Analytical Review of CMO, Corporate Bonds and MBS

·         In naked eye MBS is always more attractive than a corporate security simply because it has cover by a pool of assets. However security of MBS depends upon the movement of such assets which is mortgage. Hence Mortgage need to be intact for the period of maturity to provide security to MBS. However due to expected fall in interest rate following risks always involve which will make significant changes in mortgage and eventually to the investor of MBS.

ü  Prepayment Risk: - If market interest rate decreases and its fall below the mortgage interest rate then this will give a chance to borrowers to refinance their mortgage. If interest rate fall borrowers are more likely to payout there mortgage principle in order to take advantage of interest rate. However this situation is not as good for investor as he will get his principle back sooner than expected has to invest it in a lower interest rate which lead to lower value than that of if MBS holds its maturity.

In the given case client is investing with a purpose that payout of this investment will be used for his daughter college education. Now fall in interest rate will reduce maturity of MBS. It means he do not have any payout from MBS at the time when he need money for education of his daughter. 

ü  Contraction Risk: - It is a part of prepayment risk. It is the risk that borrowers will pay back maturity value at a faster rate than expected. This arises as a result of interest rate fall in the market. If interest rate falls below rate of interest for mortgage, borrower will accelerate payment of principle resulting to contraction.

ü  Interest Rate Risk:- One of the most attractive feature of MBS in this case is it has a higher interest rate as compared to corporate bond resulting in more payout than corporate bond. However if interest rate starts decreasing MBS will not have more payout simply because it has lesser base capital as compared to corporate bond.

ü  Increase in Bond Price: - If interest rate decreases bond price will go up. This is because as interest rate falls borrowing power and purchasing power of people goes up. This would result in increase in demand for bond and eventually bond price will go up. This will give investor a better opportunity.

Above analysis revels that investing in MBS is very risky proposition over here. This could lead to a situation where client does not have sufficient fund at maturity to cover cost of education of his daughter. Hence, after considering all aspect will recommend corporate bond for investment. 

In this part we will talk about a new situation where a new CMO is issued which is protected by a class A VADM tranche. Now it is to compare this new CMO with the corporate bond recommended earlier. For this purpose this memo needs to address following-

·         What is VADM?

VADM is ‘very accurately defined maturity’ bonds. As the name suggests this are bonds designed to payout at certain preselected times only. This is similar to ‘planned amortization class’ (PAC) bond. PAC bond are used to protect against extension and contraction risk associated with MBS. This will cover extension risk at the time of rise in interest rate. Similarly this also covers contraction risk at the time of fall in interest rate.

However payments of a VADM are supported in a different way as compared to a PAC. In PAC payments are backed by a supported bond whereas in VADM payments are supported by accretion of a Z bond. Z bond is just like zero coupon bond.

·         Description of New CMO tranche and its comparison with corporate bond recommended earlier-

Description of new CMO- The new CMO is a AA-rated, 7-year Class A VADM tranche. This VADM tranche is backed by a Z bond. Coupon rate of this VADM is 7% which is better than corporate bond. CMO has a similar rating ‘AA’ and similar maturity terms as compared to corporate bond. Features of this CMO-

1.       Protected against Z bond

2.       Higher interest rate of 7% as compared to corporate bond

3.       7 years maturity (corporate also have same maturity and client need money approximately at the same time)

Comparison with corporate bond-   

                Table showing comparison of CMO with corporate bond

Security	Rating	Interest Rate	Maturity Period	Protection
Corporate Bond	AA	6.75%	7 years	Not protected
CMO	AA	7.00%	7 Years	Protected against Z bond

               

VADM cover prepayment risk-

A CMO is collateralized mortgage obligation. It is always more attractive as it is backed up a repackage of mortgage pool. However it associates with extension risk and contraction risk. A VADM tranche is used to reduce such risk. VADM use Z bond which are similar to zero coupon bonds. Interest payable on a Z-bond is not paid at intervals instead it is added to the principal balance and available for payable only on maturity. A Z-bond is similar to a zero-coupon bond; hence it does payout at intervals and pay only at maturity, so even if there is prepayment of mortgage investors is secured against payment of Z bond, so even if there is prepayment of mortgage investors are secured against payment of Z bond. A Z bond accrues interest rather than paying it out. Therefore, the final tranche is considered the most risky for the CMO class structures.

In the given case, new CMO is a AA rated 7 year VADM with 7% coupon protected against a Z bond. Client need money for covering cost of education of his daughter at maturity of this instrument. Hence he needs protection. This CMO provides a better security to client as compared to corporate bond. Actually this CMO has following benefits

ü  Extra return as compared to corporate bond

ü  Protection against prepayment and contraction risk

Further this CMO has the same rating as corporate bond; hence it has approximately same quality as corporate bond.

Considering the situation discussed above I recommend new CMO for investment for this client.

 

Securitization and Its effect on Auto Loans

This article is made to have some specific discussion about securitization for a financial institution which is specialized on auto loans.  Now we need to get answer about some specific questions relating to this issue. Those are-

·         Importance of securitization?

Securitization is a financial process where an entity having large amount of receivable from a valid source sale a pool of such receivable to a special purpose entity who issue securities against such pool of assets. At the maturity of the security cash flow from receivable directly flow to the investor of the security.

Now as we know the process of securitization, we need to analyze the probable benefits from this process.

Ø  Liquidity benefit- The entity creates receivable known as originator (in this case the financial institution issuing auto loans) does not need to wait until it receive payments from receivables (auto loans) for flow of funds to the business. Because funds flow from sale of pool of receivables (pool of auto loans). These funds can be used by the company for generating more receivables. Hence this process provides liquidity.

Ø  Better Representations of financial status- The process of securitizations managed to offset receivables by cash in the balance sheet. So it provides a better look of the financial situation to attract more investors.

Ø  Benefits of the interest spread – Auto loans are amortizing assets. Therefore a payment of auto loans normally includes interest and principle. Now the security issued in securitization process normally carry a lower interest rate than that of the auto loans. Hence, originator gets the benefits of this interest rate spread.

Ø  Asset-Liability Management- Some financial institutions are not in position to raise long term international borrowings due to various limitations including the size of the institution. Securitization helps in improving the rating for particular deal much above the institution’s. This rating enables institution to raise funds for a longer period. Hence this facilitate in matching the tenure of the liabilities and assets.

Analyzing the above benefits we can say that the competitor company has followed securitization in order to achieve liquidity which is one of the most important concerns for a financial institution. Additionally this spread the ownership of risk associated with recovery of auto loan.

·         What are the potential benefits of securitizations to Issuer, Investors and Borrowers?

Issuer: - Issuer is a special purpose entity (SPE) usually created pursuant to a trust agreement between originator and the entity. Securitization provides several benefits to an issuer such as-

Ø  Most securitization process is to structure the transactions that will result in “off-balance-sheet” treatment for the existing assets. If securitization is a sale, cash from sale will be added to the assets and the sold assets will be taken out of balance sheet.  This will provide a better leveraged position as compared to issue of any other security. 

Ø  As security issued in securitization is secured against a pool of assets, it is more secure as compared to other security. Hence this provides an oppournity of improved rating.

Ø  As security issued in securitization is more secured as compared to other securities, it normally attract more investors, hence coupon   rate of this security is relatively less than other. So, it is a low in cost also.

Investors buying ABS: - The main participants in the ABS are institutional investor. Main benefits of investing in ABS are-

Ø  Diversification of funds – Diversification of funds is the most intended by an investor because it reduces risks. As ABS is backed by a pool of assets, it provides investor a chance to invest in diversified portfolio.

Ø   Safety – As return from ABS is backed up the cash flow from a pool of assets, it is more secured as compared to other security. Hence it is relatively safe for the investor.

Further benefit of investing in ABS backed up by auto loan is that it provides an oppournity of monthly redemption as it is backed up by monthly payment of auto loan interest and principle. Hence, it can perform the function of a mutual fund also. 

Borrowers: - Securitizations provides borrowers a better access to the market. Following are major benefits of it for the borrowers-

Ø  Reduction in interest rates- Rate of interest gets high because of risk. Securitization spread out ownership risks associated with the loan. Therefore there is a high chance of reduction in interest rate of the loan.

Ø  Reduction in borrower’s principle – Securitization provides a way to flow of funds. Hence it provides liquidity which could give chance for borrower for reduction in principle.

Impact of ABS to the Auto Loan market-

Auto loan origination is categorized as being direct and indirect. In the direct lending channel customer goes to lender directly for an auto loan, whereas indirect channel involves dealers as intermediary. Loans are given based on borrower’s credit quality. Credit quality can be of mainly of three types. Those are prime, non-prime, and subprime. This categorization has been done based on credit ability of the borrower. ABS is the process of issuing of security by backing up of this auto loans. The major impact of ABS on this market are-

Ø  ABS provides liquidity to the market as fund stars flow easily. This provides a chance for the lenders to issue loan at a lower interest rate which provide chance to a less credit quality borrower to borrow funds. However, if it is not monitored properly it could lead to a disaster situation. Because increase in poor quality borrower will increase the risk of defaulter and if defaulter amount of loan increases more than a certain proportion, it could lead to break down of the entire system and market in turn. Latest example of this could be Lehman brothers break down which lead to economic recession. Hence, one should consider its risk appetite for issuing loans to non-prime and subprime borrowers.

The graph above illustrate subprime of auto ABS by vintage year based cumulative net losses. Although relatively stable, graph shows that there is some variability in loan performance for subprime ABS over last 12 years. Not unexpectedly there is some deterioration in the performance in between 2006 to 2008, a typical recession period.

   

Ø  The use of capital can be optimized by reconfiguring portfolios to satisfy risk weighted capital adequacy norms better.

Ø   Securitization directly rewards better credit quality by reducing cost of credit enhancement and cost of funds. This serves as an incentive to the institution to improve the quality of loan generation.

Ø  The rate of asset turnover in the economy increases. For example, HFCs with excellent asset origination skills may have an insufficient balance sheet size to absorb the entire risk but can securitize loans in excess of what they feel comfortable with.

Ø  The debt market as a whole attained greater depth. This fact has been borne out by the experience in other countries. The capital markets can participate more directly in infrastructure.