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Asset-Backed Securities, Interest-Rate Agreements, and Currency Swaps. Chapter 23. © 2003 South-Western/Thomson Learning. Learning Objectives. How asset-backed securities work and why they were created Most common types of asset-backed securities

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asset backed securities interest rate agreements and currency swaps

Asset-Backed Securities, Interest-Rate Agreements, and Currency Swaps

Chapter 23

© 2003 South-Western/Thomson Learning

learning objectives
Learning Objectives
  • How asset-backed securities work and why they were created
  • Most common types of asset-backed securities
  • Benefits and risks associated with use of asset-backed securities
  • How interest-rate swaps, caps, floors, and collars can be used to reduce interest-rate risk
  • How and why currency swaps are used to manage exchange-rate risk
anatomy of securitization
Anatomy of Securitization
  • Asset-Backed Securities
    • Securities that result from process of securitization
  • Seven main sets of players
    • Borrowers
    • Loan originator
    • Special-purpose trust
    • Rating agency
    • Credit enhancer
    • Underwriter
    • Investors
slide4

Exhibit 23–1

The Anatomy of an Asset-Backed Security Offering

Source: Adapted from Leon T. Kendall and Michael Fishman (1996), A Primer on Securitization, The MIT Press, Cambridge, Massachusetts, p.3.

anatomy of securitization1
Anatomy of Securitization
  • Special Purpose Trust
    • Corporate agent
    • Buys financial obligations from loan originator
    • Works with security underwriter, credit enhancer and rating agency to issue asset-backed securities
    • Sometimes responsible for loan-servicing responsibilities
  • Due Diligence
    • Investigative process
    • Used by lender, investor or investment banker to ensure that borrower’s or security issuer’s financial statements are accurate
anatomy of securitization2
Anatomy of Securitization
  • Credit Enhancer
    • Insurance company or bank
    • Guarantees a security issue
    • Offers a letter of credit in its support, for a fee
    • Credit-worthiness can also be enhanced by
      • Establishing a reserve account
      • Over-collateralization
anatomy of securitization3
Anatomy of Securitization
  • Superior / Subordinated Debt Structures
    • Framework that allows securities to be sold in at least two different classes or tranches
      • One is lower rated, higher yielding and higher risk
      • Other is higher rated, lower yielding and lower risk
  • Tranche
    • Particular class or part of securitization issue
    • Some parts may be backed only by principal payments, others only by interest payments
    • As result, parts of various offerings also differ in terms
      • Default risk
      • Average repayment time
      • Coupon yield
securitization benefits to borrowers issuers and investors
Securitization Benefits to Borrowers, Issuers, and Investors
  • Securitization increases the funds available for
    • Home equity
    • Auto finance
    • Credit card
    • Commercial lending
    • Student loans
    • Manufactured housing
  • Costs of borrowing are lower than through traditional intermediated (indirect) finance
securitization benefits to borrowers issuers and investors1
Securitization Benefits to Borrowers, Issuers, and Investors
  • Two possible disadvantages to borrowers
    • If potential borrower fails to meet established criteria for loan intended for securitization, possible that lender will
      • Reject application
      • Charge the applicant a substantially higher loan fee or interest rate
    • The profitability of ABSs has made some lenders more aggressive in pursuing loan business
trends in common types of asset backed securities
Trends in Common Types of Asset-Backed Securities
  • Home Equity Loans
    • Type of mortgage
    • Allows borrower to use equity of one’s home as backing for a loan or revolving line of credit
  • Auto Finance
  • Credit Cards
  • Commercial Loans
  • Student Loans
  • Manufactured Housing
  • Small Business Loans
interest rate swaps
Interest-Rate Swaps
  • Interest-Rate Swaps
    • Financial instruments
    • Allow financial institutions to trade their interest payment streams to better match payment inflows and outflows
  • Derivative Instruments
    • Financial contracts (forwards, futures, options and swaps)
    • Whose values are “derived” from the values of other underlying instruments such as
      • Foreign exchange
      • Bonds
      • Equities
      • Index
interest rate caps floors and collars
Interest-Rate Caps, Floors and Collars
  • Interest-Rate Cap
    • Seller of cap agrees, for a fee, to compensate the cap buyer when an interest-rate index exceeds a specified strike rate
  • Strike Rate
    • Agreed-upon rate in an interest agreement
  • Interest-Rate Floor
    • Seller of cap agrees, for a fee, to compensate cap buyer when an interest-rate index falls below a specified strike rate
  • Interest-Rate Collars
    • Created when one simultaneously buys an interest-rate cap and sells an interest-rate floor
slide13

Exhibit 23–5

A Simple Interest Rate Cap

slide14

Exhibit 23–6

A Simple Interest Rate Floor

currency swaps
Currency Swaps
  • Currency Swaps
    • One party agrees to trade periodic payments, over a specified period of time, in a given currency, with another party who agrees to do the same in a different currency
slide16

Exhibit 23–7

Structure and Potential Benefits of a Currency Swap