MAJOR ABS SECTORS - Global Money Markets

Below we review major sectors of the asset-backed securities market.Exhibit presents a Bloomberg screen that summarizes ABS issuancefor the period January 1, 1999 through August 22, 2001.The boxlabeled “Collateral” indicates the dollar amount (billions of dollars) of ABS by type of underlying collateral,which includes credit card receivables(CARD),auto loans (AUTO),home equity loans (HOMEQ),manufactured housing loans (MANUF),and student loans (STDLN).

Second, the box labeled “Deal Structure” indicates the dollar amount of ABS by the payment structure and includes sequential (SEQ), controlled amortization structure (CAM), hard bullet and soft bullet (HB/SB), subordinated(SUB), and all others.

The next box is labeled “Interest Method” and indicates the dollar amount of floating-rate ABS issued versus all other types (e.g., fixed-rate). The final box labeled“Class Rating” shows dollar amount of ABS issuance by credit rating.

Auto Loan-Backed Securities

Auto loan-backed securities are issued by (1) the financial subsidiaries of auto manufacturers (domestic and foreign), (2) commercial banks,and (3) independent finance companies and small financial institutions specializing in auto loans.

Bloomberg Screen of ABS Issuance

Cash Flow and Prepayments

The cash flow for auto loan-backed securities consists of regularly scheduled monthly loan payments (interest and scheduled principal repayments)and any prepayments.For securities backed by auto loans,prepayments result from (1) sales and trading requiring full payoff of the loan, (2) repossession and subsequent resale of the automobile, (3) loss or destruction of the vehicle, (4) payoff of the loan with cash to save on the interest cost, and (5) refinancing of the loan at a lower interest cost.

Prepayments due to repossessions and subsequent resale are sensitive to the economic cycle. In recessionary economic periods, prepayments due to this factor increase. While refinancings may be a major reason for prepayments of mortgage loans, they are of minor importance for automobile loans. Moreover, the interest rates for the automobile loans underlying several issues are substantially below market rates if they are offered by manufacturers as part of a sales promotion.

Prepayments for auto loan-backed securities are measured in terms of the absolute prepayment speed (ABS). The ABS is the monthly prepayment expressed as a percentage of the original collateral amount.

Recall that the SMM (monthly CPR) expresses prepayments based on the prior month’s balance. There is a mathematical relationship between the SMM and the ABS measures.1

Payment Structure

There are auto loan-backed deals that are passthrough structures and paythrough structures. A typical passthrough structure for an auto loan backed deal is as follows:2

In this typical passthrough structure there is a senior tranche (A) and a subordinated tranche (B). There is also an interest-only class. While more deals are structured as passthroughs, this structure is typically used for smaller deals.

Larger deals usually have a paythrough structure. As an illustration,consider auto-loan backed securities issued from the Chase Manhattan Auto Owner Trust 2001-A displayed in the Bloomberg screen in Exhibit Note in this typical paythrough structure, the senior pieces are tranched to create a range of average lives. The subordinated piece typically is not tranched.

Credit Card Receivable ABS

Credit cards are originated by banks (e.g.,Visa and MasterCard), retailers(e.g.,JCPenney and Sears), and travel and entertainment companies(e.g., American Express). Deals are structured as a master trust. With a master trust the issuer can sell several series from the same trust. Each series issued by the master trust shares the cash flow and therefore the credit risk of one pool of credit card receivables of the issuer.

1 Letting M denote the number of months after loan origination, the SMM rate canbe calculated from the ABS rate using the following formula:

where the ABS and SMM rates are expressed in decimal form.

Tranche Amount ($) Average Life (Years) Coupon Rate

Bloomberg screen of auto loan-backed paythrough strucutre

For a pool of credit card receivables, the cash flow consists of finance charges collected, fees, interchange, and principal. Finance charges collected represent the periodic interest the credit card borrower is charged based on the unpaid balance after the grace period. Fees include late payment fees and any annual membership fees. For Visa and MasterCard, a payment is made to originators. This payment is called interchange and is made to the originator for providing funding and accepting risk during the grace period. The principal is the amount of the borrowed funds repaid. Interest to security holders is paid periodically (e.g, monthly,quarterly, or semiannually). The interest rate may be fixed or floating.A credit card receivable-backed security is a non-amortizing security.

For a specified period of time, referred to as the lockout period or revolving period, the principal payments made by credit card borrowers comprising the pool are retained by the trustee and reinvested in additional receivables. The lockout period can vary from 18 months to 10 years. So, during the lockout period, the cash flow that is paid out is based on finance charges collected and fees. After the lockout period,the principal is no longer reinvested but paid to investors. This period is referred to as the principal-amortization period.

There are three different amortization structures that have been used in credit-card receivable-backed security structures: (1) passthrough structure,(2) controlled-amortization structure, and (3) bullet-payment structure.

In a passthrough structure, the principal cash flows from the creditcard accounts are paid to the security holders on a pro rata basis. In a controlled-amortization structure, a scheduled principal amount is established.

The scheduled principal amount is sufficiently low so that the obligation can be satisfied even under certain stress scenarios. The investoris paid the lesser of the scheduled principal amount and the pro rata amount. In a bullet-payment structure, the investor receives the entire amount in one distribution. Since there is no assurance that the entire amount can be paid in one lump sum, the procedure is for the trustee to place principal monthly into an account that generates sufficient interest to make periodic interest payments and to accumulate the principal to be repaid. The time period over which the principal is accumulated is called the accumulation period. There are two basic types of bullet payments(i.e., soft versus hard) that differ according to steps taken by the issuer to insure investors will receive full payment of principal on the maturity date.3 With a soft bullet payment, investors rely exclusively on the underlying portfolio’s payment speed for full payment of the principal at maturity. So, while the principal funding account is structured to have sufficient funds to pay the entire principal on the bond’s expected maturity date, there is no guarantee.Conversely, with a hard bullet payment, the issuer purchases a maturity guarantee to ensure there will be sufficient funds to pay the entire principal on the expected maturity date.

There are provisions in credit card receivable-backed securities that require early amortization of the principal if certain events occur. Such provisions, which are referred to as early amortization or rapid amortization provisions, are included to safeguard the credit quality of the issue. The only way that the cash flows can be altered is by the triggering of the early amortization provision. When early amortization occurs, the credit card tranches are retired sequentially (i.e., first the AAA bond, then the AA rated bond, and so on).

Exhibit presents a Bloomberg screen displaying a credit card receivable structure. The deal consists of two securities (A and B) issued from the Citibank Credit Card Master Trust I, Series 1999-7. Exhibit presents a Bloomberg Security Description screen for the senior tranche A.

This tranche is rated Aaa and carries a 6.65% coupon rate paid semiannually.

Note also that next to WAL (weighted average life) in the center of the screen is an “n.a.” or not applicable. This is so because credit card receivables are non-amortizing assets so the concept of a prepayment does not apply. Hence, WAL does not apply. The amortization structure used is a soft bullet with the principal expected to be paid in a single payment on November 15, 2004. Exhibit presents a Bloomberg Security Description screen for the subordinated tranche B. Note that B is rated A2 by Moody’s and carries a higher coupon rate of 6.9%.

Bloomberg screen of a credit card receivable deal

Bloomberg security description screen of a credit card receivable ABS,senior Tranche A

Bloomberg security description screen of a credit card receivable ABS,subordinated Tranche B

There are several concepts that must be understood in order to assess the performance of the portfolio of receivables and the ability of the issuer to meet its interest obligation and repay principal as scheduled. We begin with the concept of gross portfolio yield. This yield includes finance charges collected and fees. Some issuers include interchange in the computation of portfolio yield. Charge-offs represent the accounts charged off as uncollectible. Net portfolio yield is equal to gross portfolio yield minus charge-offs. Delinquencies are the percentage of receivable that are past due a specified number of months.

The monthly payment rate (MPR) expresses the monthly payment (which includes finance charges, fees, and any principal repayment) of a credit card receivable portfolio as a percentage of debt outstanding in the previous month. For example, suppose a $500 million credit card receivable portfolio in January realized $50 million of payments in February.

The MPR would then be 10% ($50 million divided by $500 million). The MPR is an important statistic that is presented to investors in monthly credit card portfolio performance reports. An example is presented in Exhibit for four series (1999-A, 1999-B, 1999-C, and 2001- A) from the BA Master Credit Card Trust for July 2001 using Bloomberg’s CCR function. Bloomberg displays monthly credit card portfolio performance reports for the leading credit card ABS issuers. Investors use the data to make assessments about how the underlying collateral is performing and to determine the likelihood that early amortization will be triggered.

MPR is an important indicator for two reasons. With a low level of MPR, extension risk with respect to the principal payments may increase. Also a low MPR, indicating low cash flows to satisfy principal payments, may trigger early amortization of the principal.

Closed-End Home Equity Loan-Backed Securities

A home equity loan (HEL) is a loan backed by residential property. At onetime, the loan was typically a second lien on property that has already been pledged to secure a first lien. In some cases, the lien may be a third lien. In recent years, the character of a home equity loan has changed. Today, a home equity loan is often a first lien on property where the borrower has an impaired credit history so that the loan cannot qualify as a conforming loan for Ginnie Mae, Fannie Mae, or Freddie Mac. Typically, the borrower uses a home equity loan to consolidate consumer debt using the current home as collateral rather than to obtain funds to purchase a new home. Borrowers are segmented into four general credit quality groups, A, B, C, and D.

Bloomberg screen of monthly credit card portfolio performance report

Home equity loans can be either open end or closed end. An openend home equity loan is discussed in the next section. A closed-end HEL is structured the same way as a fully amortizing residential mortgage loan. That is, it has a fixed maturity and the payments are structured to fully amortize the loan by the maturity date. There are both fixed-rate and variable-rate closed-end HELs. Typically, variable-rate loans have a reference rate of 6-month LIBOR and have periodic caps and lifetime caps, just as the adjustable-rate mortgages discussed in the previous chapter. The cash flow of a pool of closed-end HELs is comprised of interest, regularly scheduled principal repayments, and prepayments, just as with mortgage-backed securities. Thus, it is necessary to have a prepayment model and a default model to forecast cash flows. The prepayment speed is measured in terms of a conditional prepayment rate (CPR).

Cash Flow

The monthly cash flow for a security backed by closed-end HELs is the same as for mortgage-backed securities. That is, the cash flow consists of

(1) net interest, (2) regularly scheduled principal payments, and (3) prepayments. The uncertainty about the cash flow arises from prepayments. Borrower characteristics must be kept in mind when trying to assess prepayments for a particular deal. In the prospectus of an offering, a base case prepayment assumption is made—the initial speed and the amount of time until the collateral is expected to season. Thus, the prepayment benchmark is issue specific and is called the prospectus prepayment curve or PPC.

Payment Structure

There are passthrough and paythrough home equity loan-backed structures. Typically, home equity loan-backed securities are securitized by both closed-end fixed-rate and adjustable-rate (or variable-rate) HELs.

The securities backed by the latter are called HEL floaters. The reference rate of the underlying loans is typically 6-month LIBOR. The cash flow of these loans is affected by periodic and lifetime caps on the loan rate.

To increase the attractiveness of home equity loan-backed securities to short-term investors, the securities typically have been created in which the reference rate is 1-month LIBOR. Because of (1) the mismatch between the reference rate on the underlying loans and that of the HEL floater and (2) the periodic and lifetime caps of the underlying loans, there is an available funds cap on the coupon rate for the HEL floater.

Exhibit presents a Bloomberg Security Description screen HEL floater issued from the Advanta Mortgage Loan Trust, Series 2000-2.This floating-rate tranche has a coupon formula of 1-month LIBOR plus 14 basis points with a floor of 14 basis points. This floater also has an available funds cap.

Bloomberg security description screen of a HEL floater

Tranches have been structured in HEL deals so as to give some senior tranches greater prepayment protection than other senior tranches. The two types of structures that do this are the planned amortization class (PAC) tranche and non-accelerating senior (NAS) tranche.

In our discussion of CMOs issued by the agencies in the previous chapter we explained how a planned amortization class tranche can be created.

These tranches are also created in HEL structures.

A NAS tranche receives principal payments according to a schedule. The schedule is not a dollar amount. Rather, it is a principal schedule that shows for a given month the share of pro rata principal that must be distributed to the NAS tranche. A typical principal schedule for a

NAS tranche is as follows:

Bloomberg screen of a HEL-Backed Deal

The average life for the NAS tranche is stable for a large range of prepayments because for the first three years all prepayments are made to the other senior tranches. This reduces the risk of the NAS tranche contracting (i.e., shortening) due to fast prepayments. After month 84, 300% of its pro rata share is paid to the NAS tranche thereby reducing its extension risk.

As an illustration, Exhibit presents a Bloomberg screen that presents a HEL-backed deal issued by the Advanta Mortgage Loan Trust, Series 2000-2. Note that tranche A6 is the NAS tranche. Moreover, tranches A2 through A5 are accelerated securities (AS) which means simply these tranches receive principal payments faster than the underlying collateral.

Open-End Home Equity Loan-Backed Securities

With an open-end home equity loan (HELOC) the homeowner is given a credit line and can write checks or use a credit card for up to the amount of the credit line. The amount of the credit line depends on the amount of the equity the borrower has in the property.

The revolving period for a HELOC is the period during which the borrower can take down all or part of the line of credit. The revolving period can run from 10 to 15 years. At the end of the revolving period, the HELOC can specify either a balloon payment or an amortization schedule (of up to 10 years). Almost all HELOCs are floating-rate loans. The interest rate paid by HELOC borrowers is typically reset monthly to the prime rate as reported in The Wall Street Journal plus a spread.

Bloomberg security description screen of a HELOC Floater

The securities created in HELOC deals are floating-rate tranches.While the underlying loans are priced based on a spread over the prime rate, the securities created are based on a spread over 1-month LIBOR.

Exhibit presents a Bloomberg Security Description screen of a HELOC floating-rate tranche issued from the Advanta Revolving Home Equity Loan Trust, Series 2000-A. This floater has a coupon formula of 1-month LIBOR plus 25 basis points with a floor of 25 basis points.The coupon payments are delivered and reset monthly.

Because HELOCs are for revolving lines, the deal structures are quite different for HELOCs and closed-end HELs. As with other ABS involving revolving credit lines such as credit card deals, there is a revolving period, an amortization period, and a rapid amortization period.

Manufactured Housing-Backed Securities

Manufactured housing-backed securities are backed by loans for manufactured homes.In contrast to site-built homes, manufactured homes are built at a factory and then transported to a manufactured home community or private land. The loan may be either a mortgage loan (forboth the land and the home) or a consumer retail installment loan.

Manufactured housing-backed securities are issued by Ginnie Mae and private entities.The former securities are guaranteed by the full faith and credit of the U.S. government. Loans not backed by the FHA or VA are called conventional loans. Manufactured housing-backed securities that are backed by such loans are called conventional manufactured housing-backed securities.

The typical loan for a manufactured home is 15 to 20 years. The loan repayment is structured to fully amortize the amount borrowed. Therefore, as with residential mortgage loans and HELs, the cash flow consists of net interest, regularly scheduled principal, and prepayments.However, prepayments are more stable for manufactured housing backedsecurities because they are not sensitive to refinancing.

There are several reasons for this. First, the loan balances are typically small so that there is no significant dollar savings from refinancing. Second, the rate of depreciation of manufactured homes may be such that in the earlier years depreciation is greater than the amount of the loan paid off.

This makes it difficult to refinance the loan. Finally, typically borrowers are of lower credit quality and therefore find it difficult to obtain funds to refinance. As with residential mortgage loans and HELs, prepayments on manufactured housing-backed securities are measured in terms of CPR.

The payment structure is the same as with nonagency mortgage backedsecurities and home equity loan-backed securities.

As an illustration, Exhibit presents a Bloomberg screen of manufactured housing-backed securities issued by Green Tree Financial Corporation, Series 1999-5. In the last column labeled “Description”, there may be some abbreviations that require explanation.SEQ means the security is a sequential-pay tranche.AFC means that tranche has an available funds cap, as discussed earlier in the chapter. MEZ stands for a mezzanine bond that provides credit support for the senior tranches but has a higher credit rating than the subordinated (SUB) bonds.

Finally, EXE stands for Excess bond, this type of bond receives any cash flows in excess of the amount of principal and interest obligated to all other securities in the structure. Exhibit presents a Bloomberg Security Description screen of shortest maturity security (A1). A1 carries a coupon rate of 6.27% and makes payments monthly. Note this security carries a AAA credit rating from Standard & Poor’s.

Student Loan-Backed Securities

Student loans are made to cover college costs (undergraduate, graduate, and professional programs such as medical school and law school) and tuition for a wide range of vocational and trade schools. Securities backed by student loans, popularly referred to as SLABS (student loan asset-backed securities), have similar structural features as the other ABS products we discussed.

Bloomberg screen of Manfactured housing-backed deal

The student loans that have been most commonly securitized are those that are made under the Federal Family Education Loan Program (FFELP). Under this program, the government makes loans to students via private lenders.The decision by private lenders to extend a loan to a student is not based on the applicant’s ability to repay the loan. If a default of a loan occurs and the loan has been properly serviced, then the government will guarantee up to 98% of the principal plus accrued interest.The federal government has a direct lending program—the Federal

Direct Student Loan Program (FDSLP)—in which the Department of Education (DOE) makes loans directly to students; however, these loans are retained by the DOE and not securitized. Loans that are not part of a government guarantee program are called alternative loans.

These loans are basically consumer loans and the lender’s decision to extend an alternative loan will be based on the ability of the applicant to repay the loan. Alternative loans have been securitized.

As Congress did with the creation of Fannie Mae and Freddie Mac to provide liquidity in the mortgage market by allowing these entities to buy mortgage loans in the secondary market, it created the Student Loan Marketing Association (“Sallie Mae”) as a government-sponsored enterprise to purchase student loans in the secondary market and to securitize pools of student loans. Its first issuance was in 1995. Sallie Mae is now the major issuer of SLABS and its issues are viewed as the benchmark issues. Other entities that issue SLABS are traditional corporate entities (e.g., PNC Bank) and non-profit organizations (Michigan Higher Education Loan Authority and the California Educational Facilities Authority). The SLABS of the latter are typically issued as tax exempt securities and therefore trade in the municipal market.

Let’s first look at the cash flow for the student loans themselves. There are different types of student loans under the FFELP, including subsidized and unsubsidized Stafford loans, Parental Loans for Undergraduate Students (PLUS), and Supplemental Loans to Students (SLS). These loans involve three periods with respect to the borrower’s payments— deferment period, grace period, and loan repayment period.

Typically, student loans work as follows. While in school, no paymentsare made by the student on the loan. This is the deferment period. Upon leaving school, the student is extended a grace period of usually six months when no payments on the loan need to be made. After this period, payments are made on the loan by the borrower.

Prior to July 1, 1998, the reference rate for student loans originated under the FFELP program was the 3-month Treasury bill rate plus a margin of either 250 basis points (during the deferment and grace periods) or 310 basis points (during the repayment period). Since July 1, 1998, the Higher Education Act changed the reference rate to the 10-year Treasury note.The interest rate is the 10-year Treasury note plus 100 basis points.

The spread over the reference rate varies with the cycle period for the loan. As with other ABS, the reference rate need not be the same as that of the underlying loans. For investors in non-Sallie Mae issues, there is exposure to collateral performance due to basis risk discussed earlier in this chapter. Typically, non-Sallie Mae issues have been LIBOR-based floaters. For Sallie Mae issues, there is an indirect government guarantee. Sallie Mae has typically issued SLABS indexed to the 3-month Treasury bill rate. However, late in the second quarter of 1999, Sallie Mae issued bonds in which the buyer of the 2-year tranche had the choice of receiving either LIBOR plus 8 basis points or the 3-month Treasury bill rate plus 87 basis points.There are available funds caps in ABS deals because of the different reference rates.

Bloomberg Screen of a SLABS Deal

Bloomberg Security Description Screen of a Sallie Mae SLABS

Panel A:Tranche A1T

Panel B:Tranche A1L

Prepayments typically occur due to defaults or loan consolidation.Even if there is no loss of principal faced by the investor when defaults occur, the investor is still exposed to contraction risk. This is the risk that the investor must reinvest the proceeds at a lower spread and in the case of a bond purchased at a premium, the premium will be lost. Studies have shown student loan prepayments are insensitive to the level of interest rates. Consolidations of loans occur when the students who have loans over several years combine them into a single loan. The proceeds from the consolidation are distributed to the original lender and, in turn, distributed to the bondholders.

SBA Loan-Backed Securities

The Small Business Administration (SBA) is an agency of the federal government empowered to guarantee loans made by approved SBA lenders to qualified borrowers.The loans are backed by the full faith and credit of the U.S. government. Most SBA loans are variable-rate loans where the reference rate is the prime rate. The rate on the loan is either reset monthly on the first of the month or quarterly on the first of January, April, July, and October. SBA regulations specify the maximum coupon allowable in the secondary market. As of this writing, the maximum coupon rate is equal to the prime rate plus 1.625%. SBA loans typically do not have caps. Newly originated loans have maturities between 5 and 25 years.

The Small Business Secondary Market Improvement Act passed in 1984 permitted the pooling of SBA loans.When pooled, the underlying loans must have similar terms and features.The maturities typically used for pooling loans are 7, 10, 15, 20, and 25 years.Loans without caps are not pooled with loans that have caps.

Most variable-rate SBA loans make monthly payments consisting of interest and principal repayment.The amount of the monthly payment for an individual loan is determined as follows.Given the coupon formula of the prime rate plus the loan’s quoted margin, the interest rate is determined. Given the interest rate, a level payment amortization schedule is determined. It is this level payment that is paid for the months until the coupon rate is reset. When variable-rate SBA loans are pooled, the amortization schedule is based on the net pool rate and the rate is recomputed either every month or every quarter.

Prepayments for SBA-backed securities are measured in terms of CPR. Voluntary prepayments can be made by the borrower without any penalty. Exhibit presents a Bloomberg screen of the historical CPR for SBA pools (all variable rate pools) for the period January 1991 until August 2001. Even a cursory glance suggests that prepayments vary considerably over time and across pools established in different years. There are several factors contributing to the prepayment speed of a pool of SBA loans. A factor affecting prepayments is the maturity date of the loan. It has been found that the fastest speeds on SBA loans and pools occur for shorter maturities. The purpose of the loan also affects prepayments. There are loans for working capital purposes and loans to finance real estate construction or acquisition. It has been observed that SBA pools with maturities of 10 years or less made for working capital purposes tend to prepay at the fastest speed. In contrast, loans backed by real estate that have long maturities tend to prepay at a slow speed. All other factors constant, pools that have capped loans tend to prepay more slowly than pools of uncapped loans.

Bloomberg Screen of historical CPR for SBA pools