CFA CFA Level 2 Asset-Backed Sector of the Bond Market

Asset-Backed Sector of the Bond Market

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    • Sarah
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      Which of the following is the least likely reason why an asset-backed security (ABS) generally requires overcollateralization while a mortgage-backed security (MBS) does not?

      1. Some ABS doe not have any tangible property as collateral
      2. Principal recovery in the event of a default is likely to be lower in an ABS
      3. The interest rates on the underlying assets in an ABS are likely to be lower than the rates on the underlying assets in an MBS

      The answer is option 3 because “The interest rates on the underlying assets for some ABSs may be lower than for MBSs and some rates on underlying assets will be higher. In any case this is not a reason for overcollateralization of ABS.”

    • Sophie Macon
      Keymaster
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      @Diya, any part of the question you don’t fully follow?

    • Sarah
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      ABS require overcollateralization? I can’t find this anywhere in my notes. I know this is kind of a silly question…

    • Sarah
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      @sophie
      Basically I don’t understand the question. I thought overcollateralization was used to enhance credit rating.
      So from this question would it be safe to assume that if a ABS used non-tangible securities it would need to be overcollateralized?

      Principal recovery for an ABS in the event of a default is likely lower than an MBS – which can’t be right because MBS is a sub-class of ABS which means answer 3 is the answer because overcollateralization has nothing to do with interest rates and would not require overcollateralization.

      Would my reasoning be correct?

    • Sophie Macon
      Keymaster
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      ABS can have (not require) overcollateralisation, it depends on situation, but most of them require some form of credit enhancement. Conceptually similar to MBS, ABS is backed by pools of loans or receivables other than primary mortgages.

    • Sophie Macon
      Keymaster
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      @diya, if an ABS uses non-tangible securities (which it normally does, e.g. auto loans, student loans etc), it needs further credit enhancement for investors/regulator to be comfortable with such securities. To do that, there are various ways, of which one is overcollateralisation. One could also obtain 3rd party guarantee on the bond performance (the US govt provided various guarantees during the financial crisis for stability), or even bond insurance, or reserve funds, or structures that have senior and subordinated debt to appropriately differentiate the risks further.

      Yes MBS is a sub-class of ABS. Yup, Answer 3 does not affect the credit risk assessment of the ABS hence would be the answer.

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