2011 CFA Program Curriculum: Level 2, Volume 5

CFA Institute

Chapter 58 ASSET-BACKED SECTOR OF THE BOND MARKET - all with Video Answers

Educators

Chapter Questions

Problem 1

Gaterpillar Financial Asset Trust 1997-A is a special purpose vehicle. The collateral (i.e., assets) for the trust is a pool of fixed-rate retail installment sales contracts that are secured by new and used machinery manufactured primarily by Gaterpillar Inc. The retail installment sales contracts were originated by the Caterpillar Financial Funding Corporation, a whollyowned subsidiary of Caterpillar Financial Services Corporation. Caterpillar Financial Services Corporation is a wholly-owned subsidiary of Caterpillar Inc. The prospectus for the trust states that:
"THE NOTES REPRESENT OBLIGATIONS OF THE ISSUER ONLY AND DO NOT REPRESENT OBLIGATIONS OF OR INTERESTS IN CATERPILLAR FINANCIAL FUNDING CORPORATION, CATERPILLAR FINANCIAL SERVICES CORPORATION, CATERPILLAR INC. OR ANY OF THEIR RESPECTIVE AFFILIATES."
The servicer of the retail installment sales contracts is Caterpillar Financial Services Corporation, a wholly-owned finance subsidiary of Gaterpillar Inc. and is referred to as the servicer in the prospectus. For servicing the collateral, Caterpillar Financial Services Corporation receives a servicing fee of 100 basis points of the outstanding loan balance.

The securities were issued on May 19, 1997 and had a par value of $$\$ 337,970,000$$. In the prospectus the securities are referred to as "asset-backed notes." There were four rated bond classes:
$$
\begin{array}{lr}
\text { Bond Class } & \text { Par Value (\$) } \\
\hline \text { Class A-1 } & 88,000,000 \\
\text { Class A-2 } & 128,000,000 \\
\text { Class A-3 } & 108,100,000 \\
\text { Class B } & 13,870,000 \\
\hline
\end{array}
$$
A. In the prospectus, the term "Seller" is used. Who in this transaction would be the "Seller" and why?
B. In the prospectus, the term "Issuer" is used. Who in this transaction would be the "Issuer" and why?
C. Despite not having the waterfall for this structure, which bond classes do you think are the senior bonds?
D. Despite not having the waterfall for this structure, which bond classes do you think are the subordinate bonds?
E. Despite not having the waterfall for this structure, explain why there appears to be credit and prepayment tranching in this structure?

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Problem 2

In the securitization process, what is the role played by the a) attorneys and b) independent accountants?

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Problem 3

How are principal repayments from the collateral used by the trustee in a securitization transaction?

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Problem 4

Suppose that the collateral for an asset-backed securities structure has a gross weighted average coupon of $8.6 \%$. The servicing fee is 50 basis points. The tranches issued have a weighted average coupon rate of $7.1 \%$. What is the excess servicing spread?

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Problem 5

Suppose that the structure for an asset-backed security transaction is as follows:
$$
\begin{array}{ll}
\text { senior tranche } & \$ 220 \text { million } \\
\text { subordinate tranche } 1 & \$ 50 \text { million } \\
\text { subordinate tranche } 2 & \$ 30 \text { million }
\end{array}
$$
and that the value of the collateral for the structure is $$\$ 320$$ million. Subordinate tranche 2 is the first loss tranche.
A. How much is the overcollateralization in this structure?
B. What is the amount of the loss for each tranche if losses due to defaults over the life of the structure total $$\$ 15$$ million?
C. What is the amount of the loss for each tranche if losses due to defaults over the life of the structure total $$\$ 35$$ million?
D. What is the amount of the loss for each tranche if losses due to defaults over the life of the structure total $$\$ 85$$ million?
E. What is the amount of the loss for each tranche if losses due to defaults over the life of the structure total $$\$ 110$$ million?

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Problem 6

A. Explain why individual loans that are of a non-amortizing type are not subject to prepayment risk.
B. Explain why securities backed by collateral consisting of non-amortizing assets may expose an investor to prepayment risk.

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Problem 7

An asset-backed security has been credit enhanced with a letter of credit from a bank with a single $A$ credit rating. If this is the only form of credit enhancement, explain why this issue is unlikely to receive a triple A credit rating.

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Problem 8

Why is it critical for monoline insurance companies that provide insurance for asset-backed security transactions to maintain a triple $A$ credit rating?

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Problem 9

What is the difference between a cash reserve fund and an excess servicing spread account?

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Problem 10

Why is the assumption about how defaults may occur over the life of an asset-backed security transaction important in assessing the effectiveness of excess servicing spread as a form of internal credit enhancement?

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Problem 11

A. Explain why a senior-subordinate structure is a form of internal credit enhancement.
B. Explain the need for a shifting interest mechanism in a seniorsubordinate structure when the underlying assets are subject to prepayments.

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Problem 12

A. What is meant by the "senior prepayment percentage" in a shifting interest mechanism of a senior-subordinate structure?
B. Why does a shifting interest mechanism affect the cash flow of the senior tranche and increase the senior tranche's exposure to contraction risk?

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00:10

Problem 13

What is a "latter of percent or call date" call provision?

Brandon Fox

Numerade Educator

Problem 14

A. What is the cash flow of a closed-end home equity loan?
B. Indicate whether you agree or disagree with the following statement: "Typically, closed-end home equity loans are loans to borrowers of the highest credit quality."

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Problem 15

The Izzobaf Home Equity Loan Trust $2000-1$ is backed by fixed-rate closedend home equity loans. The base case prepayment for this deal is specified in the prospectus as follows:
The model used with respect to the loans (the "prepayment ramp") assumes that the home equity loans prepay at a rate of $5 \%$ $\mathrm{CPR}$ in the first month after origination, and an additional $1.8 \%$ each month thereafter until the 12 th month. Beginning in the 12th month and each month thereafter, the prepayment ramp assumes a prepayment rate of $24.8 \%$ CPR.
What is the CPR assuming $200 \%$ PPC for the following months?
$$
\begin{aligned}
&\text { What is the CPR assuming } 200 \% \text { PPC for the following months? }\\
&\begin{array}{|c|c|c|c|c|c|}
\hline \text { Month } & \text { CPR } & \text { Month } & \text { CPR } & \text { Month } & \text { CPR } \\
\hline 1 & & 11 & & 30 & \\
\hline 2 & & 12 & & 125 & \\
\hline 3 & & 13 & & 150 & \\
\hline 4 & & 14 & & 200 & \\
\hline 5 & & 15 & & 250 & \\
\hline 6 & & 16 & & 275 & \\
\hline 7 & & 17 & & 300 & \\
\hline 8 & & 18 & & 325 & \\
\hline 9 & & 19 & & 350 & \\
\hline
\end{array}
\end{aligned}
$$

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03:08

Problem 16

James Tellmen is an assistant portfolio manager for a mortgage-backed securities portfolio. Mr. Tellmen's responsibility is to analyze agency mortgage-backed securities. Recently, the portfolio manager has been given authorization to purchase closed-end home equity loan-backed securities.
Mr: Tellmen is analyzing his first structure in this sector of the asset-backed securities market. Upon reading the prospectus he finds that the base case prepayment is specified and believes that this prepayment assumption is the benchmark used in all closed-end home equity loan-backed securities. Explain why you agree or disagree with Mr. Tellmen.

Jennifer Stoner

Numerade Educator

Problem 17

Why is there an available funds cap in an asset-backed security in which the collateral is adjustable-rate home equity loans?

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Problem 18

Suppose that the base case shifting interest percentage schedule for a closed-end home equity loan-backed security is as follows:
$$
\begin{array}{lc}
\hline \text { Years after Issuance } & \text { Senior Prepayment Percentage (\%) } \\
\hline 1-4 & 100 \\
5 & 90 \\
6 & 80 \\
7 & 50 \\
8 & 20 \\
\text { after year } 8 & 0 \\
\hline
\end{array}
$$
A. If there are prepayments in month 36 of $$\$ 100,000$$, how much of the prepayments is paid to the senior tranche? How much is paid to the subordinate tranches?
B. If there are prepayments in the 8 th year after issuance of $$\$ 100,000$$, how much of the prepayments is paid to the senior tranche? How much is paid to the subordinate tranches?
C. If there are prepayments in the 10 th year after issuance of $$\$ 100,000$$, how much of the prepayments is paid to the senior tranche? How much is paid to the subordinate tranches?

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Problem 19

Larry Fonest is an analyst reviewing for the first time a closed-end home equity loan-backed structure in order to determine whether or not to purchase the deal's senior tranche. He understands how the shifting interest percentage schedule is structured so as to provide the senior tranches with protection after the deal is closed. However, he is concerned that the schedule in the prospectus will not be adequate if the collateral's performance deteriorates (i.e., there is considerably greater losses for the collateral than expected). Explain to Mr. Forest what provision is included in the prospectus for protecting the senior tranches if the performance of the collateral deterionates.

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Problem 20

How is a non-accelerating senior tranche provided protection to reduce contraction risk and extension risk?

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Problem 21

A. What are the components of the cash flow for a manufactured housing-backed security?
B. What are the reasons why prepayments due to refinancing are not significant for manufactured housing loans?

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Problem 22

Why are residential mortgage-backed securities outside the United States structured more like transactions in the nonagency U.S. market than the agency market?

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00:15

Problem 23

A. What are the components of the cash flow for an auto loan-backed security?
B. How important are prepayments due to refinancing for auto loans?

Kayla Scholl

Numerade Educator

03:11

Problem 24

What is the difference between a single monthly mortality rate and an absolute prepayment speed?

Alexandra Woodruff

Numerade Educator

01:37

Problem 25

A. If the $\mathrm{ABS}$ for a security is $1.5 \%$ at month 21 , what is the corresponding SMM?
B. If the SMM for a security is $1.9 \%$ at month 11 , what is the corresponding ABS?

Mahipal Kumawat

Numerade Educator

05:55

Problem 26

A trustee for a pension fund is working with a consultant to develop investment guidelines for the fund's bond portfolio. The trustee states that the fund should be able to invest in securities backed by student loans because the loans are fully guaranteed by the U.S. government. How should the consultant respond?

Vishal Parmar

Numerade Educator

Problem 27

For a student loan-backed security, what is the difference between the deferment period and the grace period?

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Problem 28

A. What are the components of the cash flow for a Small Business Administration-backed security?
B. What reference rate is used for setting the coupon interest and how often is the coupon rate reset?

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03:16

Problem 29

A. What is the cash flow for a credit card receivable-backed security during the lockout or revolving period?
B. How is the principal received from credit card borrowers handled during the lockout or revolving period?
C. Explain why you agree or disagree with the following statement: "After the lockout period, the principal is paid to bondholders in one lump sum amount at the maturity date of the security."

Puneet Prajapati

Numerade Educator

Problem 30

A manager of a corporate bond portfolio is considering the purchase of a credit cand receivable-backed security. The manager believes that an advantage of such securities is that there is no contraction risk and no extension risk. Explain why you agree or disagree with this view.

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01:33

Problem 31

A. What is meant by the monthly payment rate for a credit card deal?
B. What is the significance of the monthly payment rate?
C. How is the net portfolio yield determined for a credit card deal?

Carson Merrill

Numerade Educator

Problem 32

What is a typical cash CDO structure?

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View

Problem 33

Explain why you agree or disagree with the following statement: "The asset manager for a $\mathrm{CDO}$ is free to actively manage the portfolio without any constraints."

Rashmi Sinha

Numerade Educator

Problem 34

Explain why you agree or disagree with the following statement: "By using an interest rate swap, the asset manager for a CDO increases the risk associated with meeting the obligations that must be paid to the senior tranche."

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Problem 35

What is the key factor in determining whether or not an arbitrage CDO can be issued?

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Problem 36

Consider the following CDO transaction:
1. The $\mathrm{CDO}$ is a $$\$ 200$$ million structure. That is, the assets purchased will be $$\$ 200$$ million.
2. The collateral consists of bonds that all mature in 8 years, and the coupon rate for every bond is the 8 -year Treasury rate plus 600 basis points.
3. The senior tranche comprises $75 \%$ of the structure ( $$\$ 150$$ million) and pays interest based on the following coupon formula: LIBOR plus 90 basis points.
4. There is only one junior tranche ( $$\$ 30$$ million) with a coupon rate that is fixed. The coupon rate is the 8-year Treasury rate plus 300 basis points.
5. The asset manager enters into an agreement with a counterparty in which it agrees to pay the counterparty a fixed rate each year equal to the 8 -year Treasury rate plus 120 basis points and receive LIBOR. The notional amount of the agreement is $$\$ 150$$ million.

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05:33

Problem 37

What are the elements of the return for the junior note holders in a synthetic CDO structure?

Dr. Satish Ingale

Numerade Educator

02:00

Problem 38

Why have banks issued synthetic balance sheet CDOs?

Oluwadamilola Ameobi

Numerade Educator

Problem 39

The primary motivation for creating the three senior bond classes, represented by Class $A$ in the suructure shown in Exhibit 1, is:
A. redistribution of credit risk.
B. redistribution of prepayment risk.
C. redistribution of interest rate risk.

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Problem 40

The primary motivation for creating two different classes of bonds, $A$ and $B$, in the structure in Exhibit 1 is:
A. redistribution of credit risk.
B. redistribution of prepayment risk.
C. redistribution of interest rate risk.

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04:18

Problem 41

If default losses over the life of the structure total $$\$ 8.0$$ million, what is the loss to the class B1 bondholders?
A. $$\$ 2.0$$ million.
B. $$\$ 4.0$$ million.
C. $$\$ 6.0$$ million.

Tim Marder

Numerade Educator

Problem 42

Which of the following credit enhancements is most likely to be incorporated into Whisper Spa's asset-backed securities?
A. Letter of credit.
B. Insurance "wrapping."
C. Overcollateralization.

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Problem 43

Haggerty's statement is most lihely:
A. justified, because the security will include internal credit enhancements.
B. justified, because Whisper Spa has the ultimate responsibility for repaying the bondholders.
C. not justified, because only internal credit enhancements are being used.

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Problem 44

By the end of the fourteenth month after the securities were issued, the underlying credit card accounts have prepaid $$\$ 30$$ million in principal in addition to regularly scheduled principal and interest payments. The amount of this principal prepaid to the holders of the A2 bond class is closesi to:
A. $$\$ 0$$.
B. $$\$ 12.0$$ million.
C. $$\$ 23.0$$ million.

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