FIAG Primer

Fixed Income Products and
Analytics
Helix Advisors Pvt. Ltd.

Primer – Bonds and Rates
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Contents
(i) Overview
(ii) Bond Characteristics
a. Issuer
b. Priority
c. Coupon Rate
d. Redemption Features
e. Day-Count Basis
(iii) Risks associated with investing in bonds
(iv) Yield Curve
a. Treasury Yield Curve
b. Spot Curve
c. Forward Curve
d. Libor Curve
e. Swap Curve
(v) Bond Yield Measures
a. Current Yield
b. Yield to Maturity
c. Yield to Call
d. Yield to Worst
(vi) Interest Rate risk
a. Duration
b. Convexity
(vii) Discount Margin
(viii) WAL of a bond
(ix) Price of a bond – components
(x) References
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Fixed income securities, historically, were promises to pay a stream of semiannual payments for
a given number of years and then repay the loan amount at the maturity date. The contract
between the borrower and the lender (the indenture) can really be designed to have any payment
stream or pattern that the parties agree to.
For example, if you borrow money and have to pay interest once a month, you have issued a
fixed-income security. When a company does this, it is often called a bond or corporate bank debt
The contract that specifies all the rights and obligations of the issuer and the owners of a fixed
income security is called the bond indenture. The indenture defines the obligations of and
restrictions on the borrower and forms the basis for all future transactions between the
bondholder and the issuer.
A "straight" (option-free) bond is the simplest case. Consider a Treasury bond that has a 6%
coupon and matures five years from today in the amount of $ 1,000. This bond is a promise by
the issuer (the U.S. Treasury) to pay 6% of the $ 1,000 par value (i.e., $60) each year for five
years and to repay the $ 1,000 five years from today.
With Treasury bonds and almost all U.S. corporate bonds, the annual interest is paid in two
semiannual installments. Therefore, this bond will make nine coupon payments (one every six
months) of $30 and a final payment of $1,030 (the par value plus the final coupon payment) at the
end of five years. This stream of payments is fixed when the bonds are issued and does not
change over the life of the bond.
Note that each semiannual coupon is one-half the coupon rate (which is always expressed as an
annual rate) times the par value. An 8% Treasury note with a face value of $ 100,000 will make a
coupon payment of $4,000 every six months and a final payment of $ 104,000 at maturity.
A U.S. Treasury bond is denominated (of course) in U.S. dollars. Bonds can be issued in other
currencies as well.
Before getting to the all-important subject of bond pricing, we must first understand the many
different characteristics bonds can have. The classification of a bond depends on its type of
issuer, priority, coupon rate and redemption features.
• Bond Issuers
As the major determiner of a bond's credit quality, the issuer is one of the most important
characteristics of a bond. There are significant differences between bonds issued by
corporations and those issued by a state government/municipality or national
government. In general, securities issued by the federal government have the lowest risk
of default while corporate bonds are considered to be riskier ventures. Of course there
are always exceptions to the rule. In rare instances, a very large and stable company
could have a bond rating that is better than that of a municipality. It is important to point
out, however, that like corporate bonds, government bonds carry various levels of risk;
because all national governments are different, so are the bonds they issue.
o Treasury Bonds – Marketable securities from (example) the US Government. All
debt issued by US is regarded as extremely safe, as is the debt of any stable
country. The debt of many developing countries, however, does carry substantial
risk. Like companies, countries can default on payments (read RUSSIAN
FINANCIAL CRISIS, 1998).
o Municipal bonds - known as "munis", are the next progression in terms of risk.
Cities don't go bankrupt that often, but it can happen (Read ORANGE COUNTY
bankruptcy, CALIFORNIA). The major advantage to munis is that the returns are
free from federal tax. Furthermore, local governments will sometimes make their
debt non-taxable for residents, thus making some municipal bonds completely
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tax free. Because of these tax savings, the yield on a muni is usually lower than
that of a taxable bond.
o Corporate Bonds - A company can issue bonds just as it can issue stock. Large
corporations have a lot of flexibility as to how much debt they can issue: the limit
is whatever the market will bear. Generally, a short-term corporate bond is less
than five years; intermediate is five to 12 years, and long term is over 12 years.
Corporate bonds are characterized by higher yields because there is a higher
risk of a company defaulting than a government. The upside is that they can also
be the most rewarding fixed-income investments because of the risk the investor
must take on. The company's credit quality is very important: the higher the
quality, the lower the interest rate the investor receives.
o Mortgage Bonds - A bond secured by a mortgage on a property. Mortgage

bonds are backed by real estate or physical equipment that can be liquidated.
The cash flows are backed by the principal and interest payments of a set of
mortgage loans. Payments are typically made monthly over the lifetime of the
underlying loans.
o International bonds (government or corporate) are complicated by different

currencies. That is, these types of bonds are issued within a market that is
foreign to the issuer's home market, but some international bonds are issued in
the currency of the foreign market and others are denominated in another
currency. Here are some types of international bonds:
The definition of the eurobond market can be confusing because of its
name. Although the euro is the currency used by participating European
Union countries, eurobonds refer neither to the European currency nor to
a European bond market. A eurobond instead refers to any bond that is
denominated in a currency other than that of the country in which it is
issued. Bonds in the eurobond market are categorized according to the
currency in which they are denominated. As an example, a eurobond
denominated in Japanese yen but issued in the U.S. would be classified
as a euroyen bond.
Foreign bonds are denominated in the currency of the country in which

a foreign entity issues the bond. An example of such a bond is the
samurai bond, which is a yen-denominated bond issued in Japan by an
American company. Other popular foreign bonds include bulldog and
yankee bonds.
Global bonds are structured so that they can be offered in both foreign
and eurobond markets. Essentially, global bonds are similar to
eurobonds but can be offered within the country whose currency is used
to denominate the bond. As an example, a global bond denominated in
yen could be sold to Japan or any other country throughout the
Eurobond market.
• Priority
In addition to the credit quality of the issuer, the priority of the bond is a determiner of the
probability that the issuer will pay you back your money. The priority indicates your place
in line should the company default on payments. If you hold an unsubordinated (senior)
security and the company defaults, you will be first in line to receive payment from the
liquidation of its assets. On the other hand, if you own a subordinated (junior) debt
security, you will get paid out only after the senior debt holders have received their share.
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• Coupon Rate
Bond issuers may choose from a variety of types of coupons, or interest payments.
o Straight, plain vanilla or fixed-rate bonds pay an absolute coupon rate over a
specified period of time. Upon maturity, the last coupon payment is made along
with the par value of the bond.
o Floating rate debt instruments or floaters pay a coupon rate that varies
according to the movement of the underlying benchmark. These types of
coupons could, however, be set to be a fixed percentage above, below, or equal
to the benchmark itself. Floaters typically follow benchmarks such as the three,
six or nine-month T-bill rate or LIBOR. For example, if market interest rates are
moving up, the coupons on straight floaters will rise as well. In essence, these
bonds have coupons that are reset periodically (normally every 3, 6, or 12
months) based on prevailing market interest rates. The most common procedure
for setting the coupon rates on floating-rate securities is one which starts with a
reference rate (such as the rate on certain U.S. Treasury securities or the
London Interbank Offered Rate LIBOR)) and then adds or subtracts a stated
margin to or from that reference rate. The quoted margin may also vary over time
according to a schedule that is stated in the indenture. The schedule is often
referred to as the coupon formula. Thus, to find the new coupon rate, you would
use the following coupon formula: new coupon rate = reference rate +/- quoted margin .Just
as with a fixed-coupon bond, a semiannual coupon payment will be one-half the
(annual) coupon rate.
Caps and floors. The parties to the bond contract can limit their exposure
to extreme fluctuations in the reference rate by placing upper and lower
limits on the coupon rate. The upper limit, which is called a cap, puts a
maximum on the interest rate paid by the borrower/ issuer. The lower
limit, called a floor, puts a minimum on the periodic coupon interest
payments received by the lender/ security owner. When both limits are
present simultaneously, the combination is called a collar. Consider a
floating-rate security (floater) with a coupon rate at issuance of 5%, a 7%
cap, and a 3% floor. If the coupon rate (reference rate plus the margin)
rises above 7% , the borrower will pay (lender will receive ) only 7%
o Inverse floaters pay a variable coupon rate that changes in direction opposite to
that of short-term interest rates. An inverse floater subtracts the benchmark from
a set coupon rate. For example, an inverse floater that uses LIBOR as the
underlying benchmark might pay a coupon rate of a certain percentage; say 6%,
minus LIBOR.
o Zero coupon, or accrual bonds do not pay a coupon. Instead, these types of
bonds are issued at a deep discount and pay the full face value at maturity.
o Accrual bonds are similar to zero-coupon bonds in that they make no periodic
interest payments prior to maturity, but different in that they are sold originally at
(or close to) par value. There is a stated coupon rate, but the coupon interest
accrues (builds up) at a compound rate until maturity. At maturity, the par value,
plus all of the interest that has accrued over the life of the bond, is paid.
o Step-up notes have coupon rates that increase over time at a specified rate.
The increase may take place once or more during the life of the issue.
o Deferred-coupon bonds carry coupons, but the initial coupon payments are
deferred for some period. The coupon payments accrue, at a compound rate,
over the deferral period and are paid as a lump sum at the end of that period.
After the initial deferment period has passed, these bonds pay regular coupon
interest for the rest of the life of the issue (to maturity).
• Redemption Features
Both investors and issuers are exposed to interest rate risk because they are locked into
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either receiving or paying a set coupon rate over a specified period of time. For this
reason, some bonds offer additional benefits to investors or more flexibility for issuers:
o Callable, or a redeemable bond features gives a bond issuer the right, but not
the obligation, to redeem his issue of bonds before the bond's maturity. The
issuer, however, must pay the bond holders a premium. There are two
subcategories of these types of bonds: American callable bonds and European
callable bonds. American callable bonds can be called by the issuer any time
after the call protection period while European callable bonds can be called by
the issuer only on pre-specified dates.
The optimal time for issuers to call their bonds is when the prevailing interest rate
is lower than the coupon rate they are paying on the bonds. After calling its
bonds, the company could refinance its debt by reissuing bonds at a lower
coupon rate.
o Convertible bonds give bondholders the right but not the obligation to convert
their bonds into a predetermined number of shares at predetermined dates prior
to the bond's maturity. Of course, this only applies to corporate bonds.
o Puttable bonds give bondholders the right but not the obligation to sell their
bonds back to the issuer at a predetermined price and date. These bonds
generally protect investors from interest rate risk. If prevailing bond prices are
lower than the exercise par of the bond, resulting from interest rates being higher
than the bond's coupon rate, it is optimal for investors to sell their bonds back to
the issuer and reinvest their money at a higher interest rate.
• DCB (Day Count Convention)
A system used to determine the number of days between two coupon dates, which is
important in calculating accrued interest and present value when the next coupon
payment is less than a full coupon period away. Each bond market has its own day-count
convention.
There are several different types of day-count conventions. For example, a 30/360 day-
count convention assumes there are 30 days in a month and 360 days in a year. An
actual/actual day-count convention uses the actual number of days in the month and year
for a given interest period.
This concept might sound illogical. After all, regardless of the particular bond market
there will always be 365 days in a year! Nevertheless, these conventions are standards
that have developed over time and help to ensure that everybody is on an even playing
field when a bond is sold between coupon dates.
o 30 / 360
The 30/360 day-count method is used in the U.S. for most corporate, agency, and
municipal bonds and for mortgage-backed securities. It is sometimes used for
floating-rate notes and short-term CDs.
To find the size of an interest period, use this formula:
360(Y2-Y1)+30(M2-M1)+(D2-D1)
where Yn is the year, Mn is the month, and Dn is the number of days. However, if D1=31, set D1=30. If D2
is 31 and D1 is 30 or 31, change D2 to 30; otherwise, leave at 31.
For example, there are 29 days between May 1 and May 30 and 30 days between
May 1 and May 31.
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To calculate the number of days in a normal coupon period, multiply the number of
calendar months in the period by 30.
o 30E / 360
The 30E/360 day-count method is used for Eurobonds and many foreign government
bonds.
To find the size of an interest period, use this formula:
360(Y2-Y1)+30(M2-M1)+(D2-D1)
where Yn is the year, Mn is the month, and Dn is the number of days. However,if Dn=31, set Dn=30.
For example, there are 29 days between May 1 and May 30, and 29 days between
May 1 and May 31, since D2 was changed to 30.
To calculate the number of days in a normal coupon period, multiply the number of
calendar months in the period by 30.
o Actual / Actual
The actual/actual day-count method is used primarily to calculate U.S. government

notes and bonds, but may also be used to calculate foreign government bonds and
floating-rate notes.
When calculating a fraction of the normal coupon period, the actual number of
calendar days in the interest period is used as the number of days for which interest
is paid, and the actual number of calendar days in the normal coupon period is used
as the denominator.
o Actual / 365
The actual/365 day-count method is used primarily to calculate Treasury bond

equivalent yields for U.S. Treasury bills, but may also be used to calculate foreign
government bonds and floating-rate notes.
is paid, and 365 is used as the denominator.
o Actual / 360
The actual/360 day-count method is used mainly for money-market securities:

medium-term CDs, short-term CDs, and floating-rate notes. The U.S. Treasury bill
dollar discount is also calculated using this method.
is paid. The denominator is 360 (12 months of 30 days each).
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Risks Associated With Investing In Bonds
Interest rate risk refers to the effect of changes in the prevailing market rate of interest on bond
values. When interest rates rise, bond values fall. This is the source of interest rate risk which is
approximated by a measure called duration.
o Recall that floating-rate securities have a coupon rate that "floats," in that it is
periodically reset based on a market-determined reference rate. The objective of the
resetting mechanism is to bring the coupon rate in line with the current market yield
so the bond sells at or near its par value. This will make the price of a floating-rate
security much less sensitive to changes in market yields than a fixed-coupon bond of
equal maturity. That's the point of a floating-rate security: less interest rate risk.
Between coupon dates, there is a time lag between any change in market yield and a
change in the coupon rate (which happens on the reset date). The longer the time
period between the two dates, the greater the amount of potential bond price
fluctuation. In general, we can say that the longer (shorter) the reset period, the
greater (less) the interest rate risk of a floating-rate security at any reset date.
The presence of a cap (maximum coupon rate) can increase the interest rate risk of a
floating-rate security. If the reference rate increases enough that the cap rate is
reached, further increases in market yields will decrease the floater's price. When the
market yield is above its capped coupon rate, a floating-rate security will trade at a
discount. To the extent that the cap fixes the coupon rate on the floater, its price
sensitivity to changes in market yield will be increased. This is sometimes referred to
as cap risk.
A floater's price can also differ from par due to the fact that the margin is fixed at
issuance. Consider a firm that has issued floating-rate debt with a coupon formula of
LIBOR + 2%. This 2% margin should reflect the credit risk and liquidity risk of the
security. If the firm's creditworthiness improves, the floater is less risky and will trade
at a premium to par. Even if the firm's creditworthiness remains constant, a change in
the market's required yield premium for the firm's risk level will cause the value of the
floater to differ from par.
Yield curve risk arises from the possibility of changes in the shape of the yield curve (which
shows the relation between bond yields and maturity). While duration is a useful measure of
interest rate risk for equal changes in yield at every maturity (parallel changes in the yield curve),
changes in the shape of the yield curve mean that yields change by different amounts for bonds
with different maturities.
Call risk arises from the fact that when interest rates fall, a callable bond investor's principal may
be returned and must be reinvested at the new lower rates. Certainly bonds that are not callable
have no call risk, and call protection reduces call risk. When interest rates are more volatile,
callable bonds have relatively more call risk because of an increased probability of yields falling to
a level where the bonds will be called.
Prepayment risk is similar to call risk. Prepayments are principal repayments in excess of those
required on amortizing loans, such as residential mortgages. If rates fall, causing prepayments to
increase, an investor must reinvest these prepayments at the new lower rate. Just as with call
risk, an increase in interest rate volatility increases prepayment risk.
Reinvestment risk refers to the fact that when market rates fall, the cash flows (both interest and
principal) from fixed-income securities must be reinvested at lower rates, reducing the returns an
investor will earn. Note that reinvestment risk is related to call risk and prepayment risk. In both of
these cases, it is the reinvestment of principal cash flows at lower rates than were expected that
negatively impacts the investor. Coupon bonds that contain neither call nor prepayment
provisions will also be subject to reinvestment risk, since the coupon interest payments must be
reinvested as they are received.
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Note that investors can be faced with a choice between reinvestment risk and price risk. A non-
callable zero-coupon bond has no reinvestment risk over its life since there are no cash flows to
reinvest, but a zero coupon bond has more interest rate risk than a coupon bond of the same
maturity. Therefore, the coupon bond will have more reinvestment risk and less price risk.
Credit risk is the risk that the creditworthiness of a fixed -income security's issuer will deteriorate,
increasing the required return and decreasing the security's value.
Liquidity risk has to do with the risk that the sale of a fixed -income security must be made at a
price less than fair market value because of a lack of liquidity for a particular issue. Treasury
bonds have excellent liquidity, so selling a few million dollars worth at the prevailing market price
can be easily and quickly accomplished. At the other end of the liquidity spectrum, a valuable
painting, collectible antique automobile, or unique and expensive home may be quite difficult to
sell quickly at fair-market value. Since investors prefer more liquidity to less, a decrease in a
security's liquidity will decrease its price, as the required yield will be higher.
Exchange-rate risk arises from the uncertainty about the value of foreign currency cash flows to
an investor in terms of his home-country currency. While a U. S. Treasury bill (T- bill) may be
considered quite low risk or even risk-free to a U.S.-based investor, the value of the T-bill to a
European investor will be reduced by a depreciation of the U.S. dollar's value relative to the euro.
Inflation risk might be better described as unexpected inflation risk and even more descriptively
as purchasing power risk. While a $ 10,000 zero-coupon Treasury bond can provide a payment of
$ 10,000 in the future with (almost) certainty, there is uncertainty about the amount of goods and
services that $ 10,000 will buy at the future date. This uncertainty about the amount of goods and
services that a security's cash flows will purchase is referred to here as inflation risk.
Volatility risk is present for fixed-income securities that have embedded options, such as call
options, prepayment options, or put options. Changes in interest rate volatility affect the value of
these options and thus affect the values of securities with embedded options.
Event risk encompasses the risks outside the risks of financial markets, such as the risks posed
by natural disasters and corporate takeovers.
Sovereign risk refers to changes in governmental attitudes and policies toward the repayment
and servicing of debt. Governments may impose restrictions on the outflows of foreign exchange
to service debt even by private borrowers. Foreign municipalities may adopt different payment
policies due to varying political priorities. A change in government may lead to a refusal to repay
debt incurred by a prior regime. Remember, the quality of a debt obligation depends not only on
the borrower's ability to repay but also on the borrower's desire or willingness to repay. This is
true of sovereign debt as well, and we can think of sovereign risk as having two components: a
change in a government's willingness to repay and a change in a country's ability to repay. The
second component has been the important one in most defaults and downgrades of sovereign
debt.
Relationships among a bond's coupon rate, the yield required by the market, and the bond's price
relative to par value
When the coupon rate on a bond is equal to its market yield, the bond will trade at its par value.
When issued, the coupon rate on bonds is typically set at or near the prevailing market yield on
similar bonds so that the bonds trade initially at or near their par value. If the yield required in the
market for the bond subsequently rises, the price of the bond will fall and it will trade at a discount
to (below) its par value. Conversely, if the required yield falls, the bond price will increase and the
bond will trade at a premium to (above) its par value.
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Yield Curve
A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but
differing maturity dates. The most frequently reported yield curve compares the three-month, two-
year, five-year and 30-year U.S. Treasury debt. This yield curve is used as a benchmark for other
debt in the market, such as mortgage rates or bank lending rates. The curve is also used to
predict changes in economic output and growth.
The shape of the yield curve is closely scrutinized because it helps to give an idea of future
interest rate change and economic activity.
There are four general shapes that we use to describe yield curves:
• Normal or upward sloping.
• Inverted or downward sloping.
• Flat.
• Humped.
However, Yield curves can take on just about any shape
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The slope of the yield curve is also seen as important: the greater the slope, the greater the gap
between short- and long-term rates. (see, US Treasuries on
http://www.bloomberg.com/markets/rates/index.html)
The appropriate discount rates for the promised payments from a Treasury bond at different times
in the future are called Treasury spot rates. The spot rates for different time periods that correctly
value (produce a value equal to market price) a Treasury bond are called arbitrage-free Treasury
spot rates, or the theoretical Treasury spot rate curve. Conceptually, spot rates are the discount
rates for (yields on) zero-coupon bonds, securities that have only a single cash flow at a future
date
Let’s do this again, a spot interest rate for maturity m is an interest rate payable on a spot loan of
maturity m that accumulates interest to maturity. Spot rates are sometimes called zero-coupon
rates because they are the rates of interest payable on obligations that accumulate all interest to
maturity. Libor [The London Interbank Offered Rate, a daily reference rate based on the interest
rates at which banks offer to lend unsecured funds to other banks in the London wholesale
money market (or interbank market)] rates for maturities of a week or more are spot rates (GBP
Libor is an exception). Table below indicates USD Libor rates for monthly maturities as of
different dates in March, 2008.
USD 3-Mar 4-Mar 5-Mar 6-Mar 7-Mar 10-Mar

s/n-o/n 3.153% 3.160% 3.153% 3.116% 3.094% 3.096%
1w 3.136% 3.134% 3.134% 3.128% 3.107% 3.080%
2w 3.133% 3.125% 3.121% 3.111% 3.062% 3.003%
1m 3.086% 3.080% 3.075% 3.058% 3.000% 2.935%
2m 3.043% 3.042% 3.039% 3.029% 2.981% 2.920%
3m 3.014% 3.008% 3.000% 2.990% 2.939% 2.901%
4m 2.966% 2.964% 2.960% 2.960% 2.886% 2.862%
5m 2.913% 2.920% 2.925% 2.929% 2.836% 2.821%
6m 2.863% 2.877% 2.893% 2.893% 2.784% 2.781%
7m 2.810% 2.830% 2.845% 2.845% 2.739% 2.735%
8m 2.756% 2.782% 2.796% 2.798% 2.687% 2.690%
9m 2.706% 2.735% 2.746% 2.754% 2.636% 2.644%
10m 2.678% 2.706% 2.716% 2.729% 2.616% 2.626%
11m 2.651% 2.679% 2.690% 2.707% 2.599% 2.606%
12m 2.626% 2.658% 2.668% 2.686% 2.575% 2.589%
Source BBA
See: http://www.bba.org.uk/bba/jsp/polopoly.jsp?d=141&a=627
http://www.bankrate.com/brm/ratewatch/other-indices.asp
A spot curve (or zero-coupon curve) is a graph of spot rates as a function of maturity.
A forward rate is a borrowing/lending rate for a loan to be made at some future date.
Alternatively, the amount that it will cost to deliver a currency, commodity, or some other
asset some time in the future.
The notation used must identify both the length of the lending/borrowing period and when in the
future the money will be loaned/ borrowed. Thus 1f1 is the rate for a 1-year loan one year from
now and 1f2 is the rate for a 1-year loan to be made two years from now, etc. Rather than
introduce a separate notation, we can represent the current 1-year rate(1 year spot) as 1f0. To
get the present values of a bond's expected cash flows, we need to discount each cash flow by
the forward rates for each of the periods until it is received.
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The idea here is that borrowing for three years at the 3-year rate or borrowing for 1 -year periods,
three years in succession, should have the same cost.
This relation is illustrated as (1+S3)^3 = (1 + 1f0)(1+ 1f1) (1+ 1f2 ) where S3 is the 3 year spot rate.
th
In the image below, USD Libor Forward curves as of 15 April 08 are given
Period LIBOR 1M LIBOR 3M LIBOR 6M LIBOR 1YR

0 2.51% 2.72% 2.94% 3.17%
1 2.76% 2.89% 3.05% 3.25%
2 2.88% 3.00% 3.13% 3.30%
3 3.00% 3.14% 3.21% 3.35%
4 3.11% 3.20% 3.27% 3.40%
5 3.27% 3.24% 3.33% 3.43%
6 3.18% 3.26% 3.35% 3.46%
7 3.24% 3.32% 3.39% 3.49%
8 3.32% 3.38% 3.42% 3.52%
9 3.37% 3.41% 3.44% 3.55%
10 3.43% 3.42% 3.46% 3.59%
11 3.40% 3.43% 3.48% 3.62%
12 3.41% 3.45% 3.51% 3.65%
13 3.44% 3.47% 3.54% 3.70%
14 3.46% 3.50% 3.57% 3.75%
15 3.49% 3.53% 3.60% 3.80%
16 3.52% 3.57% 3.64% 3.85%
17 3.55% 3.60% 3.69% 3.91%
18 3.59% 3.64% 3.74% 3.97%
19 3.63% 3.69% 3.79% 4.04%
20 3.67% 3.74% 3.86% 4.10%
21 3.73% 3.80% 3.92% 4.16%
22 3.78% 3.86% 3.99% 4.23%
23 3.85% 3.94% 4.06% 4.29%
The Swap Curve

The fixed rates on vanilla swaps(a cash-settled OTC derivative under which two counterparties
exchange two streams of cash flows. It is called an interest rate swap if both cash flow streams
are in the same currency and are defined as cash flow streams that might be associated with
some fixed income obligations) are called swap rates. The swap curve is a yield curve comprising
swap rates for different maturities of swap. Due to high liquidity in the USD swap market, the
swap curve has emerged as an alternative to Treasuries as a benchmark for USD interest rates
at maturities exceeding a year.
So, how is a Libor Curve different from a Swap Curve? For one, Swap Curve is a coupon bearing
curve while Libor is a zero coupon curve. Two, Swap rates are quoted on a BEY basis while Libor
is quoted on monthly*12 basis.
Bond Yield Measures

The income return on an investment. This refers to the interest or dividends received from a
security and is usually expressed annually as a percentage based on the investment's cost, its
current market value or its face value.
Current yield is the simplest of all return measures, but it offers limited information. This
measure looks at just one source of return: a bond's annual interest income-it does not consider
capital gains/losses or reinvestment income. The formula for the current yield is:
- 13 -
current yield = annual cash coupon payment / current bond price
Yield to maturity (YTM) is an annualized internal rate of return, based on a bond's price and its
promised cash flows. For a bond with semiannual coupon payments, the yield to maturity is
stated as two times the semiannual internal rate of return implied by the bond's price. The formula
that relates bond price and YTM for a semiannual coupon bond is:
Bond price = CPN1/(1+ YTM/2) + CPN2/[(1+ YTM/2)^2] + ….+ (CPN2n + Par)/[(1+ YTM/2)^2n]
Where
CPNt = the (semiannual) coupon payment received after t semiannual periods
n = number of years to maturity
YTM = yield to maturity
YTM and price contain the same information. That is, given the YTM, you can calculate the price
and given the price, you can calculate the YTM.
We cannot easily solve for YTM from the bond price. Given a bond price and the coupon payment
amount, we could solve it by trial and error, trying different values of YTM until the present value
of the expected cash flows is equal to price.
The yield to maturity used in the previous equation (2 X the semiannual discount rate) is referred
to as a bond equivalent yield (BEY), because most bonds issued in US pay semi-annual coupon
and thus cash flows are compounded semi-annually. Similarly, Mortgage Equivalent Yield (MEY)
can be described, where the compounding has to be done monthly because typical mortgages
and mortgage back securities pay monthly.
The yield to call is used to calculate the yield on callable bonds that are selling at a premium to
par. For bonds trading at a premium to par, the yield to call may be less than the yield to maturity.
This can be the case when the call price is below the current market price.
The yield to worst is the worst yield outcome of any that are possible given the call provisions of
the bond.
Interest Rate Risk….again

The duration /convexity approach provides an approximation of the actual interest rate sensitivity
of a bond or bond portfolio. Its main advantage is its simplicity. Limiting our scenarios to parallel
yield curve shifts and "settling" for an estimate of interest rate risk allows us to use the summary
measures, duration, and convexity. This greatly simplifies the process of estimating the value
impact of overall changes in yield.
The relation between price and yield for a straight coupon bond is negative. An increase in yield
(discount rate) leads to a decrease in the value of a bond. The precise nature of this relationship
for an option-free, 8%, 20-year bond is illustrated in the figure below.
- 14 -
First, note that the price-yield relationship is negatively sloped, so the price falls as the yield rises.
Second, note that the relation follows a curve, not a straight line. Since the curve is convex
(toward the origin) we say that an option-free bond has positive convexity. Because of convexity,
the price of an option-free bond increases more when yields fall than it decreases when yields
rises.
Convexity is a good thing for a bond owner: for a given volatility of yields, price increases are
larger than price decreases. The convexity property is often expressed by saying, "a bond's price
falls at a decreasing rate as yields rise." For the price-yield relationship to be convex, the slope
(rate of decrease) of the curve must be decreasing as we move from left to right [i.e., towards
higher yields).
Note that the duration (interest rate sensitivity) of a bond at any yield is the (absolute value of) the
slope of the price-yield function at that yield. The convexity of the price-yield relation for an
option-free bond can help you remember a result presented earlier, that the duration of a bond is
less at higher market yields.
With a callable or pre-payable debt, the upside price appreciation in response to decreasing
yields is limited (sometimes called price compression). Consider the case of a bond that is
currently callable at 102. The fact that the issuer can call the bond at any time for $ 1,020 per $
1,000 of face value puts an effective upper limit on the value of the bond. As the figure below
illustrates, as yields fall and the price approaches $ 1,020, the price-yield curve rises more slowly
than that of an identical but non-callable bond. When the price begins to rise at a decreasing rate
in response to further decreases in yield, the price-yield curve "bends over" to the left and exhibits
negative convexity.
Thus, in the figure below, so long as yields remain below level y', callable bonds will exhibit
negative convexity; however, at yields above level y', those same callable bonds will exhibit
positive convexity. In other words, at higher yields the value of the call options becomes very
small so that a callable bond will act very much like a non-callable bond. It is only at lower yields
that the callable bond will exhibit negative convexity.
- 15 -
In terms of price sensitivity to interest rate changes, the slope of the price-yield curve at any
particular yield tells the story. Note that as yields fall, the slope of the price-yield curve for the
callable bond decreases, becoming almost zero (flat) at very low yields. This tells us how a call
feature affects price sensitivity to changes in yield. At higher yields, the interest rate risk of a
callable bond is very close or identical to that of a similar option-free bond. At lower yields, the
price volatility of the callable bond will be much lower than that of an identical but noncallable
bond.
The effect of a prepayment option is quite similar to that of a call; at low yields it will lead to
negative convexity and reduce the price volatility (interest rate risk) of the security. Note that
when yields are low and callable and prepayable securities exhibit less interest rate risk,
reinvestment risk rises. At lower yields the probability of a call and the prepayment rate both rise,
increasing the risk of having to reinvest principal repayments at the lower rates.
Duration is described as the ratio of the percentage change in price to change in yield. We know
that the price change in response to rising rates is smaller than the price change in response to
falling rates for option-free bonds. The formula used for calculating the effective duration of a
bond uses the average of the price changes in response to equal increases and decreases in
yield to account for this fact.
The formula for calculating the effective duration of a bond is:
Effective duration
= (bond price when yields fall – bond price when yields rise) / (2 * initial price * change in yield in
decimal form)
=(V_ - V+) / (2 * Vo * ∆y)

Where
V_ = bond value if the yield decreases by ∆y
V+ = bond value if the yield increases by ∆y
Vo = intial bond price
∆y = Change in yield used to get to V_ and V+, expressed in decimal form
So, percentage change in bond price = - effective duration x change in yield in percent
- 16 -
Macaulay duration is an estimate of a bond's interest rat e sensitivity based on the time, in
years, until promised cash flows will arrive. Since a 5-year zero -coupon bond has only one cash
flow five years from today, its Macaulay duration is five. The change in value in response to a 1%
change in yield for a 5-year zero -coupon bond is approximately 5%. A 5-year coupon bond has
some cash flows that arrive earlier than five years from today (the coupons), so its Macaulay
duration is less than five. This is consistent with what was stated earlier: the higher the coupon,
the less the price sensitivity (duration) of a bond. Macaulay duration is the earliest measure of
duration, and because it was based on the time, duration is often stated as years. Because
Macaulay duration is based on the expected cash flows for an option-free bond, it is not an
appropriate estimate of the price sensitivity of bonds with embedded options.
Modified duration is derived from Macaulay duration and offers a slight improvement over
Macaulay duration in that it takes the current YTM into account. Like Macaulay duration, and for
the same reasons, modified duration is not an appropriate measure of interest rate sensitivity for
bonds with embedded options. For option-free bonds, however, effective duration (based on
small changes in YTM) and modified duration will be very similar.
Modified Duration = Macaulay Duration / (1 + periodic Market Yield)
Interpreting Duration
We can interpret duration in three different ways. First, duration is the slope of the price-yield
curve at the bond's current YTM. Mathematically, the slope of the price-yield curve is the first
derivative of the price-yield curve with respect to yield. A second interpretation of duration, as
originally developed by Macaulay, is a weighted average of the time (in years) until each cash
flow will be received. The weights are the proportions of the total bond value that each cash flow
represents. The answer, again, comes in years.
A third interpretation of duration is the approximate percentage change in price for a 1% change
in yield. This interpretation, price sensitivity in response to a change in yield, is the preferred, and
most intuitive, interpretation of duration.
Convexity is a measure of the curvature of the price-yield curve. The more curved the price-yield
relation is, the greater the convexity. A straight line has a convexity of zero. If the price-yield
curve were, in fact, a straight line, the convexity would be zero. The reason we care about
convexity is that the more curved the price-yield relation is, the worse our duration-based
estimates of bond price changes in response to changes in yield are.
As an example, consider an 8%, 20-year Treasury bond priced at $908 so that it has a yield to
maturity of 9%. Calculated effective duration at 9% yield of this bond is 9.42. Figure below
illustrates the differences between actual bond price changes and duration-based estimates of
price changes at different yield levels.
- 17 -
Based on a value of 9.42 for duration, we would estimate the new prices after 1% changes in
yield (to 8% and to 10 %) as 1.0942 X 908 = $993.53 and (1 - 0 .0942) X 908 = $822.47,
respectively. These price estimates are shown in the Figure along the straight line tangent to the
actual price-yield curve. The actual price of the 8% bond at a YTM of 8% is, of course, par value
($ 1,000). Based on a YTM of 10 %, the actual price of the bond is $828.41, about $6 higher than
our duration based estimate of $822.47. Note that price estimates based on duration are less
than the actual prices for both a 1% increase and a 1% decrease in yield.
The Figure illustrates why convexity is important and why estimates of price changes based
solely on duration are inaccurate. If the price-yield relation were a straight line (i.e., if convexity
were zero), duration alone would provide good estimates of bond price changes for changes in
yield of any magnitude. The greater the convexity, the greater the error in price estimates based
solely on duration. A method of incorporating convexity into our estimates of bond price changes
in response to yield changes is the subject of the next LOS.
A Bond's Approximate Percentage Price Change Based on Duration and Convexity

By combining duration and convexity we can obtain a more accurate estimate of the percentage
change in price of a bond, especially for relatively large changes in yield. The formula for
estimating a bond's percentage price change based on its convexity and duration is:
Percentage change in price = duration effect +convexity effect
= {[-duration * (∆y) ] + [ convexity * (∆y)2 ]} * 100

With ∆y entered as a decimal, the "* 100" is necessary to get an answer in percent
There are a few points worth noting here. First, the convexity adjustment is always positive when
convexity is positive because (∆y)2 is always positive. This goes along with the illustration in the
Figure above, which shows that the duration-only based estimate of a bond's price change
suffered from being an underestimate of the percentage in crease in the bond price when yields
fell, and an overestimate of the percentage decrease in the bond price when yields rose. Recall,
that for a callable bond, convexity can be negative at low yields. When convexity is negative, the
convexity adjustment to the duration-only based estimate of the percentage price change will be
negative for both yield increases and yield decreases.
Effective convexity takes into account changes in cash flows due to embedded options, while
modified convexity does not. The difference between modified convexity and effective convexity
mirrors the difference between modified duration and effective duration. Recall that modified
duration is calculated without any adjustment to a bond's cash flows for embedded options. Also
- 18 -
recall that effective duration was appropriate for bonds with embedded options because the
inputs (prices) were calculated under the assumption that the cash flows could vary at different
yields because of the embedded options in the securities. Clearly, effective convexity is the
appropriate measure to use for bonds with embedded options, since it is based on bond values
that incorporate the effect of embedded options on the bond's cash flows.
Discount Margin (DM)

The return earned in addition to the index underlying the floating rate security.
The size of the discount margin depends on the price of the floating rate security. There are three
basic situations:
1. If the price of a floater is equal to par, the investor's discount margin would be equal to the
reset margin.
2. Due to the tendency for bond prices to converge to par as the bond reaches maturity, the
investor can make an additional return over the reset margin if the floating rate bond was priced
at a discount. The additional return plus the reset margin equals the discount margin.
3. Should the floating rate bond be priced above par, the discount margin would equal the
reference rate less the reduced earnings.
The DM is the spread that, when added to the bond's current reference rate, will equate the
bond's cash flows to its current price.
Weighted Average Life (WAL)

The Weighted-Average Life (WAL) of an amortizing loan or amortizing bond is the weighted
average of the times of the principal repayments: it's the average time until a dollar of principal is
repaid.
The time weightings are based on the principal pay downs - the higher the dollar amount, the
more weight that corresponding time period will have. For example, if the majority of the
repayment amount is in 10 years the WAL will be closer to 10 years. Let's say there's an
outstanding bond with five years of $1,000 annual payments. The weighted average life would
be three years, assuming payment is made at the end of each year.
WAL is a measure of credit risk in an amortizing loan, bearing in mind that the main credit risk of
a loan is the risk of loss of principal.
WAL should not be used to calculate interest rate risk, as it only includes the principal payments,
omitting interest payments. Instead, one should use bond duration, which takes the average of all
cash flows.
Pricing a bond
Like any other fixed income security, bonds are valued by calculating the present value of each
cash flow(coupon + maturity payment) from the bond. There really are just two aspects to pricing
a bond: (1) Estimating the cash flows from the bond and (2) Using the correct discount rates to
calculate the PVs of every cash flow.
Estimating the cash flow from a bond can vary from being very straight-forward (like for Treasury
bonds) to very difficult (like mortgage backed bonds) and very uncertain (risky corporate bonds).
So, this can be similar to just some basic formulas in MS Excel to a little sophisticated with
probabilities of default being accounted for and more complex like MBS which have rule based
and trigger-dependent payment of principal and interest.
- 19 -
Another important aspect is to arrive at the discount rates to be used – Which spread to use over
which curve or point on curve.
Here are some benchmarks that exist in the market w.r.t pricing
• High-Yield Bonds: High-yield bonds are usually priced at a nominal yield spread to a
specific on-the-run U.S. Treasury bond. However, sometimes when the credit rating and
outlook of a high-yield bond deteriorates, the bond will start to trade at an actual dollar
price. For example, such a bond trades at $75.875 as opposed to 500 basis points over
the 10-year Treasury.
• Corporate Bonds: A corporate bond is usually priced at a nominal yield spread to a
specific on-the-run U.S. Treasury bond that matches its maturity. For example, 10-year
corporate bonds are priced to the 10-year Treasury.
• Mortgage-Backed Securities: There are many different types of MBS. Many of them trade
at a nominal yield spread at their weighted average life to the U.S. Treasury I-curve(the
interpolated Yield Curve). Some adjustable-rate MBS trade at a DM, others trade at a Z-
spread. Some CMOs trade at a nominal yield spread to a specific Treasury. For example,
a 10-year planned amortization class bond might trade at a nominal yield spread to the
on-the-run 10-year Treasury, or Z-bond might trade at a nominal yield spread to the on-
the-run 30-year Treasury. Because MBS have embedded call options (borrowers have
the free option of prepaying their mortgages), they are frequently evaluated using an
OAS.
• Asset-Backed Securities: ABS frequently trade at a nominal yield spread at their
weighted average life to the swap curve.
• Collateralized Debt Obligations: Like the MBS and ABS that frequently back CDOs, there
are many different pricing benchmarks and yield measures used to price CDOs. The
Eurodollar(early half of a swap curve, for more see “Swap Curve Construction”) curve is
sometimes used as a benchmark. Discount margins are used on floating rate tranches.
OAS calculations are made for relative value analysis.
• Municipal Bonds: Because of the tax advantages of municipal bonds (usually not
taxable), their yields are not as highly correlated with U.S. Treasury yields as other
bonds. Therefore, munis frequently trade on an outright yield to maturity or even a dollar
price. However, a muni's yield as a ratio to a benchmark Treasury yield is sometimes
used as a relative value measure.
References
Glossary
http://www.pimco.com/LeftNav/BondResources/Glossary/A.htm
http://www.ejv.com/bp/html/glossary3.html
Labs
http://www.cba.ua.edu/~rpascala/bond/BondForm.php
Gyaan Temples
http://www.riskglossary.com
http://www.investopedia.com
http://www.yieldcurve.com
http://seekingalpha.com
- 20 -
Structured Finance

Contents
(i) Introduction
(ii) Motivation behind development of SF industry
a. Originator
b. Investor
c. National Economy
(iii) Evolution of Market
a. US
b. Europe
c. India
(iv) Securitization Process
(v) Credit Enhancement
a. Internal
b. External
(vi) Market Participants
(vii) What can be securitized
(viii) Introduction: CMBS, RMBS, CDO.
(ix) Structure: Credit card ABS.
(x) Liability Structure
a. Z-Bonds
b. PAC & TAC Bonds
c. Companion bonds
d. Stripped Mortgage Backed Security
e. Floating rate bonds.
Introduction
A service offered by many large financial institutions for companies with very
unique financing needs which does not match conventional financial products
such as a loan. These tailor-made securities go beyond "standard" securities like
conventional loans, debentures, debt, and equity.
The essence of structured finance is that it takes pools of undifferentiated risks

and parcels them out into debt instruments with different risk profiles. The
efficiency in this process is that it allows different investors with different interests
and risk appetites to purchase exactly the risks they want.
Motivation behind Structured Finance Industry:
Originator:
• Assets are removed from balance sheet increasing the scope for
borrowing, servicing.
• Reduced financing cost by structuring a security of higher credit quality.
• Means of raising public debt without disclosure of information.
• Improved asset liability management by transferring of funding mismatch
risk.
• Credit Worthiness of borrower is not a problem.(If a bank wants to
borrow it can securitize its assets and in such case the creditworthiness
of the bank is not a problem as it is the cash flow from the collateral).
Investors:
• Superior Spread vis-à-vis debt of similar rating.

• Opportunity to diversify portfolio by participating in different asset
classes.
• Mitigation of event risk as high rated ABS are immune from event risk.
National Economy:
• Capital market development due to addition of high quality securities. to

the fixed income market.
• Source of funds for rapidly growing capital constrained banks, finance
and industrial companies
Evolution of Market
US Market:
• The growth of US Structured Finance Industry stems in large part due to

active role of government agencies like Fannie Mae, Ginnie Mae, and
Freddie Mac.
• Ginnie Mae and Fannie Mae have emerged as major operators in the
secondary market and they together purchase roughly half of the
residential Mortgage debt originated in US every year.
European Market:
• Dates back to mid 1980’s with the issuance of MBS IN the UK market.
• Driven by Centralized Mortgage lenders with mortgage capabilities far in
excess of what they could book in their balance sheet.
• Enabling laws and regulations in France, Italy, Spain and Belgium have
been the leading factors in growth of proprietary securitization since early
1990’s.
• One of the most significant regulatory change was in Mat 1998 when
German banks were given authorization to securitize their own loans.
Current Market Size $5 Trillion as of June 30 2006.(Source: Credit Market

Ratings Fitch).
India:
• Although a new concept in India it is gaining ground rapidly.

• Issuance volume in Indian Structured Finance Market was Rs. 269 billion
during 2007.
• ABS is the dominant instrument in the Indian market with issuance of Rs.
234 billion accounting for 64% of the issuance in the first half of this year,
thus remaining the largest product class, while securitization of single
corporate loans, that accounted for 29% also propped up the volume
Issuance Volume in Indian SF Market
400
Value (Rs. billion)
300 Value(Rs.
billion)
200 Number of
transactions
100
0
FY03 FY04 FY05 FY06 FY07
*Source: ICRA Estimates
Year 2003 2004 2005 2006 2007

Issuance 77.7 139.2 308.8 256.5 256.5
Securitization Process
Securitization is a process where financial assets are pooled and packaged into
securities which is further sold to investors.
The Process:
• Pooling and transfer of assets:

A portfolio of asset is pooled and sold to the SPV generally without any
recourse to the issuer. By transferring the assets we delink the credit risk of
the collateral asset pool from the credit risk of the originator. SPV is a special
purpose entity formed for specific purpose of funding the assets and is
bankruptcy remote.
Issuance:
The issuer now sells/issues tradable securities to investors. The proceeds
from the sale are used to pay the Originator.
Tranching:
Liabilities are sliced based on different risk levels, consequently producing
different returns. Together all the tranches make up the deal’s liability
structure.
Credit Enhancement:
Unlike corporate debt the liabilities in a securitized structure are credit
enhanced and the rating of the bonds can surpass the rating of the originator
or the underlying asset pool by creation of a structure that allows it to
There are mainly 2 types of credit enhancement available: Internal and
external.
Internal credit enhancement
o Excess Spread:
Excess spread is the difference between the interest rate received on the
collateral and the coupon paid on the issued security after reducing
servicing and other fees.
So if the coupon paid on the bond is 4% whereas we are receiving 4.5%

from the collateral 0.5% is the excess interest. This will be the first line of
defense against losses as the extra spread will be used to cover losses.
Let us continue with the previous example and assume there were
losses of 0.25 million.
Losses 0.25
Collateral balance 100
Certificate Balance 100
Coupon received 4.49
Coupon to be paid 4
Excess spread 0.49
*All figures are in million
We see that losses of 0.49 million can be covered with excess spread.
o Subordination:
Senior/subordinated (or A/B) structure is a popular type of internal
credit support .It is characterized by a senior (or A) class of securities
and one or more subordinated (B, C, etc.) classes that function as
the protective layers for the A tranche.
The senior classes have first claim on the cash received by the SPV
and in case of default the subordinate classes will be first hit. The
senior tranches remain unaffected till the losses wipe out the entire
subordinate class. This structure of priority of payment is referred as
cash flow waterfall and is deal specific.Also to specify there are
certain triggers in the deal which can disrupt or change the priority.
Example:
Balance
Certificates Rating (in mn) Subordination
Class 1-A Aaa 7.5 25%
Class 1-B Aa+ 1.5 10%
Class M-1 Aa 0.5 5%
Class M-2 Aa- 0.25 3%
Class M-3 A+ 0.25 0%
The subordination level in this structure is 25% and the subordinate
tranches will absorb losses up to 2.5 million (25% of 10 mn).Class M-3 is
the first loss piece.
Exercise:
Balance(in
Certificates Rating mn) Subordination?
Class IA-1 AAA 423,670,000
Class IIA-1 AAA 61,000,000
Class M-1 Aa1 27,654,000
Class M-2 Aa2 25,679,000
Class M-3 Aa3 14,617,000
Class M-4 A1 13,432,000
Class M-5 A2 10,667,000
Class M-6 A3 9,877,000
Class M-7 Baa1 10,667,000
Class M-8 Baa2 7,901,000
Class M-9 Baa3 9,877,000
o Overcollateralization
With this support structure, the face value of the underlying

collateral is larger than the security it backs. Therefore the
assets are more than the liability and this excess acts as a
cushion for tranches against the losses.
Total Certificate Collateral

Balance balance OC Amount
400 mn 410 mn 10 mn
500 mn 460 mn 40 mn
o Reserve funds:
Reserve funds are created to provide credit support to the structure.

They come in two forms: Cash reserve funds and Excess spread.
Cash reserve funds are deposits of cash generated from issuance

proceeds.
Excess spread accounts will have monthly deposits of excess spread

after payment of net coupon, servicing fees and all other expenses.
Example
WAC for mortgage pool 7.75%

Net WAC of bond classes 7.25%
Servicing fee 0.25%
Monthly deposit into reserve account 0.25%
As we have read earlier that excess spread is the first line of credit
support this form of credit enhancement relies on the assumption
that losses are low in the initial years of the deal.
The amount accumulating in the excess spread account can be used

to pay for future losses in the deal. In case the losses are low, the
accumulating excess spread can be deployed in following ways:-
Pay additional Principal to the bonds.

“Excess spread” can be a part of equity and will be released
to the owner of residual tranche.
Mechanism:
The reserve fund has a target level which is defined as percentage of

the outstanding balance. Excess spread will be deposited monthly till
the target level is reached. The required target level will reduce with
time as the bonds pay off. Amounts in excess of target level will be
released each month till the floor is reached. ”Floor” is the minimum
level which will be maintained in the account for the life of the deal.
Example
Floor (in millions) 0.75

Target level 2%
Current Reserve 1.50%
Collateral balance 100
Certificate balance 90
WAC-Collateral 5%
WAC-Bond 4.50%
Servicing fee 0.25%
Excess Spread 0.25%
In this example the current level of reserve is 0.5% short of the target and the
excess spread of 0.25% will be used to fill the reach the target. As the
outstanding balance reduces the excess in the reserve will be disposed as
mentioned above till the reserve reaches 0.75mn after which it will be frozen for
the rest of the deal
External Credit Enhancement
o Letter of Credit
A bank letter of credit is a financial guarantee wherein the issuing bank will
reimburse credit losses up to predetermined amount in return for a fees. Letters
of credit are becoming less common forms of credit enhancement, as much of
their appeal was lost when the rating agencies downgraded the long-term debt of
several LOC-provider banks in the Fixed Income Sectors: Asset-Backed
Securities—6 early 1990s.
o Bond Insurance
It is a guarantee from a monoline insurance company for the timely payment of

principal and interest. They are basically insurance policies which will reimburse
ABS of losses.
o Pool Insurance
Bond insurance cover losses resulting from defaults and foreclosures therefore
additional insurance must be obtained to cover losses from bankruptcy, fraud
and special hazards.
o Interest Rate Swap/Hedge Contracts
To mitigate interest rate mismatch risk, the Trust would use interest rate swaps,
caps, and/or other hedging arrangements. Depending on the nature of the
hedging arrangement and the importance of hedging to the overall structure,
minimum rating requirements of Hedge Counterparties for different acquisitions
of Assets may apply. Appropriate credit quality minimums are enforced for all
hedging arrangements.
Interest rate hedge or swap contracts are entered in to protect the pool structure
from fluctuations in interest rates. For example if the assets in the pool are
floating and the liabilities fixed, a plain vanilla swap would help in hedging against
any increase in interest rate.
Key Market Participants
Originator
Financial
Guarantor Depositor Investors
Senior
Rating Agency SPV
Mezz.
Junior
Servicer
(i)Primary Trustee
(ii)Master
(iii)Special
Roles and Responsibilities
Originator Lends money to borrower secured by a first priority lien, enters

into a mortgage loan purchase agreement to sell the loan to the
securitization depositor.
Depositor An entity set up by the investment bank sponsoring the

securitization purchases commercial mortgage and immediately
sells loans to a trust.
Issuer The trust is the record owner of the commercial mortgage loans,
formed by depositor pursuant to PSA.
Investors Different investors with varying risk appetites purchase certificates

with different ratings.
Trustee Responsible for administering the trust on behalf of and making

payments to the investors.
Primary Responsible for collecting the P&I for a fess generally around .5%
Servicer in return. Maybe the originating mortgage bank, They are in actual
conversation with the borrower and are a lot of times the
originators.
Master Responsible for making sure that the P&I is collected and
Servicer payments made to the investors. Also provides liquidity support.
Special Comes in picture if the assets defaults or becomes delinquent.

Servicer
Rating Rating Agencies evaluate credit risk and deal structure, assess
agency third parties, interact with investors, and issue ratings. The
provision of a structured finance rating by a rating agency can
help to mitigate asymmetric information problems arising in the
creation of a structured finance instrument, for example in
assessing the rules governing the prioritization of cash flows to the
tranches. The rating agencies also collect and assess information
on the performance of the servicer and of other third parties
involved in the transaction.
In rating Structured Finance deals, all three major agencies follow

a two-step process, which applies equally to CDOs as well as
traditional ABSs.
First, analytical models are used to assess pool credit risk,

followed by a detailed structural analysis as the second step. The
latter will crucially depend on deal specifics, as laid out in the
transaction’s documentation, and includes detailed cash flow
modeling based on the results of the credit risk analysis, legal
assessments and evaluations of collateral asset managers and
other third parties involved in the deal.
What can be Securitized
Any asset class with a stable stream of cash flow can in principle be included in
the reference portfolio and securitized. Asset type determines the type and
classification of the ABS structure - ABS, MBS, CDO, etc
Underlying pools can include the following:

1. Aircraft/auto/equipment leases
2. Corporate debt
3. Credit cards
4. Gov't related payments
5. Loans (consumer, home equity, project, student)
6. Project finance/operating income
7. Trade receivables
RMBS,CMBS and CDO structures will be covered in the next sections. Now we
will look at credit card securitizations. Will briefly look at each of these
transactions:-
• CMBS
Commercial mortgage-backed securities (CMBS) are a type of bond commonly

issued in US security markets. They are a type of mortgage-backed security
backed by mortgages on commercial real estate. CMBS issues are usually
structured as multiple tranches, similar to CMOs, rather than typical residential
"passthroughs."
In a CMBS transaction, many single mortgage loans of varying size, property

type and location are pooled and transferred to a trust. The trust issues a series
of bonds that may vary in yield, duration and payment priority. Nationally
recognized rating agencies then assign credit ratings to the various bond classes
ranging from investment grade (AAA/Aaa through BBB-/Baa3) to below
investment grade (BB+/Ba1 through B-/B3) and an unrated class which is
subordinate to the lowest rated bond class.
Investors choose which CMBS bonds to purchase based on the level of credit
risk/yield/duration that they seek. Each month the interest received from all of the
pooled loans is paid to the investors, starting with those investors holding the
highest rated bonds, until all accrued interest on those bonds is paid. Then
interest is paid to the holders of the next highest rated bonds and so on. The
same thing occurs with principal as payments are received. If there is a shortfall
in contractual loan payments from the Borrowers or if loan collateral is liquidated
and does not generate sufficient proceeds to meet payments on all bond classes,
the investors in the most subordinate bond class will incur a loss with further
losses impacting more senior classes in reverse order of priority.
• RMBS
Residential mortgage-backed securities (RMBS) are a type of bond commonly

issued in US security market. It is a type of security whose cash flows come from
residential debt such as mortgages, home-equity loans and subprime mortgages.
This is a type of mortgage-backed securities that focuses on residential instead
of commercial debt. Holders of an RMBS receive interest and principal payments
that come from the holders of the residential debt.
• CDO
Collateralized debt obligations (CDOs) are a type of asset-backed security and

structured credit product. CDOs are constructed from a portfolio of fixed-income
assets. These assets are divided into different tranches: senior tranches (rated
AAA), mezzanine tranches (AA to BB), and equity tranches (unrated).
One important distinction is that between static and managed deals. With the
former, collateral is fixed through the life of the CDO. With a managed CDO, a
portfolio manager is appointed to actively manage the collateral of the CDO. The
life of a managed deal can be divided into three phases:
o Ramp-up lasts about a year, during which the portfolio manager

initially invests the proceeds from sales of the CDO's securities.
o The reinvestment or revolver period lasts five or more years. The
manager actively manages the CDO's collateral, reinvesting cash
flows as well as buying and selling assets.
o In the final period, collateral matures or is sold. Investors are paid off.
CDO is a broad term that can refer to several different types of products. They
can be categorized in several ways. The primary classifications are as follows:
o Source of funds -- cash flow vs. market value
Cash flow CDOs pay interest and principal to tranche holders using the
cash flows produced by the CDO's assets. Cash flow CDOs focus
primarily on managing the credit quality of the underlying portfolio.
Market value CDOs attempt to enhance investor returns through the

more frequent trading and profitable sale of collateral assets. The CDO
asset manager seeks to realize capital gains on the assets in the CDO's
portfolio. There is greater focus on the changes in market value of the
CDO's assets. Market value CDOs are longer-established, but less
common than cash flow CDOs.
o Motivation -- arbitrage vs. balance sheet

Arbitrage transactions (cash flow and market value) attempt to capture
for equity investors the spread between the relatively high yielding assets
and the lower yielding liabilities represented by the rated bonds. The
majority, 86%, of CDOs are arbitrage-motivated.
Balance sheet transactions, by contrast, are primarily motivated by the

issuing institutions’ desire to remove loans and other assets from their
balance sheets, to reduce their regulatory capital requirements and
improve their return on risk capital. A bank may wish to offload the credit
risk in order to reduce its balance sheet's credit risk.
o Funding -- cash vs. synthetic
Cash CDOs involve a portfolio of cash assets, such as loans, corporate

bonds, asset-backed securities or mortgage-backed securities.
Ownership of the assets is transferred to the SPV issuing the CDO's
tranches. The risk of loss on the assets is divided among tranches in
reverse order of seniority. Cash CDO issuance exceeded $400 billion in
2006.
Synthetic CDOs do not own cash assets like bonds or loans. Instead,
synthetic CDOs gain credit exposure to a portfolio of fixed income assets
without owning those assets through the use of credit default swaps, a
derivatives instrument.
Credit Card ABS: Structure
The typical setup has three different cash flow periods: revolving, controlled
amortization (in some cases, accumulation), and early amortization. This
structure is designed to mimic a traditional bond, in which interest payments are
made every month and principal is paid in a single “bullet” payment on the
maturity date.
In addition to issuing investor securities, every seller is required to maintain an

ownership interest in the trust. This participation performs several critical
functions.
• It acts as a buffer to absorb seasonal fluctuations in credit card
receivables balance,
• is allocated all dilutions (balances canceled due to returned
goods)and fraudulently generated receivables that have been
transferred to the trust,
• and ensures that the seller will maintain the credit quality of the
pool since the seller owns a portion of it.
Regardless of whether the trust is a stand-alone or a master trust, the same

general structure is used for every deal. The typical setup has three different
cash flow periods: revolving, controlled amortization (in some cases, controlled
accumulation), and early amortization. Each period performs a different function
and allocates cash flows differently.
This structure is designed to mimic a traditional bond, in which interest payments
are made every month and principal is paid in a single “bullet” payment on the
maturity date.
All collections on the receivables are split into finance charge income and
principal payments.
Finance charges are used to pay the investor coupon and servicing expenses
fees, as well as to cover any receivables that have been charged off in the
month. Any income remaining after paying these is usually called excess spread
and is released to the seller.
o Revolving Period
During the revolving period, monthly principal collections are used to purchase
new receivables generated in the designated accounts or to purchase a portion
of the seller’s participation if there are no new receivables. If there are not
enough new receivables to reinvest
in, an early amortization will be triggered because the seller’s participation has
fallen below the required minimum, or, in some cases, the excess principal
collections will be deposited in an excess funding account and held until the
seller can generate more credit card
receivables
o Controlled Amortization/Accumulation
In the case of controlled amortization), which typically runs for

12 months, principal collections are no longer reinvested but are paid to investors
in 12 equal controlled amortization payments.
o Controlled accumulation
It follows a similar procedure, except that the controlled payments are deposited
into a trust account, or principal funding account (PFA), every month and held
until the expected maturity date on which the investors will be paid the full
amount.
o Early Amortization
Severe asset deterioration, problems with the seller or servicer, or certain legal
troubles can trigger early amortization at any point in the deal, whether it is
revolving, amortizing, or accumulating.
• Common amortization triggers are:
Seller/Servicer
1. Failure or inability to make required deposits or payments.
2. Failure or inability to transfer receivables to the trust when necessary.
3. False representations or warranties that remains un-remedied.
4. Certain events of default, bankruptcy, insolvency, or receivership of seller or
servicer.
Legal
1.Trust becomes classified as an “investment company” under the Investment

Company Act of 1940.
Performance
1. Three -month average of excess spread falls below zero.

2. Seller’s participation falls below the required level.
3. Portfolio principal balance falls below the invested amount.
Liability Structure
• Z Bonds-
Z tranches (also known as Accretion Bonds or Accrual Bonds) are structured

so that they pay no interest until the lockout period ends and they begin to
pay principal. Instead, a Z-tranche is credited "accrued interest" and the face
amount of the bond is increased at the stated coupon rate on each payment
date. During the accrual period the principal amount outstanding increases at
a compounded rate and the investor does not face the risk of reinvesting at
lower rates if market yields decline. Typical Z-tranches are structured as the
last tranche in a series of sequential or PAC mad companion tranches and
have average lives of 18 to 22 years. However, Z-tranches can be structured
with intermediate-term average lives as well. After the earlier bonds in the
series have been retired, the Z-tranche holders start receiving cash
payments that include both principal and interest.
• PAC & TAC Bonds-
o They are type of CMO bonds.

o PAC Bonds are designed to eliminate prepayment risk by
transferring the risk to other bonds in CMO.
o They offer fixed principal redemption as long as prepayments on
the underlying collateral remains under fixed PSA.
o The bonds to which the risk is transferred is called support or
companion bond.
PAC Bond Redemption Schedule

Exhibit 2
o PSA
Public Securities Association Convention accounts for ageing or seasoning
pattern observed in MBS (New loans have lesser prepayment rates which
increases with the age of the loan)
A pool is said to have 100% PSA if its CPR starts at 0 and increases by 0.2%
each month until it reaches 6% in month 30. It is a constant 6% after that. A PSA
of 50% indicates CPRs that are half those of 100% PSA. A PSA of 150%
indicates CPRs that are one-and-a-half those of 100% PSA.
PSA Illustrated
Exhibit 1
TAC Bonds-They are same as they the PAC Bonds except that they
offer one sided protection and shield investors from higher interest
rates up to a specified PSA.
• Floating Rate bonds-

o Floating CMO Bonds are bonds whose coupon is reset monthly
at a spread above the index.
o To ensure that the coupon income from collateral is sufficient to
make collateral payments floater is combined with an inverse
floater.
o A floater is a fixed income instrument whose coupon fluctuates
with some designated reference rate whereas for Inverse floater
coupon rates move inversely with the index.
• Stripped Mortgage Backed Security-

o Created by dividing cash flow from different mortgage security
and allocating specified percentages of principal and Interest to
specified strips.
o Most common examples are IO and PO STRIPS.
• Companion Tranches-
Every, CMO that has PAC or TAC tranches in it will also have companion
tranches (sometimes called support bonds), which absorb the prepayment
variability that is removed from the PAC and TAC tranches. Once the
principal is paid to the active PAC and TAC tranches according to the
schedule, the remaining excess or shortfall is reflected in payments to the
active companion tranche. The average life of a companion tranche may vary
widely, increasing when interest rates rise and decreasing when rates fall. To
compensate for this variability, companion tranches offer the potential for
higher expected yields when prepayments remain close to the rate assumed
at purchase.
Prepayments:
Prepayments are the primary feature that differentiates the MBS market from
other fixed income sectors. A prepayment is the early repayment of mortgage
principal that results from the sale of a home, or the refinancing or partial
principal pay down (curtailment) of an existing mortgage.
Prepayment Convention
o Single Month Mortality (SMM): This refers to the prepayment rate for a
month and forms the basis for all prepayment calculations. The SMM is
the fraction of the beginning month balance that prepays during the
month. By convention the scheduled principal is subtracted from balance
before calculating the prepayment rate.
o Conditional Prepayment Rate is the annualized version of the SMM.It is

the cumulative prepayment rate over 12 months given the same SMM
each month.
SMM= 1- (1-CPR) ^12
o PSA
Public Securities Association Convention accounts for ageing or seasoning
pattern observed in MBS (New loans have lesser prepayment rates which
increases with the age of the loan)
A pool is said to have 100% PSA if its CPR starts at 0 and increases by 0.2%
each month until it reaches 6% in month 30. It is a constant 6% after that. A PSA
of 50% indicates CPR’s that are half those of 100% PSA. A PSA of 150%
indicates CPR’s that are one-and-a-half those of 100% PSA.
PSA Illustrated
Exhibit 1
Factors affecting Prepayment:
Two major factors affecting prepayments are Housing Turnover and Refinancing
• Housing Turnover:
Sale of a home typically lead to an attached mortgage being paid off. Therefore
turnover rate of existing home will n will determine Housing Turnover in effect
depends on a number of factors.
o Overall Turnover Rate

Overall Turnover rate is the total number of houses sold. It is important for us
to know the number of existing houses sold which are not assumable and are
mortgaged.
o Seasonal Variation in Home Sales: Seasonal highs occur in

summers and lows in winters.
o Relative Mobility-Overall Turnover rate depends upon the type of

loan. Balloon discounts prepay faster than conventional discounts.
o Seasoning: Seasoning refers to gradual increase in prepayment

speeds on a pool of new mortgages till it reaches a steady level.
• Refinancing
Refinancing occurs when borrowers take out new mortgages (at lower rates) and
pay off existing ones.
Since most U. S. residential mortgages do not carry a prepayment penalty ,

refinancing decision primarily depends upon change in Interest rates. As
mortgage rates decline, a homeowner may choose to refinance his existing
mortgage with a lower rate mortgage.
The size of the refinancing incentive, combined with the borrower's ability to be
approved for a new mortgage (reflecting home price appreciation and the
borrower's credit situation) affect the likelihood of prepayments from refinancing.
Risks associated with Prepayment:
o Contraction Risk: When mortgage rates decline, prepayments on a MBS

will increase and can surpass the estimated levels. This will reduce the
average life. The disadvantage to the investor is that the funds received
from prepayments will have to be reinvested at lower rates. This
reinvestment risk arising due to shortening of average life is referred to
as contraction risk.
o Extension Risk- Now in case when interest rates rise, the prepayment
can slow down and fall below the expected levels. This will result in
increase in average life of MBS. The investors are affected since their
money is locked at lower interest rates for longer duration.
Due to prepayments at lower interest rates, bonds show negative convexity

(price can tend to fall at lower yields) – this is akin to a callable bond – therefore
MBS bonds are looked at option embedded bonds. This is one more reason that
the OAS(Option adjusted spread) approach is used to price/compare bonds.
Residential Mortgage Backed
Securities (RMBS)

Contents
(i) Overview
(ii) Definition
(iii) RMBS Structure
a. “I” Structure
b. “Y” Structure
c. “H” Structure
(iv) Cash Flow of RMBS (Waterfall)
(v) Priorities of Payment
a. Interest Payment
b. Principal Payment
(vi) Credit Enhancement
Forms of Credit Enhancement
i. External
ii. Internal
a. Excess Spread
b. Overcollateralization
c. Available Fund Cap
d. Subordination/Credit Tranching
(vii) Step-down and Trigger Test
(viii) Advantages of RMBS Structure
a. Advantages of Originator
b. Principal Payment
(ix) Risk associated with RMBS
a. Prepayment Risk
b. Extension Risk
(x) Other Important features
Overview:
From its inception in the early 1990s, the Home Equity Loan (HEL) market has experienced a
dramatic evolution from a market predominantly representing second lien loans to prime
borrowers to first line loans to credit impaired borrowers, including a wide variety of loan types, for
example, fixed rate, hybrid adjustable rate and interest only loans. As lending practices evolved
and investor acceptance of the product grew, the structure used to securitize loans in this sector
also evolved. The earliest securitization employed financial guarantee from third-party Wrap
providers. By the mid 1990s, the structure evolved to employ senior/subordinate tranching of
credit risk, seller-paid mortgage insurance or deep mortgage insurance (MI) and Net Interest
margin (NIM) transaction to monetize front end residuals.
Recently, the advent of both single-name CDS and the ABX.HE credit index have increased
notional trading volume and allowed investors to express directional opinions (long or short)
regarding issuer originations and servicing practices, relative vintage performance and capital
structure arbitrage.
RMBS Market Overview:

The consumer asset –backed securities (ABS) market consists of securities backed by pool of
assets such as credit card receivables, auto loans and leases, student loans and Home Equity
Loans (HELs). The largest sector of the ABS market is the HEL market, which has evolved from
securitizations of traditional second lien mortgages to prime borrowers in early 1990s to include
several different types of mortgage products to credit impaired borrowers.
The HEL sector has experienced outstanding growth, especially over the years till 2006. Growth
in this sector was largely driven by following:
• The historically low mortgage rates that prevailed over the period;
• Unprecedented home price appreciation;
• Increased consumer leverage;
• Greater investor acceptance of nontraditional mortgage products; and
• Demand for mortgage credit exposure in the form of deeper subordination
Home Equity Issuance, 1996 through September 2006
The origins of the residential ABS market lie in the development of non-agency mortgage market
in the mid- to late 1980s. Many of the mortgage loans made by lenders exceed the Agency
(FNMA and FHLMC) underwriting guidelines, typically by either original loan balance or
underwriting criteria. The non-conforming product encompassed Jumbo-A and Alternative- A (Alt-
A loans to prime borrowers). The non-conforming market developed as a means to securitize
these loans and generally made use of internal credit enhancement via senior/subordinate
structure used in Residential ABS Market today.
Because the earliest residential ABS securitizations were collateralized by second lien loans to
prime borrowers, the sector earned the name Home Equity Loan (HEL) ABS. During the early to
mid – 1990s, monoline lenders extend the second lien lending practice to subprime and non-
prime borrowers, assuming the first lien position when financing a subprime borrowers to his or
her limit.
Today, cash-out refinance loans still dominate the collateral backing of most residential ABS
transactions. These loans allow borrowers to access the equity in their homes to consolidate
debts, lower their monthly payments, finance home improvements, pay for education or purchase
consumer durables. The loans may be fixed, adjustable rates (2/28, 3/27 or 5/25 hybrid ARMs) or
interest-only loan structures.
RMBS Defined:
According to investopedia.com:
A type of security, whose cash flows come from residential debt such as mortgages, home-equity
loans and subprime mortgages. This is a type of mortgage-backed securities that focuses
on residential instead of commercial debt.
According to “The Handbook of Fixed Income Securities” by Frank J. Fabozzi:

A residential mortgage backed securities is an instrument whose cash flow depends on the cash
flows of underlying pool of residential mortgages.
In essence, The RMBS comprises a large amount of pooled residential mortgages. When you
invest in a mortgage-backed security you are lending money to a homebuyer or business. An
MBS is a way for a smaller regional bank to lend mortgages to its customers without having to
worry if the customers have the assets to cover the loan. Instead, the bank acts as a middleman
between the homebuyer and the investment markets.
A Basic RMBS Structure:
MBS - The Unresolved Issues

Borrowers
Withholding taxes on Trustees
interest payments Investors
Diversified Investors
Insurance Company
SPV Banks
Limited Company Trusts
Seller & (Pass Through Vehicle) Pension Funds
Nature of Instrument Mutual Funds
Servicer FII
System and Process
Under-writing standards
Portfolio Performance Credit
(History) Enhancement
Documentation Market Listing
Stamp Cost on transfer Role for Banks, Recognised
MIS / Accounting Standard Insurance companies, Maker as security
Specialised Agency Role for Disclosure
specialised Standards
. Rating agency
Agency
Three Typical RMBS deal Structure type:

• “I” Simple and Straight Forward
• “Y” Most Popular
• “H” Like two “I” structure combined.
Illustration of “I” Structure (eg. Countrywide 2002-1)
o In this structure, all collateral together support senior and subordinate bonds.
Illustration of “Y” Structure (as in Ameriquest 2005-R5)
o Here senior bonds are backed by separate collateral groups, but the sub bonds are
backed by all collaterals.
o Collateral groups could be separated by coupon type (Fixed/ARM) or loan size
(conforming/non-conforming). To facilitate the purchase of senior bonds by GSEs (eg
Fannie and Freddie), the second separation has become dominant in recent vintages.
o Most .Y. structures blend fixed and ARM loans. Typically ARM loans represent about 80%
of total loans.
Illustration of “H” Structure (as in Countrywide 2005-4)
o Both senior and sub bonds are backed by separate collateral groups (mostly by fixed and
ARM).
o Used to be fairly common, but less so today.
Typical Cash Flow Waterfall of RMBS Deal:
Priority of Payments explained:
• In order to understand home equity structures, it is important to understand the priority of

payments across the various bonds in the capital structure.
• The two priorities of payment flavors can be referred to as Interest-Principal (IPIP) or
Interest-interest or IIPP.
• In the IIPP structure, Interest is paid to all bonds before principal is paid to senior bonds.
This IIPP structure is most common in subprime deals. This structural feature ensures
that all bonds will receive timely payment of interest.
Interest Payment
o Most home equity bonds are floaters. The bond coupon rate is the sum of index rate
(mostly 1-mo. LIBOR) and bond margin. Bond coupon rates are adjusted every
month based on the corresponding change in the index rate.
o Actual bond interest payments may be lower than what we expect from bond coupon
rate. In this scenario, there is an interest shortfall for this bond.
o Interest shortfall could be caused by two reasons:
Credit Related: Credit related shortfalls result from high delinquencies. Due to
large amount of excess spread and servicer advances, credit related shortfalls
are extremely rare.
Available Fund Cap (AFC): Bond payment is subject to the limit of collateral
interest received (will be discussed in detail later).
o AFC interest shortfall can be repaid in future months when excess spread is available
after paying collateral losses and building up overcollateralization to target. Interest
rate swaps and caps also help reduce the cap risk.
o Servicer Advances: In nearly all home equity deals, servicers are required to advance
delinquent principal and interest to the extent that such advance is recoverable.
Servicers can recover advances from future collateral cash flow and therefore
advances aren’t considered credit support, but rather act to improve deal liquidity.
Principal Payment
o All collateral principal payments (scheduled or prepaid) will be allocated to senior
bonds until the step-down date.
o After the step-down date, all bonds start receiving principals if collateral performance
based trigger tests are passed.
o Principal can be allocated to a bond as long as the more senior bond has at least 2X
the original credit support.
o Losses that exceed available credit support will result in a write down or reduction in
bond balance.
Credit Enhancement: An Important aspect of (‘R)MBS Transactions
A common feature of all types of securitization transactions is the use of credit enhancement, i.e.
a cushion put in place to protect investors against expected losses. The credit enhancement is
sized to reflect an expected loss level determined under a series of adverse scenarios that could
affect the asset pool during its life.
The credit enhancement for a specific deal is usually a combination of several forms of credit
enhancement mechanisms and is a reflection of the specific characteristics of the securitized
assets, the goals of the securitization sponsor and the requirements of the rating agencies.
Credit enhancement is normally sized by the rating agencies to help attain the desired ratings for
the securitization notes. Senior asset-backed notes are usually assigned the highest rating (triple-
A). Internal or external credit enhancement for asset-backed notes is typically complemented with
structural investor protection built into the securitization transaction.
The credit enhancement and the other structural enhancements should amongst them address
most of the adverse eventualities that could affect the asset pool and the securitization bonds.
Along with the legal protections they help create bonds which are fundamentally different and
more resilient than other fixed income instruments.
Forms of Credit Enhancement (CE)

Forms of Credit Enhancement
❏ External - provided by an outside party
➢ Bank letter of credit
➢ Insurance company surety bond
➢ Financial assurance company guarantee
➢ Subordinated loans from third party
❏ Internal - provided by originator or within the deal structure
➢ Reserve account/refunded or build up from excess
spread
➢ Originators guarantee
➢ Senior-subordinated structure
➢ Excess spread
➢ Overcollateralization
➢ Minimum required debt service coverage ratio (DSCR)
❏ Trigger events
One of the most essential elements in structuring an asset-backed security is establishing

adequate credit enhancement levels. The role of credit enhancement is to bridge the credit quality
of the assets, which may be B or BB, to the level of the desired rating of the asset-backed
security, generally AAA. The credit enhancement is sized to absorb the expected losses that the
pool could experience during the life of the asset-backed security, down to a residual level
corresponding with the expected losses under the required rating level.
The credit enhancement can be structured in a number of different ways.
External - Provided by an Outside Party

In the earlier stages of the development of the asset-backed market, the external
credit enhancement prevailed. It is called external because it is provided by an outside
party, a bank opening a letter of credit (LOC) or an insurance company and a monoline
insurer providing a surety bond, or a company giving some other form of guarantee. It
would also take the form of a loan provided by a third party and subordinated to the
senior asset-backed bonds sold to investors.
However, it is important to remember that in the case of external credit
enhancement, the rating of the security has a direct link with the rating of the credit
enhancer, whether it is a bank providing an LOC or an insurance company providing a
surety bond. Any rating downgrade, any bad news, any volatility in the quality or
performance of the respective credit enhancer will have a direct impact on the
performance or the rating of the insured securitization bond.
Internal - Provided by Originator or Within the Deal Structure

As the market developed, a new type of credit enhancement emerged. This credit support
is provided within the structure by the originator or through mechanisms internal to the
deal structure (subordination, overcollateralization, etc). The originator for instance, could
provide some kind of a corporate guarantee for the asset-backed securities issued. Such
a guarantee is typically attached to the most junior tranches of an asset-backed security
for the purposes of improving their rating and improving their distribution in the market
place.
Discussed below are some important and common tools to create Credit Enhancement in
a transaction.
Excess spread (XS)
Overcollateralization (OC)
Available Fund Cap (AFC)
Subordination/Credit tranching
Excess spread (XS)

• Excess spread is the difference between collateral interest received and interest
payment to investors.
• Excess spread is the first layer of credit enhancement. How is Excess Spread
Distributed?
• Given the relatively high collateral coupon in home equity deals, excess spread is
an important part of credit enhancement.
What Determines the Size of Excess Spread?
• Structural
o ARM Percentage: The higher the percentage of ARM loans the lower the
risk of excess spread. This is due to the fact that a rise in interest rate will
result in a higher coupon on both the collateral and the bond.
o Expenses: The higher the expenses of a transaction the lower the
excess spread. Servicing fee is the biggest portion of expenses in most
subprime home equity deals.
o Swaps/Caps: Swaps and caps have been used increasingly in recent
years to reduce the basis risk associated with subprime deals (will
discuss it later in details).
o Hybrid ARM Mix: Most subprime bonds reset monthly to 1 Mo Libor
while most loans are fixed for 2 or 3 years and then become floating.
During this initial fixed period, increases in Libor will reduce excess
spread.
• Performance
o Prepayments: The value of excess spread is a function of the
outstanding balance of the loans. So faster prepays will reduce the value
of excess spread since the balance of the loans are reduced.
o Losses: The higher the amount of losses the lower the amount of excess
spread. In addition, losses that occur earlier have more excess to offset
losses. So both the magnitude and timing of losses impact the value of
excess spread.
Overcollateralization (OC)
• Overcollateralization (OC) is the difference between collateral and bond
balances.
• OC is the second layer of credit enhancement after excess spread.
• Each deal has specific OC target (about the 1.0%-4.0% of original loan balance
at deal issuance).
• As with other subordinate bonds, after the stepdown date, the required OC
amount can be reduced to 2x the original %. Eg if original target was 4% of
original balance, after stepdown, the target OC will equal 8% of current balance.
OC in any deal can be created in two ways. Either it can be fully funded at the
time of origination/closing or can be built over a period of time to the targeted
amount. In the latter, OC is gradually built up as excess spread is used to pay off
the senior bonds first before paying to the residual holders. Once the initial target
ids reached, the future deficiency in OC will be covered by using available excess
spread to pay of senior debts.
Available Fund Cap (AFC)

• Home equity bond interest payment is subject to the cap set by the collateral net
WAC.
• Net WAC is equal to gross WAC minus servicing fee, trustee fee, MI premium
and other expenses.
• Rating agencies don’t consider AFC risk as part of rating. In other words, rating
agencies are rating the coupon up to capped rate.
• Several factors cause the AFC risk
o Mismatch between deal assets and liabilities: fixed rate loans back floating
bonds
o ARM loans have 2- to 3-yr initial fixed rate periods during which the loan
rates don’t change.
o Even after entering into the floating rate period, ARM loans reset every six
months but bond coupon always change every month
o Slight index mismatch: ARM loans use 6-mon LIBOR as index and bonds use
1-mon LIBOR
o ARM coupon resets are subject to initial reset cap, periodic cap and lifetime
caps.
• Cap shortfalls may be carried forward and paid to investors at a later time.
• Swaps and cap derivates are often included in home equity deals and help
reduce AFC risk.
Subordination or ‘credit-tranching’,
It means that the cash flows generated by the assets are allocated with different priority to
the different classes of notes in order of their seniority. In case of subordination, the face
value of the bonds is equal to the value of the assets. The subordinate structures are
known as a senior/subordinated structure, or also as a senior/mezzanine/subordinated
structure. In a simple senior/subordinated structure the senior tranche is usually rated
AAA and it receives the cash flow generated by the assets first, for the purposes of
interest and principal payment while the subordinated piece (also called equity piece),
receives cash flows second and absorbs the losses first. The priority of the cash flow
distribution comes from the top, waterfall like, while the distribution of the losses rises
from the bottom.
Another form of internal credit enhancement is the requirement that the cash flows
generated by the assets over a specified period of time exceed the debt service requirement of
the bonds over the same period by a predetermined factor. The minimum required debt service
coverage ratio (DSCR) it that factor. The revenue from the assets must exceed the debt service
several times, thus allowing for monitoring performance and applying excess debt service to
accelerate bond amortization in case of adverse events affecting the transaction.
Step-down and Trigger Test

• Step Down Date: The date after which subordinate bonds can receive principal
payments.
• Deals are eligible to step down at the earlier of Month 37 or when all senior bonds
are paid off
• But step-down can happen only when performance-based trigger tests are
passed.
• All deals have delinquency trigger and recent vintages also have cumulative loss
trigger.
• Both trigger tests must be passed for a deal to step down.
• Trigger values could be dynamic, where the target values change as deals
season.
Cash Flow Impact of Trigger Test

o If a trigger fails, all principal goes to senior most bondholders.
o Triggers are evaluated every month after the step down. Triggers may
initially pass the test and vice-versa.
o If trigger tests pass and deals step down, a big portion of principal will be
distributed to the junior bonds and residual/OC holder.
o If trigger tests fail, senior bonds receive all principal payments.
o Failing triggers reduces average life of senior bonds and lengthens
subordinated bonds.
o Failing triggers results in more credit enhancement being retained in the
deals.
o Most home equity bonds are priced assuming triggers pass.
o Recent triggers structures and strong deal performance has resulted in
most triggers passing for recent vintages.
Advantages of RMBS Structures
The object of all transactions is
• The reduction of the credit risks connected with the assets, either through the
disposal or guarantee of the assets,
• The virtual elimination of originator risk and
• In the case of funded or "true sale" transactions an increase in liquidity in the near
term.
Advantages for the Originator

• Reduction in assets on balance sheet and improvement in key ratios such as
ROE, potentially leading to improvements in credit rating / quality classifications
• Portfolio management tool based on the transfer of asset credit risk to an SPC or
hrough risk coverage
• Possible lower borrowing costs versus conventional financings, especially if costs
of capital can be saved
• Higher leverage using receivables for corporate financing purposes
• Decreased reliance on the bank market and the general corporate debt capacity
through an additional financing source which can be used opportunistically
• Diversification of the investor base, for example, away from shareholders and
corporate bond investors
• Increased liquidity creating capacity for new business or investments
• Anonymous market access available to the receivables originator through ABCP
multi-seller programmes
• In Germany, (possibly) trade tax advantages in cases where the so-called
permanent debt problem can be avoided
Advantages for Investors

• Relative value pick-up compared to corporate bonds in same rating category
• For rated paper, thorough review and ongoing surveillance from experienced
rating agencies
• Especially in higher rated instruments, excellent and stable asset quality and
good reputation of the transaction participants
• Higher yield potential for investors with tolerance for higher risk, innovative
structures or more exotic assets
• High investor demand and improving secondary market liquidity
• Possibility for indirect participation in targeted pools via a professional external
asset manager
• Targeted construction of better risk diversification in own portfolio
Risks associated with RMBS:
Prepayment risk
• Prepayment risk is the risk that homeowners will pay off more than their required
monthly mortgage payments.
• Prepayment is usually precipitated by a decline in interest rates.
• As prepayments occur, the amount of principal retained in the bond declines
faster than what otherwise may be expected-thereby shortening the average life
of the bond by returning principal prematurely to the bondholder, potentially at a
time when interest rates are low.
Extension risk
• Extension risk is the risk that homeowners will decide not to make prepayments
on their mortgages to the extent initially expected-instead they make only the
required monthly payment.
• Extension can be the result of an increase in interest rates-as rates rise, there is
little incentive to refinance.
• As the prepayments that were expected do not materialize, the average length of
term (average life) originally estimated begins to creep out further along the
curve, resulting in a security that is lengthier in term.
Other Important Features of RMBS Deals:

• The heart of an RMBS structure is a “bankruptcy remote special purpose vehicle
(SPV)” - usually a trust but may be a company
• An RMBS transaction involves the sale of residential mortgages to an SPV
funded through an issue of rated and, occasionally, unrated bonds
• The capacity of an SPV to meet its obligations on the bonds relies heavily on the
cash flows from the underlying residential mortgages
• Losses and late payments on the residential mortgages affect the ability of an
SPV to meet its obligations on the bonds
• Credit enhancements, liquidity support, and other structural features are
incorporated into RMBS transactions to cover income and cash flow shortfalls
Credit enhancements cover losses on the underlying residential mortgages
• Liquidity support covers timing differences between cash flows on the residential
mortgages and payment obligations on the bonds
• Interest rate swaps hedge the basis risk between the yield on fixed rate
residential mortgages and the floating rate coupon on the bonds
• Currency swaps hedge the A$ cash flows on the residential mortgage loans and
the payments on non-A$ denominated bonds
Commercial Mortgage
Backed Securities
Contents
i. Introduction
ii. Types of CMBS
iii. CMBS market
a) Overview of Global Market
iv. Property Type of CMBS
a) Residential and Non Residential Properties
v. CMBS transactions overview
a) Deal structure in CMBS
vi. Credit Enhancement in CMBS
a) External and internal CE
b) Loss Position
vii. Structural Issues in CMBS
viii. Waterfall Mechanism
ix. Interest Type and tranche type in CMBS
x. CMBS Investor Motivation & Issues
xi. Some Definitions
Introduction of CMBS
In very simple way we can define CMBS as
1. Commercial Mortgage Backed Securities (“CMBS”) are bonds, sold through

the capital markets, the
payments on which are backed by mortgage loans, which in turn
are backed by cash flows from commercial properties
2. CMBS market allows participants to gain exposure
to commercial property through the liquid capital markets
3. The bonds issued are usually split into separate
tranches, each with its own risk profile
4. The tranches are typically rated by one or more credit rating agencies
5. CMBS are a segment of structured finance markets like RMBS, ABS, and
CDOs etc.
Types of CMBS
There are mainly five types of CMBS as mentioned below
1. Credit Tenant Lease Transactions

2. Single Borrower – Single Property
3. Single Borrower – Multiple Properties
4. Multiple Borrowers – Multiple Properties
5. Synthetic CMBS Transactions
If we will look the Global network we have different types of CMBS like in
Australia we have two types of CMBS
1. Small ticket multi-borrower

2. Large ticket single-borrower
CMBS Market Overview
An Overview of world wide CMBS
Year-to-date volume ($Bil.) US CMBS BREAKDOWN (Year to Date)

2008 2007 ($Bil.) (%)
US 8.8 65.9 Fusion 7.3 84%
Non-US 4.9 24.4 Single Borrower 1.4 16%
TOTAL 13.7 90.4 TOTAL 8.8 100%
REIT Financings
Year-to-date volume ($Bil.)
2008 2007
Unsec. Notes 0.0 3.6
MTN 0.0 0.2
TOTAL 0.0 3.8
Spread (Basis Points)

Fixed Rate Avg. Week 52-wk
(Conduit) Life 16-Apr Earlier Avg.
5 S+275 S+320 119
AAA 10 S+275 S+289 115
AA 10 S+800 S+825 274
A 10 S+1,000 S+1,100 375
BBB 10 T+1,571 T+1,565 687
BB 10 T+2,100 T+2,000 870
B 10 T+2,500 T+2,200 1,221
Floating Rate (Large-loan)
AAA 5 L+275 L+275 83
AA 5 L+400 L+400 136
A 5 L+500 L+500 191
BBB 5 L+650 L+650 299
CMBS total return

Total Return (%)
Avg. Month Year Since

As of 4/16 Life To Date to Date 1/1/1997
Inv.-grade 6 -0.5 -4.3 100.3
AAA 5.9 -0.9 -3 102.8
AA 6.6 2.6 -14.1 81.7
A 6.7 4.7 -17.7 68.5
BBB 6.9 7.6 -21.7 49.6
th
*N.B: The above data has been taken from CMBS market statistics as of 24
April 2008.
Property Type in CMBS
Residential properties
Residential properties are properties that provide residences for individuals or

families. These include single houses and multifamily properties such as
apartments, condominiums and co-ops. As hotels and motels provide temporary
residences and thus are not categorized as residential properties.
Non-residential properties
Non-residential properties are typically broken down into five major

subcategories:
1. Commercial real estate includes both office building and retail space. Office
properties range from major multitenant buildings to a single tenant building,
often built with the needs of a specific tenant or tenants in mind. An example of
the later would be a medical office building near the hospital. Retail properties
vary from large regional shopping center containing over a million of square
meter space to a small stores with single tenant found in every town. It is also
common to find retail combined with office space, particularly on the first floor of
office building in major cities.
2. Industrial real estate includes properties used for light or heavy manufacturing
as well as associated warehouse space.
3. Hotels and motels vary considerably in size and facilities. Motels and smaller
hotels are used primarily for business travelers and families to spend a night.
4. Recreational real estate includes uses of country clubs, marinas, sports
complexes, and so on.
5. Institutional real estate is a general category for property that is used by
special institutions such as government agency, a hospital or a university. All of
these buildings outlined above have a potential to generate income which
depends on its ability to attract tenants to rent space in the building as well as
expenses associated with the operating the building. “The rents depend on many
factors, including the outlook for national economy, the economic base of the
area in which property is located, the demand for type of space provided by the
property in the location being analyzed and the supply of similar competitive
space”3. Commercial properties are typically leased to tenants for a specific
period of time, which assign rights, duties and responsibilities between the lessor
(owner) and lessee (tenant). The term of lease include legal considerations that
are designed to protect the interest of both parties and specify how payments are
to be made over the time period. In Commercial property market, the supply and
demand for space interact to establish the market rent rate for a property. And in
capital markets debt and equity funds are raised for investment and financing,
and claims on these debt and equity instruments are traded. These claims
include funds to acquire stocks, bonds, and other invest able assets including
real estate income property investments At any time, the supply of real estate is
fixed and claims on these assets are priced relative to all other capital assets. To
attract investors, real estate must be expected to earn a competitive risk-adjusted
rate of return. The capitalization rate implicitly considers the riskiness of the
property and its future NOI net operating income. For a given capitalization rate,
investors are obviously willing to pay a higher price for a greater amount of rental
income.
CMBS transactions overview
We will deal with following parameters like
1. Typical CMBS deal Structure :
Security Package & Mortgage Security Package &

P&I on Loan Collateral P&I on Notes
Rent Loan Amount Issuance

proceeds
2. CMBS counterparties & their interrelation

How CMBS works
1. Lender originates commercial mortgage loan(s) to Borrower(s)

2. Borrower provides mortgage security to Lender
3. Arranger (investment bank) structures transaction and select
loan pool for CMBS issuance
4. Rating Agencies provide and maintain ratings on CMBS notes.
5. CMBS Issuer sells notes to Investors
6. CMBS Issuer sells notes to Investors
7. Issuer uses notes proceeds to purchase loan (pool) from originator
8. Servicer collects principal & interest (“P&I”) on the loan pool and pays
P&I on the notes and provides reports to Investors
9. Security Trustee holds the security for the benefit of the note-holder
and enforce a security in case of default.
In above we have also showed the parties in bold letter for their involvements in
CMBS transactions.
So far we have seen the CMBS overviews and different participants’ involvement
in different process. Now we will look into note structure for a typical CMBS.
We have different tranches in CMBS starting from top rating (AAA) to Non rated
tranche. We can visualize the loss effect in different notes in simple ways that is
illustrated below
Credit enhancement is primarily derived through the subordination of note

tranches, Funded reserves, Excess spread and trapping mechanism but it can be
seen sometimes that Liquidity facility also play an important role in Credit support
mechanism.
Credit Enhancements
Credit enhancements protect investors when the cash flows from the underlying
assets are insufficient to pay the interest and principal for a security in a timely
manner. An issuer uses credit enhancements to improve a security’s credit
rating, and, therefore, its pricing and marketability. Aside from the coupon rate
paid to investors, the largest expense in structuring an asset-backed security is
the cost of credit enhancements. Issuers constantly attempt to minimize the costs
associated with providing credit protection to investors. Credit enhancements
come in several different forms, although they can generally be divided into two
main types: external (third party or seller’s guarantees) or internal (structural or
cash flow driven). External/Third Party Credit Enhancements As a general rule,
third party credit enhancers must have a credit rating at least as high as the
rating sought for the security. Third party credit support is often provided through
a letter of credit or surety bond from a highly rated bank or insurance company.
Currently, there are only a few highly rated third party credit enhancers. Further,
there is the possibility that the ratings assigned to a third party credit enhancer
could be lowered. Although it rarely happens, such an event could cause the
security itself to be downgraded. As a result, issuers are relying less and less on
third party credit enhancements.
Third party letter of credit: For issuers with credit ratings below the level sought
for the security issued, a third party may provide a letter of credit to cover a
certain amount of loss or percentage of losses. Any draws on the letter of credit
protection are often repaid (if possible) from subsequent excess cash flows from
the securitized portfolio.
Surety bonds: Third party surety bond providers, usually triple-A rated mono-line
insurance companies, generally provide a guarantee for 100 percent of the
principal and interest payments. Internal Credit Enhancements Among internal
enhancements, the securitized assets and transaction’s cash collateral accounts
provide most of the credit support. These cash collateral accounts and separate
junior classes of securities protect the senior class by absorbing losses before
the cash flows from the senior certificate are interrupted. Senior/subordinate
structures can be layered so that each position benefits from all the credit
protection of the positions subordinate to it. The junior positions are subordinate
in the payment of both principal and interest to the senior positions in the
securities. A typical security structure may contain any of the following internal
enhancements, which are presented in order from junior to senior, that is, from
first to absorb losses to the last:
Excess spread: The excess spread is created from the monthly portfolio yield on
the receivables supporting an asset-backed security. The excess spread is
generally greater than the coupon’s servicing costs and expected losses for the
issued securities. Any remaining finance charges after funding, servicing costs,
and losses, is called excess spread. This residual amount may eventually revert
to the institution/seller as additional profit. However, it is available for the trust to
cover any losses that are greater than what is normally expected for the portfolio.
Such losses may arrive from higher than projected charge-offs or servicing costs,
or lower than projected revenues.
Cash collateral accounts: These are segregated trust accounts, fully or partially
funded at the outset of the deal. They can be drawn on to cover shortfalls in
interest, principal, or servicing expenses if excess spread is reduced to zero. The
account can be funded by the issuer, but may be funded by a loan from a third
party financial institution. This loan will be repaid from the proceeds of the trust
assets, but only after all secured certificate holders have been paid in full.
Collateral invested amount (CIA): The CIA is a privately placed ownership

interest in the trust assets, subordinate in payment rights to all investor
certificates. It may be referred to as a residual interest in the trust or the “equity
piece,” because a seller often creates and holds this interest to provide credit
support for the issue. It may, however, be sold to an outsider. Like a layer of
subordination, the CIA serves the same purpose as the cash collateral account. It
makes up for shortfalls if excess spread is insufficient. If the CIA absorbs losses,
it can be reimbursed from any available excess spread. The CIA is usually an un-
certificated ownership interest.
Subordinate security classes: Subordinate security classes are junior in claim

to other debt. They are repayable only after other classes of the security with
higher claims have been satisfied. Some securities may contain more than one
class of subordinated debt, and one subordinated class may have a higher claim
than other such positions.
Performance-based enhancement: Most securities contain performance

related features designed to protect investors (and credit enhancers) against
portfolio deterioration. Poor portfolio credit performance can trigger additional
safeguards, such as an increase in the spread account available to absorb
losses or the accelerated repayment of principal (early amortization). The earliest
performance-based enhancement typically requires the capture of excess spread
within the trust to provide additional credit protection when the portfolio begins to
show signs of deterioration. If delinquencies and loss levels continue to
deteriorate, early amortization may occur in revolving securitizations. Early
amortization triggers are usually based on a three-month rolling average to
ensure that amortization is accelerated only if the pool’s performance is
consistently weak. However, you should criticize covenants that cite supervisory
thresholds or adverse supervisory actions as triggers for early amortization
events or the transfer of servicing as unsafe and unsound banking practices.
Illustration of Credit Enhancement/Loss Positions
To illustrate the credit enhancement concept, losses in a hypothetical

securitization would be absorbed as follows.
First loss tranche: Usually the residual interest is typically retained by the
originator and is established at the normal expected rate of portfolio credit losses.
The excess spread, which funds the residual interest, normally should absorb
expected portfolio losses, so that the credit support provided by the originator’s
investment provides an additional cushion against unexpected losses.
Second loss tranche: Referred to as the cash collateral account, typically

covers losses that exceeds the originators retained interest. This second level of
exposure is usually capped at some multiple of the pool’s expected losses
(customarily between three and five times these losses), depending on the
desired credit ratings for the senior positions. A high grade, well capitalized credit
enhancer that is able to diversify the risk often absorbs this risk.
Senior tranches: Investors that buy the asset backed securities themselves
bear the lesser credit risk of the senior tranches. These are often divided into a
senior tranche and a mezzanine tranche. Although these investors are exposed
to other types of risk, such as prepayment or interest rate risk, senior level
classes of asset-backed securities typically have less exposure to credit loss
because of the credit support offered by the junior tranches as well as other
credit enhancements.
Structural Issues in CMBS
• Priority of Payment – Sequential Triggers

• Available Funds Caps
Release Premium in addition of Allocated Loan Balance in Event of
Asset Sales
• A/B Note Structure as compared to Mezz with Joint Creditor Agreement
• Potential Conflicts between Servicer, Originator and B piece Holder
Quality and Extent of Disclosure of Ongoing Reporting
Prioritization of Payments- Waterfall Mechanism
The highest-rated bonds are paid-off first in the CMBS structure. Any return of
principal caused by amortization, prepayment, or default is used to repay the
highest-rated tranche first and then the lower-rated bonds. Any interest received
on outstanding principal is paid to all tranches. However, it is important to note
that many deals vary from this simplistic prioritization assumption.
For example, consider the GMAC 1999-C3 deal. The bonds that are rated AAA
by Fitch (classes A-1-a, A-1-b, A-2 and X) are the Senior Certificates. Classes B
through M are organized in a simple sequential structure. Principal and interest
are distributed first to class B and last to class N. Unfortunately, the Senior
Certificates are not as simple in their prioritization.
The loans underlying the GMAC 1999-C3 are divided into two groups. Group 2
consists of the multifamily loans and Group 1 consists of the remaining loans
(retail, office, warehouse, etc.). In terms of making distributions to the Senior
Certificates, 61% of Group 1's distribution amount is transferred to Group 2’s
distribution amount. Group 1’s distribution amount is used to pay:
1) Interest on bond classes A-1-a , A-1-b, and the portion of interest on the Class
X on components A-1-a and A-1-b pro rata, and 2) Principal to the Class A-1-a
and A-1-b in that order.
Loan Group 2’s distribution amount is used to pay:
1) Interest on Class A-2 and the portion of interest on the Class X components
from A-2 to N pro rata, and
2) Principal to the Class A-2;
In the event where the balances of all the subordinated classes (Class B through
Class M) have been reduced to zero because of the allocation of losses, the
principal and interest will be distributed on a pro rata basis to Classes A-1-a, A-1-
b and A-2.
Loan default adds an additional twist to the structuring. Any losses that arise from
a loan defaults will be charged against the principal balance of the lowest rated
CMBS bond tranche that is outstanding (also known as the “first loss piece”). For
the GMAC 1999-C3 deal, losses are allocated in reverse sequential order from Cl
N through Class B. After Class B is retired, classes A-1-a, A-1-b, and A-2 bear
losses on a pro-rata basis. As a consequence, a localized market decline (such
as a rapid decline in the Boston real estate market) can lead to the sudden
termination of a bond tranche. Hence, issuers seek strategies that will minimize
the likelihood of a microburst of defaults.
As long as there is no delinquency, CMBS are well behaved. Unfortunately,
delinquency triggers intervention by the servicer (whose role will be discussed
later in the chapter). In the event of a delinquency, there may be insufficient cash
to make all scheduled payments. When there are insufficient funds, the servicer
is supposed to advance principal and interest on a continued basis, as long as
both amounts can eventually be recovered.
Interest Types in CMBS
We can classify the interest type into following main category listed below
Fixed: Rate has an interest rate that is fixed throughout the life of the class
Floating: Rate has an interest rate that resets periodically based upon a
designated index and that varies directly with changes in the index.
Interest Only: Receives some or all of the interest payments made on the
underlying securities or other assets of the series trust but little or no principal.
Interest Only classes have either a notional or a nominal principal balance. A
notional principal balance is the amount used as a reference to calculate the
amount of interest due on an Interest Only class. A nominal principal balance
represents actual principal that will be paid on the class. It is referred to as
nominal since it is extremely small compared to other classes.
Principal Only: Does not bear interest and is entitled to receive only payments of
principal.
WAC: Coupon related to collateral interest rate has an interest rate that
represents an effective weighted average interest rate that may change from
period to period. A Weighted Average Coupon class may consist of components,
some of which have different interest rates.
WAC_IO: Excess interest receives the excess of the collateral interest over the
amount of interest payable to all other bonds in the deal. Note that WAC IO
bonds may also contain a component with a real principal balance, despite the IO
tranche type.
CAP: Fixed Rate, but capped to collateral net rate Bond has a fixed rate.
However, this rate might be capped, generally at the collateral net rate
Tranche Type in CMBS
We have different types of CMBS tranches
Junior: Junior tranche, generally with a sub-investment-grade rating
Mezzanine: Mezzanine tranche, generally with an investment-grade rating (but

not AAA)
Super Senior: Super senior tranche, which receives credit support from other
senior bonds
Senior: Senior tranche, generally with AAA rating
Ratio Strip: Receives principal (and possibly interest) as a direct strip from
collateral with net rates between particular bands (as with ratio-strip PO bonds in
RMBS deals)
Multifamily carve-out: The practice of "carving-out" a multifamily tranche started

in approximately 1998, and still happens in selected deals today. The collateral is
split into two groups, and an “AAA-rated” bond is created that is primarily backed
by 100% multifamily loans.11 Freddie Mac and Fannie Mae are the only known
buyers of this tranche, and the bond is created to conform to the investment rules
specified in their charters.
Because of its position on the capital structure, if there are defaults in the
multifamily loans, generally the bond will get cash from other property types as
well, so the name “multifamily carve-out” can be slightly misleading. Also, if other
property types default, cash may be taken from the “multifamily carve-out” to help
make other AAA-rated bonds whole.
A small portion of all CMBS – consisting exclusively of deals backed by loans on

multifamily properties (i.e., apartment buildings) – carry guarantees from the
federal government or GSEs.
CMBS Investor Motivation & Issues
• Relative Yield Advantage to alternative investments

• Allocation to property debt without need for origination
& servicing
• Portfolio diversification from other fixed income and
structured investment products
• As market develops, risk & return characteristics of deals can be
benchmarked against each other
We can see security packages in CMBS as well. We have mainly two types of
security package one is secured loan from Lender to Borrower and another is
secured notes issued by issuer.
We have different type of Lender security package like Registered Mortgage over
property and others like
• Leases:
1. Registered mortgage
2. Assignment by way of security
• Security interest over borrower’s assets
• Security interest over shares
Lender Security Package for secured creditors is from Lender and swap
counterparties.
Like Lender we have issuer security package for assignment of loans and
security documents and security interest over all assets of the issuer.
We can list down the security package for issuer in terms of secured creditors is
• Note holders
• Trustee and receiver
• Liquidity facility provider
• Swap counterparty
• Paying agent
• Trust Manager
• Servicer
Some Definitions
Participation Loans
Some CMBS transactions contain participation loans. These are whole loans that
have been split into multiple pieces that may be owned separately. Each piece is
known as a participation note. From the borrower's perspective, there is still only
one mortgage loan, so prepayment and default behavior occur at the mortgage
level.
A common type of participation loan is the A/B loan. The loan is carved into a
senior and junior portion (known as the A note and B note). The senior portion
has first priority on any payments on the whole mortgage and will receive all cash
it is due before the junior portion receives payments. In addition, the junior
portion will take losses before the senior portion. Another common type of
participation loan is the pari-passu split, where the loan is split into multiple
pieces at the same level of priority. Often these two types are combined, with a
loan split into an A note and a B note, and the A note then further split into two or
more pari-passu notes.
Rake Bond
A loan is split into an A note and a B note and each piece is included in the deal -
the A note backing the main certificates issued by the deal and the B note
backing one or more tranches that receive payments solely from that B note then
B note is said to be Rake Bond.
Trust Assets
Where both A note and B notes are involved to form securities in this case, there
would be a PNOTE line for both the A note and the B note. Both the A note and
the B note would be considered "trust assets", meaning that they are owned by
the trust and back certificates issued by the trust. If the B note does not back
tranches issued by the deal, there will be no PNOTE line for the B note. Though
the B note does exist in real life, it is not considered a "trust asset" for this
particular deal because it does not back any certificates issued by that deal.
Pool assets
In continuation of the above for Trust assets, Both the A notes and B notes in
such a case would be considered "trust assets", because both are owned by the
trust, but only the A note would be considered a "pooled asset", because only the
A note is pooled with other mortgages to back the main group of bonds in the
deal.
Call Protected IO Tranche
Typical CMBS structures contain a WAC IO. The WAC IO generally gets excess
interest. But in some deals, the WAC IO interest entitlements are further carved
up. Examples include carving the WAC IO into a PAC IO and a new WAC IO
(very typical of deals backed by conduit and fusion collateral) or carving the WAC
IO into a Call Protected IO and a new WAC IO, and then sometimes further
carving up the new WAC IO into smaller interest entitlements often based on
loan originator, fixed strip rates, etc. (typical in deals backed by short-term
floating rate collateral).
Call Protected IOs are carved out of the amount of excess interest that would
otherwise go to a single WAC IO based on the call protection end dates of the
underlying loans. Basically, the call protected IO is structured to receive all WAC
IO interest as if each underlying loan prepays on its respective call protection end
date, if that interest amount is available, even if that isn't necessarily how the
loans pay down. Whatever is not taken by the call protected IO is usually left for
the non-call protected IO, or the new WAC IO.
Defeasance
Defeasance is a method of call protection used on some CMBS loans that

protects the deal against prepayments (and, even better, defaults), while at the
same time allowing the borrower to release a property from the lien of the
mortgage.
Prepayment in CMBS
Defeasance and yield maintenance are used to define the prepayment terms of a
CMBS loan before its maturity.
Yield Maintenance:
Yield maintenance is an actual payoff of the loan made up of two parts: the
remaining principal balance on the loan and a prepayment penalty. The
prepayment penalty applies because the borrower is paying off the loan prior to
the maturity date; it allows the lender to attain the same yield as if the borrower
had made all scheduled mortgage payments until maturity. The penalty is based
on the difference between the interest rate on the loan and a specified reference
rate (generally defined in the “NOTE”), and the remaining payments on the loan
multiplied by this interest rate differential. The higher the borrower’s loan rate and
the lower the current market rates, the greater the yield maintenance penalty.
Unlike defeasance, there are no transaction costs associated with yield
maintenance and the debt payments are paid off in cash instead of US Treasury
securities.
Defeasance:
Defeasance is a method of call protection used on some CMBS loans that

protects the deal against prepayments (and, even better, defaults), while at the
same time allowing the borrower to release a property from the lien of the
mortgage
Pre-payment penalty option:
This is really a CMBS-type analytic and not particularly relevant to HE (for

example) deals. This option says don't prepay a particular asset if the resulting
prepayment penalty is greater than X% of the amount that you would be
prepaying.
It's a very common analytic for CMBS deals because that is often how
developers decide if it makes good sense to refinance, sell a particular property
or just keep going. For example, if I sell now but can only get 104% of my loan
amount for the property then it doesn't make any sense if my YM penalty amount
comes out to be 5% of what I have to prepay (assuming that amount is the entire
remaining balance). With CMBS deals you are looking at things on more of a
property to property basis but with HE deals prepayments are forecasted on
more of a pool "statistical" level.
The more common approach to HE penalties is to use the "Prepay Penalty

Haircut" option and just make an assumption that some % of the total penalty
cash that comes in will not be collected (typically 10%, 15%, etc.). Note that there
is no direct and intuitive correlation to any info on the Asset Detail page and how
this will affect prepayment and penalty levels on normal amortizing residential
collateral
Prepayment Calculation
1. For deals with loan level (or Agency pool level) collateral information,
1MO, 3MO, 6MO, 9MO, 12MO and LIFE average historical prepayments
are calculated based on the PSA standard. The PSA standard
methodology is to find which prepayment rate, when applied to each
piece of the collateral (i.e. loan) over the specific average period,
appropriately changes the aggregate collateral balance from the start of
the specific averaging period to the aggregate collateral balance at the
end of the specific averaging period.
For example, a deal which negatively amortizes over the specified period
and experiences no prepayments on any loans will show a historical
prepayment rate of 0, even though the collateral balance increased. If
the collateral balance remained exactly the same, a Negam deal's
historical prepayment rate would be positive, NOT 0.
For Option ARM loans, the minimum payment option is assumed to be

the P&I payment for amortization and historical prepayment calculation
purposes. For this reason if a borrower chose to pay the full interest
payment, or the fully- amortizing P&I payment, this would show up as a
positive historical prepayment.
If the actual decrease in the collateral balance is smaller than the

decrease, then the historical CPR shown will be negative.
For deals with pooled (i.e. rep. lines, plug pools) collateral information,
1MO, 3MO, 6MO, 9MO, 12MO and LIFE average historical prepayments
are also calculated based on the PSA standard method. However, in this
case, the calculations are performed on the aggregate collateral plug
pools since no individual loan/pool information is available.
Therefore, prepayment rates calculated with PSA standard for non-

CMBS deals should be interpreted as the prepayment rate
including the default effect.
Default in CMBS:
Default option in CMBS:

Determinants of Option Values
Now that we have defined the conditions that lead to the exercise of the options,
we need to identify the determinants of the options’ values. The value of the
embedded options depends upon many factors. The direct determinants are
1. Current balance of mortgage
2. Term to maturity of mortgage
3. Mortgage payments including interest and principal, and the

amortization schedule
4. Prepayment terms and penalties
5. Net operating income from the collateral property
6. Volatility of net operating income
7. Terms of default and foreclosure costs
8. Interest rates
9. Volatility of interest rates
10. Correlation between interest rates and net operating income
The first four items specify the information necessary to calculate the promised
cash flows of the underlying mortgage.
This information in conjunction with current and the potential future interest rates
are necessary for calculating the value of the prepayment option. Items 5, 6, and
7 which relate to the property are essential for valuing the default option. The last
three items are critical for valuing all assets, including the mortgage, the real
estate, and the options.
Default, Liquidity and Losses:
It is customary to forecast by projecting future defaults, not future loss.
For example, it is common practice to assume a 12-month lag between default

incident and loan/asset liquidation. (You can change this lag value to any number
of months, including 0 months to indicate no lag.) So even if the default rate is
100 CDR (i.e. , 100% of the collateral defaults immediately), no losses will occur
until 12 months have transpired. The amount actually written down as a loss is
controlled by your severity (or 100 minus your recovery) percentage forecast
assumption.
In addition, the cash flows are affected by your assumptions for servicer
advancing on defaulted principal and interest. 100% advancing indicates that the
servicer is making the payments, whereas 0% indicates no payments during the
defaulted period.
The Combined Default and Prepayment:
Since the call and put options are embedded in the mortgage debt, the call option
and the put option cannot actually be separated. The incentive to prepay as we
have discussed is linked not just to the general level of interest rates, but to the
ever changing level of operating income of the property and the resulting
available refinancing spread. Thus, the value of the prepayment option is related
to factors that affect the value of the default option. Similarly the incentive to
default is related to the level of interest rates which in turn affects the value of the
prepayment option. Moreover, borrowers who either prepay or default terminate
the contract of the mortgage. This results in the termination of both options. Our
triggering conditions, thus, do not work independently, but need to be evaluated
simultaneously.
Collateralized Debt Obligations
(CDO)

Contents
(i) Introduction
(ii) Structure of a CDO
(iii) Life of a CDO
a. Ramp-up Phase
b. Revolving Period
c. Amortization Phase
(iv) Coverage Tests
a. Overcollateralization Ratios
b. Interest Coverage Ratios
(v) Cash flow CDO: Interest Waterfall Sample
(vi) Cash flow CDO: Principal Waterfall Sample
(vii) Sponsor’s Motivation
a. Economics of an Arbitrage Transaction
(viii) Arbitrage and Balance Sheet CDO
a. Cash flow CDOs
b. Market Value CDOs
c. Arbitrage CDOs
i. Arbitrage market Value CDOs
ii. Arbitrage cash flow CDOs
iii. Arbitrage Cash flow CDOs
d. Balance sheet cash flows CDOs
(ix) Synthetic CDO
a. Fully Funded Synthetic Transactions
b. Partially Funded Synthetic Transactions
Introduction
A Collateralized Debt Obligation (CDO) is an asset-backed security, backed by a diversified pool

of one or more classes of debt (corporate and emerging market bonds, asset-backed and
mortgage backed securities, real estate investment trusts, and bank debt). The list of asset types
included in a CDO portfolio is continually expanding.
When the underlying pool of debt obligations consists of bond-type instruments, the CDO is
referred to as a Collateralized Bond Obligation (CBO). When the underlying pool of debt
obligations consists of only bank loans, the CDO is referred to as a Collateralized Loan Obligation
(CLO).
In a way, A CDO is similar to a regular mutual fund that buys bonds. However, unlike a mutual
fund, most of the securities sold from a CDO are themselves bonds, rather than shares. In
simplest terms, a CDO is an arrangement that raises money primarily by issuing its own bonds
and then invests the proceeds in a portfolio of bonds, loans, or similar assets. Payments on the
portfolio are the main source of funds for repaying the CDO's own securities.
The basic concept behind a CDO is the redistribution of risk - Some securities backed by
a pool of assets in a CDO will be higher rated than the average rating of the portfolio and some
will be lower rated.
Structure of a CDO
In a CDO structure, there is an asset manager responsible for managing the portfolio of debt
obligations. There are restrictions imposed (i.e., restrictive covenants) as to what the asset
manager may do and certain tests that must be satisfied for the debt obligations in the CDO to
maintain the credit rating assigned at the time of issuance.
The funds to purchase the underlying assets, referred to as the Collateral Assets, are
obtained from the issuance of debt obligations. These debt obligations are also referred to as
tranches. The tranches are:
• Senior tranches
• Mezzanine tranches
• Subordinate/equity tranche
There will be a rating sought for all but the subordinate/ equity tranche. For the senior
tranches, at least an A rating is typically sought. For the mezzanine tranches, a rating of BBB but
no less than B is sought. Since the subordinate/equity tranche receives the residual cash flow, no
rating is sought for this tranche.
The order of priority of the payments of interest and principal to the CDO tranches is
specified in the prospectus. What is important to understand is that the payments are made in
such a way as to provide the highest level of protection to the senior tranches in the structure.
This is done by providing certain tests (Dealt in detail little later) that must be satisfied before any
distribution of interest and principal may be distributed to the other tranches in the structure. If
certain tests are failed, the senior tranches are then retired until the tests are passed. The ability
of the asset manager to make the interest payments to the debt holders and repay principal to the
debt holders depends on the performance of the collateral assets. The proceeds to meet the
obligations to the CDO tranches (interest and principal repayment) can come from
• Coupon interest payments from the collateral assets
• Maturity of collateral assets
• Sale of collateral assets
Life of A CDO
It is useful to view a CDO as having a lifecycle that consists of several phases.

• Ramp-up phase: The first phase is the ramp-up phase, when the manager uses the
proceeds from issuing the CDO to purchase the initial portfolio. The CDO's governing
documents generally specify parameters for the initial portfolio but not the exact
composition. For example, the terms of the CDO might require that the initial portfolio
have a minimum average rating, a minimum average yield, a maximum average
maturity, and a minimum degree of diversification. During the ramp-up phase, the
manger must select assets so that the portfolio satisfies all the parameters.5
• Revolving Period: The second phase is the revolving period during which, the
manager actively manages the portfolio and reinvests cash flow from the portfolio.
The reinvestment phase allows a CDO to remain outstanding – without amortization
of the CDO's own bonds – even though the assets in the underlying portfolio reach
their maturity dates.
• Amortization Phase: The third period is the amortization phase. During the
amortization phase, the manager stops reinvesting cash flow from the portfolio.
Instead, the manager must apply the cash flow toward repaying the CDO's debt
securities.
A manager generally is required to follow certain rules in managing the portfolio. The
rules protect investors by somewhat limiting the manager's discretion. For example, one rule
might require the manager to maintain the average yield or spread on the managed assets above
a certain level. Another rule might require the manager to maintain the average maturity of the
assets within a certain range.
Many CDO's include performance tests that can trigger the early start of the amortization
phase if the deal performs poorly. For example, many deals include an "overcollateralization" test
based on the ratio of the portfolio balance to the balance of the CDO's debt securities. Likewise,
many CDOs also include an interest coverage test, based on the ratio of interest cash flow on the
portfolio to the interest that the CDO must pay on its own securities. If either ratio falls below a
specified threshold, the deal would enter early amortization. The tests are designed to protect
investors by triggering amortization if a deal's performance deteriorates. However, a CDO
manager sometimes can manipulate the tests to avoid early amortization. In those cases, rating
agencies are likely to downgrade the CDO's securities.
Coverage Tests
In CDO, two coverage tests—overcollateralization and interest coverage tests—are designed

to protect investors against a deterioration of the reference portfolio. While the
overcollateralization ratio is calculated based on the par value of the collateral assets in a cash
flow CDO, a market value CDO uses mark-to-market prices in testing overcollateralization. The
coverage tests involve comparing a tranche’s coverage ratios with the tranche’s required
minimum ratios as specified in the guidelines. Higher ratios provide greater protection for the
investors. A representative coverage test ranges are provided in the Table1 below.
AAA BBB
O/C I/C O/C I/C
High-Yield CDO 150-130 120-130 105-112 110-120
Investment Grade CDO 108-115 115-125 103-105 100-105
Structured Finance CDO 110-125 115-125 103-105 100-105
Table1:
Overcollateralization Ratio:
Principal Par Value of the Reference Portfolio

O/C Ratio for Class A = --------------------------------------------------------------------------
Principal par Value of Class A only
Principal Par Value of the Reference Portfolio

O/C Ratio for Class B = --------------------------------------------------------------------------------
Principal par Value of Class A + Principal Par Value of Class B
Interest Coverage Ratios:
Scheduled interest due on the reference portfolio

I/C Ratio for Class A = ---------------------------------------------------------------------------------
Scheduled Interest on Class A only
Scheduled interest due on the reference portfolio

I/C Ratio for Class B = ---------------------------------------------------------------------------------
Scheduled Interest on Class A + Scheduled Interest on Class B
Cash flow CDO: Interest Waterfall Sample
Cash flow CDO: Principal Waterfall Sample
Sponsor’s Motivation
CDOs are categorized based on the motivation of the sponsor of the transaction. If the motivation
of the sponsor is to earn the spread between the yield offered on the collateral assets and the
payments made to the various tranches in the structure, then the transaction is referred to as an
arbitrage transaction. If the motivation of the sponsor is to remove debt instruments (primarily
loans) from its balance sheet, then the transaction is referred to as a Balance Sheet Transaction
(This handled in more detail, little later).
Sponsors of balance sheet transactions are typically financial institutions such as banks
and insurance companies seeking to reduce their capital requirements by removing loans due to
their higher risk-based requirements.
Economics of an Arbitrage Transaction

The key as to whether or not it is economic to create an arbitrage CDO is whether or not
a structure can offer a competitive return for the subordinate/equity tranche. To understand how
the subordinate/equity tranche generates cash flows, consider the following basic $100 million
CDO structure with the coupon rate to be offered at the time of issuance as shown:
Tranche Par Value Coupon Rate

Senior $80,000,000 LIBOR + 70 basis points
Mezzanine $10,000,000 Treasury rate plus 200 basis points
Subordinated/equity $10,000,000 -------
Suppose that the collateral assets consist of bonds that all mature in 10 years and the coupon
rate for every bond is the 10-year Treasury rate plus 400 basis points. Notice that the collateral
assets pay a fixed rate but 80% of the capital structure is based on a floating rate (LIBOR). Thus,
there is a mismatch with respect to the coupon characteristics of the collateral assets and the
liabilities.
One way that the asset manager hedges this mismatch is by using an interest rate swap.
A swap is simply an agreement to periodically exchange interest payments with the payments
benchmarked off of a notional amount. The notional amount is not exchanged between the two
swap parties. Rather it is used simply to determine the dollar interest payment of each party. This
is all we need to know about an interest rate swap in order to understand the economics of an
arbitrage transaction. Keep in mind, the goal is to show how the subordinate/equity tranche can
be expected to generate a return.
The interest rate swap that the asset manager would use would have a notional amount
of $80 million. Suppose that the terms of the interest rate swap are as follows:
• The asset manager must pay a fixed rate each year equal to the 10-year Treasury rate
plus 100 basis points
• The asset manager receives LIBOR
Let's assume that the 10-year Treasury rate at the time the CDO is issued is 7%. Now we can
walk through the cash flows for each year. Look first at the collateral assets. The collateral assets
will pay interest each year (assuming no defaults) equal to the 10-year Treasury rate of 7% plus
400 basis points. So the interest will be:
Interest from collateral assets = 11 % × $100,000,000 = $11,000,000
Now let's determine the interest that must be paid to the senior and mezzanine tranches. For the
senior tranche, the interest payment will be:
Interest to senior tranche = $80,000,000 × (LIBOR + 70 bp)
The coupon rate for the mezzanine tranche is 7% plus 200 basis points. So, the coupon rate is
9% and the interest is:
Interest to mezzanine tranche = 9% × $10,000,000 = $900,000
Finally, let's look at the interest rate swap. The asset manager is agreeing to pay the swap
counterparty each year 7% (the 10-year Treasury rate) plus 100 basis points, or 8% of the
notional amount. In our illustration, the notional amount is $80 million. The reason the asset
manager selected the $80 million is because this is the amount of principal for the senior tranche.
So, the asset manager pays to the swap counterparty:
Interest to swap counterparty = 8% × $80,000,000 = $6,400,000
The interest payment received from the swap counterparty is LIBOR based on a notional amount
of $80 million. That is,
Interest from swap counterparty = $80,000,000 × LIBOR
Now we can put this all together. Let's look at the interest coming into the CDO:
Interest from collateral assets = $11,000,000
Interest from swap counterparty = $80,000,000 × LIBOR
Total Interest Received = $11,000,000 + $80,000,000 × LIBOR
The interest to be paid out to the senior and mezzanine tranches and to the swap counterparty
includes:
Interest to senior tranche = $80,000,000 × (LIBOR + 70 bp)

Interest to mezzanine tranche = $900,000
Interest to swap counterparty = $6,400,000
Total Interest paid = $7,300,000+ $80,000,000 × (LIBOR + 70 bp)
Netting the interest payments coming in and going out we have:

Total Interest Received = $11,000,000 + $80,000,000 × LIBOR
(-) Total Interest paid = $7,300,000+ $80,000,000 × (LIBOR + 70 bp)
Net Interest = $3,700,000 - $80,000,000 × (LIBOR + 70 bp)
Since 70 basis points times $80 million is $560,000, the net interest remaining is $3,140,000 (=
$3,700,000 N $560,000). From this amount any fees (including the asset management fee) must
be paid. The balance is then the amount available to pay the subordinate/equity tranche. Suppose
that these fees are $634,000. Then the cash flow available to the subordinate/equity tranche is
$2.5 million. Since the tranche has a par value of $10 million and is assumed to be sold at par,
this means that the return is 25%.
Obviously, some simplifying assumptions have been made. For example, it is assumed that there
are no defaults for the collateral assets. It is assumed that all of the collateral assets purchased
by the asset manager are non-callable and therefore the coupon rate would not decline because
issues are called. Moreover, as explained earlier, at the end of the reinvestment period the asset
manager must begin repaying principal to the senior and mezzanine tranches. Consequently, the
interest swap must be structured to take this into account since the entire amount of the senior
tranche is not outstanding for the life of the collateral assets.
Despite the simplifying assumptions, the illustration does demonstrate the basic economics of the
CDO, the need for the use derivative instruments—in the example, an interest rate swap—and
how the subordinate/equity tranche will realize a return.
Arbitrage and Balance Sheet CDOs
Most CDOs can be placed into either of two main groups: Arbitrage and Balance Sheet
transactions. Figure 1shows the conceptual breakdown between the two structures. Before
looking at these two structures in detail we will first try to understand the difference between Cash
flow CDOs and Market Value CDOs.
Cash flow CDOs: A cash flow CDO is one where the collateral portfolio is not subjected to active
trading by the CDO manager. The uncertainty concerning the interest and principal repayments is
determined by the number and timing of the collateral assets that default. Losses due to defaults
are the main source of risk.
Market value CDOs; A market value CDO is one where the performance of the CDO tranches is
primarily a mark-to-market performance, i.e. all securities in the collateral are marked to market
with high frequency. Market value CDOs leverage the performance of the asset manager in the
underlying collateral asset class. As part of normal due diligence, a potential CDO investor needs
to evaluate the ability of the manager, the institutional structure around him, and the suitability of
the management style to a leveraged investment vehicle.
CDO
Arbitrage Balance Sheet
Cash Flow Market Value Cash Flow
Figure1: CDO Structure
Arbitrage CDOs
The aim of Arbitrage CDOs is to capture the arbitrage opportunity that exists in the credit-spread
differential, between the high yield collateral and the highly rated notes. The idea is to create
collateral with a funding cost lower than the returns expected from the notes issued. Most
arbitrage deals are private ones, where size is not large and the number of assets included in the
deal is very limited compared to the cash flow type.
Arbitrage market value CDOs

Arbitrage market value CDOs, unlike balance sheet CDOs where there is no active
trading of loans in the portfolio; go through a very extensive trading by the collateral
manager, necessary to exploit perceived price appreciations. This type of CDO relies on
the market value of the pool securitized, which is monitored on a daily basis. Every
security traded in capital markets, with estimated price volatility, can be included in this
type of CDO.
In fact, the primary consideration is the price volatility of the underlying collateral. The
important aspect is the collateral manager’s capacity to generate a high total rate of
return. The CDO manager has a great deal of flexibility in terms of the asset included in
the deal. During the revolver period, the collateral manager can increase or decrease the
funding amount that changes the leverage of the structure.
Arbitrage cash flow CDOs
By their very nature, collateral assets have been purchased at market price and are
negotiable instruments, therefore most assets are bonds. However syndicated loans,
usually tradable, have been included in past transactions. As arbitrage deals, the
collateral assets can be refinanced more economically by re -tranching the credit risk and
funding cost in a more diversified portfolio. Unlike arbitrage market value CDOs, the
collateral assets are not traded very frequently.
Balance sheet cash flows CDOs
Balance sheet deals are structures for the purpose of capital relief, where the asset securitized is
a lower yielding debt instrument. The capital relief reduces funding costs or increases return on
equity, by removing, the assets that take too much regulatory capital, from the balance sheet.
These transactions rely on the quality of the collateral that is represented by guaranteed bank
loans with a very high recovery rate. The relative low coupon attached to these assets, results in
a smaller spread cushion than the corresponding arbitrage structure. However, given their relative
superior quality, they require less subordination when used in a CDO deal. In the majority of the
cases, the sold assets are loan-secured portfolios. The size of a typical balance sheet CDO is in
general very large, as the transaction must have an impact on the ROE of the institution looking
for capital relief.
Synthetic CDO
A synthetic collateralized debt obligation, or synthetic CDO, is a transaction that transfers the
credit risk on a reference portfolio of assets. The reference portfolio in a synthetic CDO is made
up of credit default swaps. Thus, a synthetic CDO is classified as a credit derivative. Much of the
risk transfer that occurs in the credit derivatives market is in the form of synthetic CDOs.
Understanding the risk characteristics of synthetic CDOs is important for understanding the nature
and magnitude of credit risk transfer.
In most conventional, Cash Flow CDOs, assets are actually transferred into the SPV. However,
the process of transferring loans to the SPV requires significant up front work. A loan-by-loan
analysis is necessary to check it complies with the securitization program and to verify that there
are no special clauses attached to any loan limiting its transfer.
The first stage of evolution of the conventional CDO arrived when the credit risk was transferred
into the SPV through a credit default swap (CDS), and when the underlying credit ownership of
the underlying pool remained in the originator’s book. For this the term synthetic is used, since the
risk was synthetically transferred out of the originator’ balance sheet. With synthetic CDO’s, the
big advantage is that sensitive client relationship issues arising from loan transfer notification,
assignment provisions and other restrictions can be avoided. Also, client confidentiality can be
maintained. Not to mention that it takes less time to complete the transaction.
Fully Funded Synthetic Transactions:

Historically, the fully funded CDO was the first to be used as an alternative to the more
traditional structure. In a fully funded synthetic CDO, the SPV issue notes for
approximately 100% of the reference portfolio. The proceeds of these notes are generally
invested in high quality securities used as collateral that have a 0% risk weight.
In order to hedge its credit risk exposure in its loan portfolio, the originating bank enters
into a Credit Default Swap (CDS) with either the same SPV or with an OECD (bank. With
the CDS the originator buys credit protection in return for a premium. The premium
received is then added to the interest notes received by the note investors.
Partially Funded Synthetic Transactions:

In fully funded CDOs, the bank originator is far from achieving an efficient capital use.
Fully funded CDO-CLO may sometimes be a relatively expensive program. However, it is
also true that as term funding debt, a CDO/CLO program remains less exposed to the risk
that credit spreads may widen.
The structure behind a partially funded CDO transaction is very similar to that of a fully
funded one. The originator bank buys credit protection directly from an SPV or from an
OECD bank. The difference is that the SPV issues a lower amount of notes because it
guarantees a lower amount of collateral. What really characterizes this structure is the un-
funded piece called the Super Senior. This is a very high quality financial paper, virtually
with a zero probability of being exposed to a credit loss.
The originating bank enters in a CDS (super senior CDS) with an OECD bank for the
amount of the super senior tranche.

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Fixed Income Products and

Helix Advisors Pvt. Ltd.

o Mortgage Bonds - A bond secured by a mortgage on a property. Mortgage

o International bonds (government or corporate) are complicated by different

Foreign bonds are denominated in the currency of the country in which

To find the size of an interest period, use this formula:

To find the size of an interest period, use this formula:

The actual/actual day-count method is used primarily to calculate U.S. government

The actual/365 day-count method is used primarily to calculate Treasury bond

The actual/360 day-count method is used mainly for money-market securities:

However, Yield curves can take on just about any shape

USD 3-Mar 4-Mar 5-Mar 6-Mar 7-Mar 10-Mar

Period LIBOR 1M LIBOR 3M LIBOR 6M LIBOR 1YR

The Swap Curve

Bond Yield Measures

Interest Rate Risk….again

=(V_ - V+) / (2 * Vo * ∆y)

Modified Duration = Macaulay Duration / (1 + periodic Market Yield)

A Bond's Approximate Percentage Price Change Based on Duration and Convexity

Percentage change in price = duration effect +convexity effect

= {[-duration * (∆y) ] + [ convexity * (∆y)2 ]} * 100

Discount Margin (DM)

Weighted Average Life (WAL)

Helix Advisors Pvt. Ltd.

The essence of structured finance is that it takes pools of undifferentiated risks

Motivation behind Structured Finance Industry:

• Superior Spread vis-à-vis debt of similar rating.

• Capital market development due to addition of high quality securities. to

• The growth of US Structured Finance Industry stems in large part due to

Current Market Size $5 Trillion as of June 30 2006.(Source: Credit Market

• Although a new concept in India it is gaining ground rapidly.

Issuance Volume in Indian SF Market

*Source: ICRA Estimates

Year 2003 2004 2005 2006 2007

• Pooling and transfer of assets:

Internal credit enhancement

So if the coupon paid on the bond is 4% whereas we are receiving 4.5%

*All figures are in million

With this support structure, the face value of the underlying

Total Certificate Collateral

Reserve funds are created to provide credit support to the structure.

Cash reserve funds are deposits of cash generated from issuance

Excess spread accounts will have monthly deposits of excess spread

WAC for mortgage pool 7.75%

The amount accumulating in the excess spread account can be used

Pay additional Principal to the bonds.

The reserve fund has a target level which is defined as percentage of

Floor (in millions) 0.75

It is a guarantee from a monoline insurance company for the timely payment of

o Interest Rate Swap/Hedge Contracts

Roles and Responsibilities

Originator Lends money to borrower secured by a first priority lien, enters

Depositor An entity set up by the investment bank sponsoring the

Investors Different investors with varying risk appetites purchase certificates

Trustee Responsible for administering the trust on behalf of and making

Special Comes in picture if the assets defaults or becomes delinquent.

In rating Structured Finance deals, all three major agencies follow

First, analytical models are used to assess pool credit risk,

Underlying pools can include the following:

Commercial mortgage-backed securities (CMBS) are a type of bond commonly

In a CMBS transaction, many single mortgage loans of varying size, property

Residential mortgage-backed securities (RMBS) are a type of bond commonly

Collateralized debt obligations (CDOs) are a type of asset-backed security and

o Ramp-up lasts about a year, during which the portfolio manager