Fixed-Income Securitization for CFA Level I

What this chapter covers

Fixed-Income Securitization: topics in the order to study them

1. 1Securitization Process and BenefitsIt sets out the parties, the SPE and the basic structure that every later topic builds on.
2. 2Residential Mortgage Loans and Mortgage TypesYou need the loan features, such as fixed-rate, adjustable-rate, amortization, recourse and LTV, before you study securities backed by them.
3. 3Mortgage Pass-Through Securities and Prepayment RiskThis is the core topic, introducing prepayment, contraction risk and extension risk for a single pool.
4. 4Collateralized Mortgage Obligations (CMOs)CMOs make sense only once you see the prepayment risk in pass-throughs that tranches are built to reallocate.
5. 5Non-Mortgage ABS and Commercial MBSThese follow CMOs because they apply the same securitization framework to other collateral, such as auto loans, credit card receivables and commercial mortgages. Once you know the structure, tranching and prepayment ideas, you can focus on what changes with the collateral.
6. 6Covered Bonds and Credit EnhancementIt contrasts covered bonds with securitization and finishes with the tools that improve credit quality, so it works as a closing comparison.

How to prepare Fixed-Income Securitization

1. Draw the securitization structure from memory: originator, SPE, servicer, investors, and the direction of loans and cash. Repeat until you can do it without notes.
2. Make a one-page table of mortgage types and their features. Note who bears interest rate risk and who bears prepayment risk in each case.
3. For pass-throughs, work out what happens to prepayments when rates fall and when they rise. Link each case to contraction or extension risk and to negative convexity.
4. For CMOs, sketch each tranche type and ask which risk it takes on and which risk it shields. Sequential and planned amortization class (PAC) with support tranches reallocate prepayment risk. Floating-rate and inverse floater tranches are created from a fixed-rate tranche, so they reallocate interest rate risk among tranches.
5. Compare ABS, CMBS and covered bonds side by side: collateral, recourse, prepayment features and where the assets sit on the balance sheet.
6. List the credit enhancement types, internal and external, and say how each absorbs losses. Then do timed practice questions and review every wrong answer by the reason you missed it.

Common mistakes in Fixed-Income Securitization

• Mixing up contraction risk and extension risk.

  Fix: Link the label to the rate move: falling rates mean faster prepayments and a shorter life (contraction); rising rates mean slower prepayments and a longer life (extension).

• Thinking a CMO removes prepayment risk.

  Fix: Remember that the total risk in the pool stays the same. A CMO only moves it between tranches, so some tranche always absorbs it.

• Treating covered bonds like ABS.

  Fix: Note that covered bond assets stay on the issuer's balance sheet and investors keep a claim on the issuer. The cover pool is dynamic, so the issuer replaces defaulted or prepaid assets. In ABS the assets move to an SPE and investors rely on the pool.

• Confusing internal and external credit enhancement.

  Fix: Ask if the protection comes from the deal's own structure (subordination, overcollateralization, excess spread) or from a third party (guarantee, letter of credit).

• Mixing up recourse and non-recourse loans.

  Fix: Tie each term to what the lender can claim after default: recourse means the borrower's other assets too; non-recourse means only the property.

• Skipping the structure and jumping straight to risk questions.

  Fix: Spend time on the SPE and cash flow flow first. Most later questions are easier once you can say where the cash comes from and who is paid first.

Last-day revision: Fixed-Income Securitization

• ✓Securitization moves loans to an SPE, which issues securities backed by the pool's cash flows.
• ✓The SPE is legally separate from the originator, which isolates the assets from the originator's bankruptcy.
• ✓A fixed-rate mortgage pays level payments, with interest falling and principal rising over time.
• ✓Recourse loans let the lender claim other assets of the borrower; non-recourse loans limit the claim to the collateral.
• ✓Prepayments tend to rise when rates fall, which creates contraction risk.
• ✓Prepayments tend to slow when rates rise, which creates extension risk.
• ✓Pass-through securities pass interest, scheduled principal and prepayments to investors, net of fees.
• ✓CMO tranches redistribute prepayment risk but do not remove it from the pool.
• ✓CMBS loans are usually non-recourse and have call protection (prepayment penalties, defeasance, lockouts), whereas residential mortgages are typically prepayable without such protection; recourse varies by jurisdiction.
• ✓Credit enhancement can be internal, such as subordination and overcollateralization, or external, such as a guarantee.
• ✓Covered bonds are obligations of the issuer, backed by a cover pool that stays on its balance sheet. The cover pool is dynamic: the issuer must replace defaulted or prepaid assets. Investors also have recourse to the issuer.
• ✓Read the question for who bears the risk and in which rate environment before choosing an option.

Fixed-Income Securitization practice questions

• An investor is analyzing an auto loan asset-backed security whose collateral is a pool of amortizing auto loans. Compared with a credit card…
• A borrower takes a 200,000 fixed-rate, level-payment, fully amortizing mortgage at a 6% annual rate with monthly payments. The monthly payme…
• Compared with a sequential-pay CMO's first tranche, a CMO's last tranche is most likely to offer investors:
• Compared with a typical mortgage-backed security issued through a securitization, a covered bond most likely:
• A bank issues a covered bond backed by a pool of residential mortgage loans held on its balance sheet. If the bank becomes insolvent, covere…
• A covered bond differs from a typical asset-backed security issued through a securitization most likely because the covered bond:
• Mortgage rates fall sharply, and a large share of borrowers in a pass-through pool refinance. Compared with a pool with stable mortgage rate…
• Compared with internal credit enhancement, external credit enhancement such as a third-party guarantee most likely exposes the investor to:

Fixed-Income Securitization in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

• FRM Part IMortgages and Mortgage-Backed Securities
• CMA FinalSecuritization
• CA FinalSecuritization
• FRM Part IIStructured Credit Risk