Collateral pools

There is a loan-to-value limit imposed of 60% for residential mortgages and 100% for public sector loans and hedging contracts against interest rate risk are permitted in the collateral pool. 

Many securitisations by regular issuers of MBS will have a relatively low average seasoning on their collateral pool at launch. Loans that have been originated relatively recently will have had little opportunity to fall behind with their payments so this pool is likely to have low arrears. Experience suggests that arrears tend to increase over the first two years and then stabilise as the collections process and, if necessary, repossessions take effect. Therefore, when comparing the arrears within collateral pools, it is important to also consider the age of the loans in the portfolios. 

The first step in the Fitch rating process is to estimate the probability of default for each loan in the collateral pool. This will take into account all the factors discussed in the previous section. 

European RMBS transactions contain a combination of various features designed to protect investors from the impact of defaults on mortgages in the underlying collateral pool, including excess spread, reserve fund, and subordination of any lower priority notes. 

In European RMBS transactions, bonds are not generally written down when losses are incurred in the collateral pool. Instead, the losses are recorded in a principal deficiency ledger, which records the extent to which the balance outstanding on the notes exceeds the remaining assets. Usually, both excess spread and the reserve fund can be used to cover losses and so pay down the principal deficiency ledger. This mechanism is beneficial to holders of the lower-rated notes because the notes do not get written off immediately and any future excess spread will be used to cover the loss. 

Transactions may include a substitution period during which the issuer is allowed to use principal receipts to purchase additional mortgages. This, in effect, allows the issuer to prevent the collateral pool (and therefore the notes) paying down, giving noteholders certainty of cash flows during this period. However, at the end of the substitution period, principal payments will be used to redeem notes in the normal manner. 

Exhibit 11.9). These transactions normally revert to sequential redemption when the collateral pool reaches a certain minimnm size. 

Mortgage master trusts require the seller to maintain a certain minimum interest in the collateral pool held by the master trust. In credit card transactions this is used to absorb the monthly fluctuations in the balance outstanding on the credit cards and ensure there is always sufficient collateral to support the notes. In RMBS transactions the minimum seller s interest tends to be smaller as the mortgages have a more stable repayment profile, and this is primarily available to cover set-off risk in the event of originator insolvency. In existing transactions it is the minimum trust size rather than the minimum seller s share that has been the key constraint. 

If any losses are realised on loans in the collateral pool, they will be covered by trapping any excess cash flowing through the cash flow waterfall, so the size of excess spread relative to the losses being incurred is an important indication of the transaction s financial health. In the Holmes Financing master trust, excess spread is measured on a quarterly basis. Exhibit 11.17 shows it that has been averaging around 60 bps per year, massively exceeding the 0.5 bp loss rate. 

Exhibit 11.18 shows the principal payment rate is somewhat erratic on a monthly basis but has generally been increasing. However, with a collateral pool of 24 billion and principal collections running at their average rate of 4%, it would take less than one month to accumulate the principal required to redeem the largest outstanding note. 

The average seasoning of the loans in collateral pools can vary considerably between different transactions and so a direct comparison may be misleading. For this reason the analysis presented here tracks the performance of the collateral against the estimated average seasoning of the collateral. 

Similar analysis of the losses within the collateral pools supporting the MBS transactions gives the loss profile shown in Exhibit 11.20. The marginal loss rates used in this analysis are calculated as the total cumulative loss on the transaction as a proportion of the collateral that has been... 

There is a wide variety of European securitisation transactions that are backed by one form or another of commercial property. This variety stems from the range of types of commercial property that may be included in the collateral pool, the type of borrower or borrowers, and the level of exposure to any underlying industries or sectors. As a result, it is not always clear where this sector begins or ends, and although it may be tempting to invent new subclassifications for the various fragments of the sector, this is not necessarily particularly helpful for investors or the market in general. To complicate matters further, a number... 

Investing in CMBS, whether they are single-asset or multiborrower transactions, requires an appreciation of the nature of the underlying properties and the inherent sensitivities of the cash flows they generate. The type and extent of analysis undertaken should be tailored to reflect the characteristics of the collateral pool and also whether the proposed investment is at a senior or junior level in the capital structure. 

Under a guarantee agreement, the originator is able to recover an amount equal to the net realised losses on the reference pool of loans, including the costs incurred in the foreclosure and recovery process, in return for a periodic payment of a guarantee fee. This fee is calculated to make up any shortfall between the interest received on the credit-linked note collateral pool and the expenses and interest costs of the issuing SPV. Realised losses are applied in reverse sequential order to the notes, by can-... 

In addition to debt, there may be unrated subordinated—or equity—interests issued. Although the equity interest in a CDO is structured like a bond, it does represent the residual interest in the CDO vehicle its return is variable and linked to the residual value of the collateral pool after all debt liabilities have been extinguished. Given that the equity resides in the first loss position, it carries the greatest risk and warrants the highest return—and represents a leveraged exposure to the asset class. More is offered on CDO equity later in this chapter. 

Market valne transactions aggressively nse ramp-up periods to acquire assets when accumulating the collateral pool. There is typically a liquidity facility, which is in place prior to the closing of the transaction, to help bridge the acquisition of assets. The principal repayment of liabilities are extinguished when the nnderlying assets are sold (traded) out of the portfolio, rather than when they matnre. 

CDO equity is not a straightforward instrument and must be assessed carefully by investors due to their complexity and limited liquidity. The asset manager, the quality of the collateral pool and the amount of leverage are very important issues for consideration. In addition, potential investors must consider how the equity investment fits with his or her broader portfolio. 

In order to model the asset s cash flow, it uses a Monte Carlo simulation to generate expected default times for each piece of collateral and utilizes Copula functions and equity indexes to estimate correlation in the default times. The default times allow CDOManager to determine the cash flow expected from each asset over the life of a transaction. Summing up the cash flow from all of the assets generates a picture of the expected future cash flow from the CDO collateral pool. 

Pool insurance an insurance policy provided by a composite insurance company to cover the risk of principal loss in the collateral pool. The claims paying rating of the insurance company is important in determining the overall rating of the issue. 

Senior Junior note classes credit enhancement is provided by subordinating a class of notes ( class B notes) to the senior class notes ( class A notes). The class B note s right to its proportional share of cash flows is subordinated to the rights of the senior noteholders. Class B notes do not receive payments of principal until certain rating agency requirements have been met, specifically satisfactory performance of the collateral pool over a predetermined period, or in many cases until all of the senior note classes have been redeemed in full. 

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