1. Financial Market Theory
Tuesday, October 31, 2017
Professor Edwin T Burton

2. ABS (Asset-Backed Securities)
Includes a wide variety of securities: CLOs, CDOs, CMBS, and on and on (in 2007, amounted to 20 % of all non-government lending in the United States…now much less)
Simple Principle
Create a “pool” of cash flows
Then create new securities that assigned some part of the pool’s cash flows
Why? To credit different “credit” and “duration” securities
October 31, 2017
October 27-29, 2015

3. A Simple One Period ABS (Asset Backed Security) with default risk
The Pool:
Bond A Pays $ 100,000 at end of period
with 90 % probability
Bond B Pays $ 100,000at end of period
with 90 % probabiilty
The New Securities to Be Created From The Pool:
Security 1 Pays $ 100,000 if either bond fails to default
Security 2 Pays $ 100,000 if both bonds fail to default
Securities 1 and 2 are examples of ABS
October 31, 2017

4. The riskiness of the newly created securites: 1, 2
Imagine that each bond, A and B, separately have a 10 percent chance
of default.
What is the probability that Security 1 defaults (that both A and B will default)?
What is the probability that Security 2 defaults (that either A or B will default
or both)?
October 31, 2017

5. If bonds A and B are “independent”
1/10 times 1/10 = 1/100, meaning that the probability that both default is 1/100 or a one percent chance of simultaneous default
Not very likely
Get a AA rating for the first tranche (Security 1)
That neither one will default: 90/100 times 90/100 or 81 percent of the time.
Pretty often (slightly more than 1/5 of the time)
Get a C rating for the second tranche (Security 2)
October 31, 2017
October 27-29, 2015

6. But, what if the bonds are not “independent”
What if their correlation is one? (Which means that either both pay off or both default, not one or the other)
Then each of Security 1 and Security 2 have a 90 percent chance of paying off
Both get a B- rating
Compared to independence pricing
“Independence” assumption overprice Security One
“Independence” assumption underprice Security Two
October 31, 2017
October 27-29, 2015

7. What is a CDO? Collateralized Debt Obligation
Could be a pool of any group of fixed income securities or bank loans
CLO is a special case of CDO: CLO is Collateralized Loan Obligation (bank loans normally, but could be car loans, etc.)
October 31, 2017
October 27-29, 2015

8. CMBS Collateralized Mortgage-Backed Securites
Commercial real estate (mostly office buildings are financed by CMBS)
Typical office mortgage financing is 5 – 7 year maturites (unlike residential mortgages)
October 31, 2017
October 27-29, 2015

9. What is financed by CMBS?
Residential mortgages
Commercial mortgages
Car loans
Credit card receivables
Home equity loans
Student loans
Defaulted loans (auto, credit card, etc.)
Almost anything
October 31, 2017
October 27-29, 2015

10. What Else “Credit Enhancements”
Main enhancement is a CDS (credit default swap)
CDS is basically an insurance contract
Normally on a debt instrument (note or bond)
An act of default (not paying interest or principal) triggers the payment of CDS, insurer takes the defaulted note or bond and gives the insured the cash value as if no default)
October 31, 2017
October 27-29, 2015

11. History of US ABS Issuance
October 31, 2017
October 27-29, 2015

12. ABS Issuance in Europe
October 31, 2017
October 27-29, 2015