may take to the detriment of the other. A classic example is the shareholder-manager relationship where the managers may use their position for personal gain rather than for
2018 Kaplan, Inc.
Page 301
Topic 36 Cross Reference to GARP Assigned Reading – Ashcroft & Schuermann
the shareholders to whom they owe a fiduciary duty. On the other hand, adverse selection is when one party possesses important hidden information. For example, a persons driving ability is private knowledge and a potential buyer of auto insurance will have the incentive to represent themselves as good drivers even if they are not. Mechanisms are designed to minimize these information problems such as board oversight for the managers and examination of driving records for those seeking auto insurance.
There are seven frictions in the mortgage securitization process. Each friction is discussed as follows.
Friction 1: Mortgagor and originator. The typical subprime borrower is typically
financially unsophisticated. As a result, the borrower may not select the best borrowing alternative for themselves. In fact, the borrower may not even be aware of the financing options available. On the other hand, the lender may steer the borrower to products that are not suitable.
Friction 2: Originator and arranger. The arranger (issuer) purchases the loans from
the originators for the purpose of resale through securitized products. The arranger will perform due diligence but still operates at an information disadvantage to the originator. That is, the originator has superior knowledge about the borrower (adverse selection problem). In addition, the originator may falsify or stretch the bounds of the application resulting in larger than optimal lending (predatory lending or predatory borrowing as discussed in

LO 36.1: Explain the subprim e m ortgage credit securitization process in the United States.
The subprime securitization process in the United States involves several different parties beginning with the borrowing needs of the home buyer. The borrower (mortgagor) applies for a mortgage and, conditional on the due diligence of the lender, is extended a loan with the residence serving as collateral. Borrowers range in quality from prime (i.e., strong credit history) to Alt-A (i.e., borrowers with good credit but more aggressive underwriting standards) to subprime (i.e., borrowers with poor credit history). Lenders sell a significant portion of their loans to a third-party (special purpose vehicle) and receive cash in return. Prime loans that meet conforming standards are sold to government sponsored enterprises (GSEs). The remaining loans are increasingly being sold and taken off the originators balance sheet. Approximately 73% of newly originated subprime mortgages were securitized in 2003 and 2006.
F r i c t i o n s i n S u b p r i m e M o r t g a g e S e c u r i t i z a t i o n

LO 35.9: Explain the decline in dem and in the new-issue securitized finance products following the 2007 financial crisis.
The financial crisis of 20072009 was a direct result of the subprime mortgage problems that led to an asset-backed commercial paper standstill. The liquidity crisis faced by large financial institutions led to a worldwide recession. U.S. mortgage defaults quickly rippled worldwide through the globally integrated banking system and global investments in structured credit products backed by U.S. mortgages. Collateralized debt obligations (CDOs) and other ABS were key contributors in poor lending decisions in the U.S. mortgage market.
Key factors that led to the loss in market confidence and the 20072009 financial crisis were the impact of the credit crunch, shadow banking system, leverage, lack of transparency, credit rating agencies practices, accounting rules, and liquidity. These factors led to negative sentiment among investors and a sharp decline in the new-issue securitization market.
2018 Kaplan, Inc.
Page 295
Topic 35 Cross Reference to GARP Assigned Reading – Choudhry, Chapter 12
The widespread use of securitization to remove assets from the balance sheet of financial institutions eventually led to the credit crunch. Subprime lenders made excessive amounts of low quality loans and then removed these loans from their balance sheets through ABS. Investors were overconfident in buying these ABS and unaware of the risks in this market.
The securitization structure is designed to break the link between loan originators and borrowers. Loans are carefully grouped and packaged into tranches and sold to investors who have no knowledge of the credit quality of the original borrowers. A shadow banking system was created where entities are not bound by the same regulatory requirements of normal banks. These entities in the shadow banking system were referred to as special investment vehicles (SIVs). SIVs funded loans through commercial paper and did not rely on the central banks discount window as a backup source of funding. This worked until the shadow bank was no longer able to find investors in this market. The inability to refinance the securitized products led to a liquidity crisis.
SIVs were highly leveraged just prior to the market collapse in 2007. Leverage ratios of 1:15 were common at this time. Some SIVs had leverage ratios as high as 1:50 as they increased their borrowing in an attempt to compensate for the shrinking credit spreads during the bull market. The use of leverage was even more problematic for CDOs that invested in other CDOs.
The lack of transparency resulted in increasingly complex products. Valuing products with no transparency is extremely difficult. As the credit crisis progressed, the wide variety of ABS tranches that existed in the market became very difficult to mark-to-market due to the widening of credit spreads for tranches and the changing correlation risk for ABS portfolios. To complicate matters even further, the changes in correlations had different impacts for different seniority levels of tranches.
Credit rating agencies (CRAs) were overly optimistic in their ratings due to poor credit quality models and a lack of understanding of the degree of correlation risk for ABSs. High ratings were justified for lenders on the assumption that the residential real estate market would continue to increase in value. The models used by rating agencies did not correctly incorporate the impact of correlations or sharp declines in real estate values.
Investors viewed securitized products as AAA rated with high liquidity. Unfortunately, the liquidity of ABS was overestimated. As the first losses were realized in the subprime lending market, SPVs needed to unwind or sell off investments in securitized paper. The SPVs mispriced the securities initially by failing to include a liquidity premium.
The impact of the liquidity crisis was even greater due to mark-to-market accounting rules. As investments were marked-to-market, it created a downward spiral effect in asset prices of securitized products. In the flight-to-quality environment of a liquidity crisis, financial institutions were required to mark down asset values based on highly stressed prices in the secondary market. To complicate things further, securitized products were more negatively impacted than plain vanilla commercial paper, which is characteristic of markets where participants are attempting to shed risky assets for safer ones.
Page 296
2018 Kaplan, Inc.
Topic 35 Cross Reference to GARP Assigned Reading – Choudhry, Chapter 12
K e y C o n c e p t s
LO 35.1
Securitization is the process of issuing securities against an asset pool. The proceeds of the security sale collateralize the purchase of the assets from the originator, thereby removing the liability and involvement of the originator. A special purpose vehicle (SPV) is used to separate the assets from the originator and customize the products for investors.
LO 35.2
A common credit enhancement of securitized assets is overcollateralization where the principal value of the notes issued by the SPV are valued less than the principal value of the original underlying assets. The first-loss piece or equity piece absorbs initial losses. This non-rated junior tranche is often held by the originator.
LO 35.3
The master trust is a special type of structure that is used for frequent issuers. The difference in how payments are received from the underlying collateral over the asset-backed securitys life determines whether the ABS is better suited to the amortizing or revolving structure.
LO 35.4
Financial institutions benefit from securitization by funding assets, balance sheet management, and risk management. Securitization benefits investors by providing access to liquid assets that were previously not available to them.
LO 35.5
Credit enhancements such as overcollateralization, pool insurance, subordinating note classes, margin step-up, and excess spread enable originators to lower costs while providing investors customized products that meet their needs.
LO 35.6
The portfolio performance of ABS and MBS products is largely dependent on the ability of individuals to pay off their obligations in the form of consumer debt and mortgages. Performance measures serve as trigger methods to accelerate amortization.
The loss curve shows the expected cumulative loss for the life of the collateral pool. The absolute prepayment speed (APS) measures prepayment by comparing the actual period payments as a percentage of the total collateral pool balance.
2018 Kaplan, Inc.
Page 297
Topic 35 Cross Reference to GARP Assigned Reading – Choudhry, Chapter 12
LO 35.7
The delinquency ratio is computed by dividing the value of credit card receivables more than 90 days past due by the total credit card receivables pool. The default ratio is calculated by dividing the amount of written off credit card receivables by the total credit card receivables pool. The monthly payment rate (MPR) is calculated as the percentage of monthly principal and interest payments divided by the total credit card receivables pool.
The debt service coverage ratio (DSCR) is calculated by dividing net operating income (NOI) by the total amount of debt payments. The weighted average coupon (WAC) is calculated by multiplying the mortgage rate for each pool of loans by its loan balance and then dividing by the total outstanding loan balance for all pools. The weighted average maturity (WAM) is the weighted average months remaining to maturity for the pool of mortgages in the MBS. The weighted average life (WAL) of the mortgage notes issued is calculated by summing the time to maturity multiplied by a pool factor, which is the outstanding notional value adjusted by the repayment weighting.
LO 35.8
Common methodologies used to estimate prepayments for securitized products collateralized by mortgages or student loans are the constant prepayment rate (CPR) and the Public Securities Association (PSA) method.
The CPR is calculated as: CPR = 1 (1-SMM)12
The PSA typically assumes that prepayments will increase as a pool approaches maturity. The MBS pool of mortgages has a 100% PSA if its CPR begins at 0 and increases 0.2% each month for the first 30 months.
LO 35.9
Key factors that led to the loss in market confidence and the financial crisis of 20072009 include: the impact of the credit crunch, shadow banking system, leverage, lack of transparency, credit rating agencies practices, accounting rules, and liquidity.
Page 298
2018 Kaplan, Inc.
Topic 35 Cross Reference to GARP Assigned Reading – Choudhry, Chapter 12
C o n c e p t C h e c k e r s
1.
2.
3.
4.
5.
A major benefit of securitization for a financial institution is the ability to remove assets from the balance sheet, which lowers risk and the required regulatory capital. While a large portion of the risk is removed from the balance sheet the originating financial institution often maintains a portion of the risk. Which of the following terms best identify the risk that is maintained by the originator? A. Correlation. B. Excess spread. C. First-loss piece. D. Guarantor of collateral value.
Securitized products are often customized to meet the needs of the investor as well as the originator. What type of asset-backed securities (ABSs) typically uses a revolving structure? A. Residential mortgage. B. Credit card debt. C. Commercial mortgage. D. Commercial paper.
Which of the following statements regarding credit enhancements in the process of structuring a securitization through a special purpose vehicle (SPV) is correct? A. The securitization process is structured such that the asset side of the SPV has a
lower cost than the liability side of the SPV.
B. Credit enhancements are typically only associated with mortgage-backed
securities (MBS) and are not used in other types of asset-backed securities (ABS). C. The most senior class of notes is often overcollateralized in order to reduce the
risk of the asset-backed security (ABS).
D. A margin step-up is sometimes used by an asset-backed securities (ABS) where
the coupon structure increases after a call date.
Which of the following measures are most likely to be used by a securitized product backed by student loans? A. Single monthly mortality (SMM), constant prepayment rate (CPR), and Public
Securities Association (PSA).
B. Loss curves and absolute prepayment speed (APS). C. Weighted average life (WAL), weighted average maturity (WAM), and weighted
average coupon (WAC).
D. Debt service coverage ratio (DSCR) and monthly payment rate (MPR).
Assume an MBS is composed of the following four different pools of mortgages:

$2 million of mortgages that have a maturity of 90 days. $3 million of mortgages that have a maturity of 180 days. $5 million of mortgages that have a maturity of 270 days. $10 million of mortgages that have a maturity of 360 days.
What is the weighted average maturity (WAM) of these mortgage pools? A. 167 days. B. 225 days. C. 252 days. D. 284 days.
2018 Kaplan, Inc.
Page 299
Topic 35 Cross Reference to GARP Assigned Reading – Choudhry, Chapter 12
C o n c e p t C h e c k e r An s w e r s
1. C The originator often maintains ownership of the first-loss piece, which is the class of assets with the lowest credit quality and is the most junior level where losses are first absorbed in the event of a default.
2. B Revolving structures are used with products that are paid back on a revolving basis, such as credit card debt or auto loans. Credit card debt does not have a pre-specified amortization schedule; therefore the principal paid back to investors is in large lump sums rather than amortizing schedules.
3. D ABS issues may use a margin step-up that increases the coupon structure after a call date.
Credit enhancements play an important role in the securitization process for both the asset- backed security (ABS) and mortgage-backed security (MBS) issues. The liability side of the SPV has a lower cost than the asset side of the SPV to create an excess spread prior to administration costs. The lowest class of notes are often overcollateralized where the principal value of the notes issued are valued less than the principal value of the original underlying assets.
4. A The constant prepayment rate (CPR) and the Public Securities Association (PSA) method are
common methodologies used to estimate prepayments for student loans and mortgages.
5. D The WAM is calculated as follows:
WAC = [90(2 million) + 180(3 million) + 270(5 million) + 360(10 million)] /
(2 million + 3 million + 5 million +10 million)
= (180 million + 540 million + 1,350 million + 3,600 million) / 20 million
= 5,670 million / 20 million
= 284 days
Page 300
2018 Kaplan, Inc.
The following is a review of the Credit Risk Measurement and Management principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
U n d e r s t a n d i n g t h e Se c u r i t i z a t i o n o f S u b p r i m e M o r t g a g e C r e d i t
Topic 36
E x a m F o c u s
This topic describes many important aspects of the subprime markets. Seven frictions between market participants are discussed involving mortgagors, originators, arrangers, rating agencies, asset managers, and investors. You should understand the information problem (moral hazard or adverse selection) for each friction. Characteristics of subprime mortgages are also discussed including loan terms, performance, and subordination. For the exam, be familiar with subprime mortgage securitization, the frictions in the subprime market, and the process of rating subprime securities.
T h e S u b p r i m e S e c u r i t i z a t i o n P r o c e s s

LO 35.8: Explain the prepayment forecasting methodologies and calculate the constant prepayment rate (CPR) and the Public Securities Association (PSA) rate.
Common methodologies used to estimate prepayments for an MBS or ABS collateralized by mortgages or student loans are the constant prepayment rate (CPR) and the Public Securities Association (PSA) method. Assumptions regarding the rate of prepayment are required to estimate the cash flows for an MBS. Prepayments will reduce the yield of an MBS, assuming principal payments remain unchanged.
The CPR is calculated as: CPR = 1 (1SM M )12. The single monthly mortality (SMM) is the single-month proportional prepayment. Factors that influence the CPR are market environment, characteristics of the underlying mortgage pool, and the outstanding balance of the pool.
2018 Kaplan, Inc.
Page 293
Topic 35 Cross Reference to GARP Assigned Reading – Choudhry, Chapter 12
Example: Constant prepayment rate
Suppose an ABS has an SMM of 1.5%. This implies that the approximate prepayment for the month is equal to 1.5% of the remaining mortgage balance for the month less the scheduled principal repayment. Calculate the CPR for this MBS.
Answer:
The CPR for this MBS equals 16.59%, calculated as: CPR = 1 (1 0.015)12 = 0.1659.
The PSA typically assumes that prepayments will increase as a pool approaches maturity. The MBS pool of mortgages has a 100% PSA if its CPR begins at 0 and increases 0.2% each month for the first 30 months. A graph of the CPR for an ABS as it approaches maturity is illustrated in Figure 5.
Note that the middle line in Figure 5 represents 100% PSA where the prepayments are assumed to start at 0 and increase 0.2% each month up until month 30. After 30 months, the 100% PSA is assumed to be at a constant 6% (calculated as 0.2 times 30 months) until maturity. Other prepayment scenarios are then calculated as a percentage of this 100% base case. Thus, a 50% PSA assumes 50% of the initial increase for the first 30 months. In Figure 5, the bottom line represents the 50% PSA scenario where prepayments are assumed to increase 0.1% each month for the first 30 months, before reaching a constant prepayment rate of 3%. Similarly, the top line represents the 150% PSA scenario where prepayments are assumed to increase 0.3% each month for the first 30 months, before reaching a constant prepayment rate of 9%.
0
30
60
Months
90
120
Page 294
2018 Kaplan, Inc.
Topic 35 Cross Reference to GARP Assigned Reading – Choudhry, Chapter 12
Figure 6 summarizes performance tools discussed in this topic based on the type of ABS or MBS.
Figure 6: ABS and MBS Performance Tools
Performance Analysis Tools
loss curves
absolute prepayment speed (APS)
delinquency ratio
default ratio
monthly payment rate (MPR)
debt service coverage ratio
(DSCR)
Asset Type auto loans auto loans credit cards
credit cards credit cards
Calculation
expected cumulative losses prepayments / pool balance past due receivables / pool
balance
defaults / pool balance
receivables collected / pool
balance
commercial mortgages
NOI / debt payments
weighted average coupon (WAC)
mortgages
weighted average maturity
(WAM)
weighted average life (WAL)
mortgages
mortgages
single monthly mortality (SMM) mortgages, home-equity,
student loans
constant prepayment rate (CPR)
Public Securities Association
(PSA)
mortgages, home-equity,
student loans
mortgages, home-equity,
student loans
weighted pool coupon
payments
weighted pool maturity
^ (a / 365) x PF(t)
prepayment / pool balance – (1-SMM)12 1 – (1-SMM)12
[CPR / (0.2)(months)] x 100
S e c u r i t i z a t i o n a f t e r t h e C r e d i t C r u n c h