Asset-Backed Securities, Interest-Rate Agreements, and Currency Swaps Chapter 23 © 2003 South-Western/Thomson Learning

Slide 2 Learning Objectives  How asset-backed securities work and why they were created  Most common types of asset-backed securities  Benefits and risks associated with use of asset-backed securities  How interest-rate swaps, caps, floors, and collars can be used to reduce interest-rate risk  How and why currency swaps are used to manage exchange-rate risk

Slide 3 Anatomy of Securitization  Asset-Backed Securities  Securities that result from process of securitization  Seven main sets of players  Borrowers  Loan originator  Special-purpose trust  Rating agency  Credit enhancer  Underwriter  Investors

Slide 4 Exhibit 23–1 The Anatomy of an Asset-Backed Security Offering Source: Adapted from Leon T. Kendall and Michael Fishman (1996), A Primer on Securitization, The MIT Press, Cambridge, Massachusetts, p.3.

Slide 5 Anatomy of Securitization  Special Purpose Trust  Corporate agent  Buys financial obligations from loan originator  Works with security underwriter, credit enhancer and rating agency to issue asset- backed securities  Sometimes responsible for loan-servicing responsibilities  Due Diligence  Investigative process  Used by lender, investor or investment banker to ensure that borrower’s or security issuer’s financial statements are accurate

Slide 6 Anatomy of Securitization  Credit Enhancer  Insurance company or bank  Guarantees a security issue  Offers a letter of credit in its support, for a fee  Credit-worthiness can also be enhanced by  Establishing a reserve account  Over-collateralization

Slide 7 Anatomy of Securitization  Superior / Subordinated Debt Structures  Framework that allows securities to be sold in at least two different classes or tranches  One is lower rated, higher yielding and higher risk  Other is higher rated, lower yielding and lower risk  Tranche  Particular class or part of securitization issue  Some parts may be backed only by principal payments, others only by interest payments  As result, parts of various offerings also differ in terms  Default risk  Average repayment time  Coupon yield

Slide 8 Securitization Benefits to Borrowers, Issuers, and Investors  Securitization increases the funds available for  Home equity  Auto finance  Credit card  Commercial lending  Student loans  Manufactured housing  Costs of borrowing are lower than through traditional intermediated (indirect) finance

Slide 9 Securitization Benefits to Borrowers, Issuers, and Investors  Two possible disadvantages to borrowers  If potential borrower fails to meet established criteria for loan intended for securitization, possible that lender will  Reject application  Charge the applicant a substantially higher loan fee or interest rate  The profitability of ABSs has made some lenders more aggressive in pursuing loan business

Slide 10 Trends in Common Types of Asset- Backed Securities  Home Equity Loans  Type of mortgage  Allows borrower to use equity of one’s home as backing for a loan or revolving line of credit  Auto Finance  Credit Cards  Commercial Loans  Student Loans  Manufactured Housing  Small Business Loans

Slide 11 Interest-Rate Swaps  Interest-Rate Swaps  Financial instruments  Allow financial institutions to trade their interest payment streams to better match payment inflows and outflows  Derivative Instruments  Financial contracts (forwards, futures, options and swaps)  Whose values are “derived” from the values of other underlying instruments such as  Foreign exchange  Bonds  Equities  Index

Slide 12 Interest-Rate Caps, Floors and Collars  Interest-Rate Cap  Seller of cap agrees, for a fee, to compensate the cap buyer when an interest-rate index exceeds a specified strike rate  Strike Rate  Agreed-upon rate in an interest agreement  Interest-Rate Floor  Seller of cap agrees, for a fee, to compensate cap buyer when an interest-rate index falls below a specified strike rate  Interest-Rate Collars  Created when one simultaneously buys an interest-rate cap and sells an interest-rate floor

Slide 13 Exhibit 23–5 A Simple Interest Rate Cap

Slide 14 Exhibit 23–6 A Simple Interest Rate Floor

Slide 15 Currency Swaps  Currency Swaps  One party agrees to trade periodic payments, over a specified period of time, in a given currency, with another party who agrees to do the same in a different currency

Slide 16 Exhibit 23–7 Structure and Potential Benefits of a Currency Swap