Title LM18 Asset-Backed Security (ABS) Instrument and Market Features IFT Notes.pdf ✅

LM18 ABS Instrument and Market Features 2025 Level I Notes © IFT. All rights reserved 1 LM18 Asset-Backed Security (ABS) Instrument and Market Features 1. Introduction ........................................................................................................................................................... 2 2. Covered Bonds ...................................................................................................................................................... 2 3. ABS Structures to Address Credit Risk ........................................................................................................ 3 4. Non-Mortgage Asset-Backed Securities ...................................................................................................... 4 5. Collateralized Debt Obligations...................................................................................................................... 5 Summary ...................................................................................................................................................................... 7 Required disclaimer: IFT is a CFA Institute Prep Provider. Only CFA Institute Prep Providers are permitted to make use of CFA Institute copyrighted materials which are the building blocks of the exam. We are also required to create / use updated materials every year and this is validated by CFA Institute. Our products and services substantially cover the relevant curriculum and exam and this is validated by CFA Institute. In our advertising, any statement about the numbers of questions in our products and services relates to unique, original, proprietary questions. CFA Institute Prep Providers are forbidden from including CFA Institute official mock exam questions or any questions other than the end of reading questions within their products and services. CFA Institute does not endorse, promote, review or warrant the accuracy or quality of the product and services offered by IFT. CFA Institute®, CFA® and “Chartered Financial Analyst®” are trademarks owned by CFA Institute. © Copyright CFA Institute Version 1.0
LM18 ABS Instrument and Market Features 2025 Level I Notes © IFT. All rights reserved 2 1. Introduction This learning module covers:  Covered bonds  Typical credit enhancement structures used in securitizations  Non-mortgage asset-backed securities  Collateralized debt obligations 2. Covered Bonds Covered bonds are senior debt obligations issued by a financial institution and backed by a segregated pool of assets that typically consist of commercial or residential mortgages or public sector assets. Covered bonds are similar to ABS, but they differ because of their:  Dual recourse nature: Investors have claims against both the issuing financial institution and the underlying asset pool.  Balance sheet impact: The underlying asset pool remains on the issuing financial institution’s balance sheet. It is not transferred to a separate SPV. The covered pool bondholders retain a top-priority claim against the pool.  Dynamic cover pool: The underlying asset pool is not static. The issuing financial institution must replace any prepaid or non-performing assets in the cover pool to ensure sufficient cash flows until maturity. In contrast, ABS pass through default and prepayment risk to investors.  Redemption regimes in the event of sponsor default: In the event of sponsor default, redemption regimes align the covered bond’s cash flows as closely as possible to the original maturity schedule. o In the case of hard-bullet covered bonds, if payments do not occur according to the original schedule, a bond default is triggered and bond payments are accelerated. o Soft-bullet covered bonds delay the bond default and payment acceleration of bond cash flows until a new final maturity date, which is usually up to a year after the original maturity date. o Conditional pass-through covered bonds convert to pass-through securities after the original maturity date if all bond payments have not yet been made. Because of these additional safety features, covered bonds usually have lower credit risks and therefore lower yields as compared to otherwise similar ABS.
LM18 ABS Instrument and Market Features 2025 Level I Notes © IFT. All rights reserved 3 3. ABS Structures to Address Credit Risk Credit Enhancement Three main types of internal credit enhancements widely used in securitization transactions are:  Overcollateralization: The value of the collateral exceeds the face value of the issued bonds. This provides a safety cushion to investors.  Excess spread: This is the difference between the coupon on the underlying collateral (say 8%) and the coupon paid on the securities (say 6%). The excess spread (8% - 6% = 2%) can absorb collateral shortfall or be used to build up reserves.  Subordination or credit tranching: More than one bond class or tranches are created, and they differ in how they share any losses resulting from defaults in the collateral pool. External credit enhancements like financial guarantees by banks or insurance companies, letters of credit, and cash collateral accounts are also commonly used. These are not covered in the curriculum. Credit Tranching Credit tranching was covered in the previous learning module. Exhibit 3 from the curriculum illustrates this ‘waterfall structure’. The four tranches have differing yields and degrees of risk, and they are affected differently in the event of a default. Class A, the most senior investor tranche with the highest ranking in the capital structure, receives principal payments first, carries the least risk, and provides the lowest return. Class B mezzanine tranche assumes slightly higher risk but offers higher returns. Class D absorbs losses first and has the highest risk, but also the highest potential yield. Because of the
LM18 ABS Instrument and Market Features 2025 Level I Notes © IFT. All rights reserved 4 residual nature of its claims to cash flows from the asset pool, the lowest tranche is sometimes referred to as the "equity" tranche. 4. Non-Mortgage Asset-Backed Securities A wide range of assets apart from mortgage loans are used as collateral for asset-backed securities (e.g. auto loans, credit card receivables, personal loans, commercial loans). Based on the way the collateral pays, ABS can be categorized into two types: amortizing and non-amortizing. Examples of amortizing loans backing an ABS: mortgage loans and automobile loans. An example of non-amortizing loans backing an ABS: credit card receivables. This learning module focuses on credit card receivable ABS and a residential solar ABS. Credit Card Receivable ABS Credit cards such as Visa and MasterCard are used to finance the purchase of goods and services, as well as for cash advances. When a cardholder makes a purchase using a credit card, he is agreeing to repay the amount borrowed (purchase amount) to the issuer of the card within a certain period, typically a month. If the outstanding amount is not repaid within this grace period, then a finance charge (interest rate) is applied to the balance not paid in full each month. Credit card receivables are pooled together to act as a collateral for credit card receivable- backed securities. Cash flow, on a pool of credit card receivables consists of:  Finance charges: These represent the periodic interest the credit card borrower is charged on the unpaid balance after the grace period.  Fees and principal repayments. Fees include any late payment fees and any annual membership fees. Characteristics of Credit Card Receivable-backed Securities Payment Structure  The security holders are paid an interest periodically (e.g., monthly, quarterly, or semiannually). The interest rate may be fixed or floating.  The principal payments made by borrowers do not flow through to investors during a period known as the lockout period. Instead, the repayments are reinvested to issue new loans. As a result, credit card receivables increase during the lockout period. During this period, the cash flow to security holders comes from finance charges and fees. Amortization Provision  Credit card receivable-backed securities are non-amortizing loans. The principal is not amortized during the lockout period.  Certain provisions in credit card receivable-backed securities require early amortization of the principal if certain events occur. Such provisions are referred to as