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THE DETERMINANTS OF YIELD SPREADS
RICHARD H. BORGMAN
A DISSERTATION PRESENTED TO THE GRADUATE SCHOOL
OF THE UNIVERSITY OF FLORIDA IN PARTIAL FULFILLMENT
OF THE REQUIREMENTS FOR THE DEGREE OF
DOCTOR OF PHILOSOPHY
UNIVERSITY OF FLORIDA
TABLE OF CONTENTS
ABSTRACT ................................... ... ........... iv
1 INTRODUCTION ................................... 1
2 INSTITUTIONAL FEATURES OF SECURITIZATION ........ 8
The Market for Asset-Backed Securities ................... 8
The Framework of an Asset-Backed Security ................ 11
Implications for Pricing ............................... 26
3 PREVIOUS LITERATURE ............................ 32
Bond Pricing Studies ............................... .. 32
Mortgage-Backed Security Pricing Studies .................. 35
Asset-Backed Security Literature ......................... 45
4 ASSET-BACKED SECURITY RISK FACTORS AND
HYPOTHESES FOR PRICING ......................... 52
Default Risk (Part 1): Credit Rating ................ ..... 53
Option Characteristics of an ABS ........................ 57
Default Risk (Part 2): The Sufficiency of Credit Rating ....... 67
Marketability ...................................... 72
Collateral ................... ............... ........ 76
Summary: Hypotheses Concerning the Determinants of ABS Yield
Spreads ......................... .............. 77
5 METHODOLOGY AND DATA ......................... 80
D ata ................ .... ................. ...... 81
Sample Description: Entire ABS Sample ................... 85
Regression Sample ................................. 88
The M odel ........................................ 89
6 REGRESSION RESULTS ............................ 101
The Basic Absolute Spread Model ....................... 101
Interactive Variables for B Tranches and Multiple A Tranches ... 117
Reputation and Originator Rating ....................... 119
"Are Banks Different?" .......... ................... 122
Credit Enhancement ................................. 126
7 CONCLUSION ................................... 146
Implications of the Analysis ........................... 147
Extensions of the Pricing Analysis ...................... 149
A ABS GLOSSARY .................... ............ 151
B REGRESSION TERMS AND ABBREVIATIONS ........... 155
C RELATIVE SPREAD REGRESSIONS ................... 162
REFERENCES ................................... .......... 168
BIOGRAPHICAL SKETCH ..................................... 175
Abstract of Dissertation Presented to the Graduate School
of the University of Florida in Partial Fulfillment of the
Requirements for the Degree of Doctor of Philosophy
THE DETERMINANTS OF YIELD SPREADS
Richard H. Borgman
Chairman: Mark J. Flannery
Major Department: Finance, Insurance, and Real Estate
Asset-backed securitization has enjoyed rapid growth in its rather short existence
as a public market These nonmortgage, nongovernment-guaranteed asset-backed issues
have created a new source of fixed income securities for investors and a new source of
liquidity for banks and other lending firms. This study examines the determinants of
asset-backed securities' (ABS) equilibrium yield spread over Treasury, using a cross-
section of primary market issue prices.
The process of converting illiquid assets to traded securities involves a complex
set of institutional arrangements and structures that create an intricate set of risks for the
investor. These institutional arrangements, structures, and risks are analyzed as a
precursor for specifying a model of the determinants of pricing. This model extends
models previously used in pricing studies of corporate bonds and mortgage-backed
There is no standard data source for these securities, so there have been no
previous studies of how these securities are priced. A major contribution of the study is
the assembly and analysis of a substantial dataset that describes the pricing and
characteristics of over 700 ABS at issue. Ordinary least square regressions are utilized
in the pricing analysis, which includes issues from 1985 through 1992. This analysis
finds that ABS pricing (absolute and relative yield spreads) is rational and prices reflect
premiums for default risk, interest rate and reinvestment risk, and marketability. As one
would expect in a rapidly evolving market, institutional forms have changed frequently,
and new ones have been added, over the sample period. To some degree, the market has
required premiums for the unfamiliar or new and discounted for experience. ABS in
general do not exhibit negative convexity and are not subject to excessive prepayment
risk. Although the complicated structures utilized to separate the risk of the collateral
from the risk of the originator are effective, as indicated by the preponderance of AAA
rated issues, investors nonetheless require information in addition to credit rating
concerning an issue's pool and/or servicing when pricing the issue.
The significant growth of asset securitization by banks and other lenders via
nonmortgage, nongovernment-guaranteed asset-backed security issues has created a new
source of fixed income securities for investors and a new source of liquidity for banks
and other lending firms. While it has been suggested that asset-backed securities are
technically superior to traditional on-balance sheet means of financing because of
potentially lower costs and more efficient risk allocation, there has been no systematic
evaluation of how investors price these securities. This study examines the determinants
of asset-backed securities' equilibrium yield spread over Treasury, using a cross-section
of primary market issue prices.
The asset-backed security (ABS) market, in existence just since 1985, has rapidly
grown to over $60 billion of new issues a year. The process of converting illiquid assets
to traded securities involves a complex set of institutional arrangements and structures
(described in Chapter 2) that creates an intricate set of risks for the investor. There is no
standard data source for these securities, so there have been no studies of how these
securities are priced. A major contribution of the study is the assembly and analysis of
a substantial dataset that describes the pricing and characteristics of over 700 ABSs at
issue. This study offers the opportunity to analyze a new market and characterize the
market maturation process. It investigates the sensitivity of these asset-backed securities
to prepayment risk--do they exhibit sensitivity like mortgage-backed securities or exhibit
positive convexity like noncallable corporate bonds. It also analyzes the sufficiency of
credit rating to characterize credit quality in a heterogeneous market. Investors may
utilize other information in addition to credit rating, such as originator characteristics and
credit enhancement amount and type. If investors do use originator rating, the market
may not believe the claims of a "bankruptcy remote" legal structure.' Finally, the study
assesses whether standard proxies for marketability, default risk, and interest rate risk are
priced in this new market.
Securitization refers to the transformation of private loans negotiated between a
borrower and a lender into publicly traded (or at least saleable) securities. It separates
the originator from the ultimate investor. It is reflected by two streams: loan sales
(confined to banking) and the more narrowly defined (but more broadly practiced)
securitization, credit securitization or the issuing of asset-backed securities.2 Credit
securitization differs from single loan sales because it involves the pooling of assets--such
as mortgages, automobile loans, or credit card receivables--and the creation and sale of
'In the securitization process, a "bankruptcy remote" special purpose vehicle or entity
(SPV/SPE) is established to separate the risks of the pool of collateral from the originator. The
SPV is a specially chartered corporation that purchases the loans (collateral) from the originator
and is the actual issuer of the securities. Thus there is no liability created on the balance sheet
of the originator. For banks, the "bankruptcy remote" terminology is not exactly correct, since
banks cannot go bankrupt; rather, they can be declared insolvent. If this separation of the
originator from the issuer were not complete, it would imply an off-balance sheet liability for a
2Some authors would not include loan sales under the rubric of securitization. Greenbaum and
Thakor (1987) sharply distinguish between the two: "[S]ecuritization involves qualitative asset
transformation .... Thus, securitization enhances liquidity, reduces credit risk and restructures
cash flows. Loan sales merely separate funding from origination." (p. 380).
new securities collateralized by the pool of assets. Mortgage-backed securities usually
have an explicit or implicit guarantee from a U.S. government agency and are not the
concern of this study. Asset-backed securities with other types of collateral are addressed
here. These securities are usually rated triple A, a rating attained by the addition of some
sort of credit enhancement.3 Securitization transfers risk from the originator and often
restructures risk bearing to some degree.
The rapid growth of securitization over a relatively short time indicates that the
process has become an important tool for banks and other firms and an important subject
of study.4 The first nonmortgage backed, nongovemment-guaranteed, publicly issued
asset-backed security was introduced in March of 1985 by Sperry Corporation, a $192.5
'Credit enhancement refers to any additional protections for investors against default risk that
are included in the structure of the issue. These include guarantees of principal and interest
payments by third party insurers, senior/subordinate structures, and cash collateral accounts which
are a stated percentage of principal maintained as a separate account as a first loss protection for
4Asset securitization is used by many types of firms to reduce leverage, to diversify funding,
and, especially for lower rated originators, to raise less expensive funds. Asset securitization is
used by banks in fund raising, in asset-liability management, in meeting customer demand, and
in avoiding regulatory taxes (reserve requirements and deposit insurance premiums on funding
deposits, and regulatory capital requirements). Borrowers benefit through an increased supply of
loans, potentially lower costs, and increased credit on terms lenders might not provide to such a
degree otherwise, such as fixed rate mortgages. Investors have a greater supply and variety of
investment opportunities suited to specific needs. The banking system arguably has been made
more stable through an increase in liquidity for previously nonmarketable assets, through increased
opportunities for diversification, and because of an increased ability to compete for borrowers.
The overall economic system benefits through more optimal risk bearing. In fact, Roll (1987)
points to financial innovations such as collateralized mortgage obligations as helping to "complete
the market" and thus creating value (through lower required yields on the underlying mortgages).
Jameson, Dewan, and Sirmans (1992) attempt to measure the welfare benefits of CMOs and find
them to be substantial.
million issue backed by computer lease receivables.5 Yet in a short time the market for
these securities has grown dramatically. New issues for 1993 were just over $60 billion.
New issues for 1994 are expected to total between $62 billion and $70 billion, rising from
$1.23 billion in 1985.6
The growth in securitization is likely to continue, spurred by some recent
regulatory and legislative events. First, in November, 1992, the SEC passed Rule 3a-7
exemption to the Investment Company Act of 1940. Under this exemption, a broad
variety of assets not previously eligible can now be securitized.7 According to Asset
Sales Report, the adoption was "politically geared toward fostering the securitization of
small business loans" and thus to alleviate the credit crunch (ASR, November 30, 1992,
p. 1). However, the effects are more far reaching than just small business loans, allowing
for the securitization of student loans and unsecured consumer loans, for example.
Second, the Clinton administration has expressed support (with modifications) for the
Financial Asset Securitization Investment Trust (FASIT), proposed to Congress in May,
5The first private issue occurred slightly earlier in 1985 by Comdisco, a $35 million issue
backed by computer leases.
6Asset Sales Report, January 1, 1994, p. 1. Hereafter Asset Sales Report will be referred to
as ASR and references will be made parenthetically.
'Prior to this exemption, ABSs were issued under exemptions provided by Rule 3c-5 to the
1940 Act. Under Rule 3c-5(a), assets that primarily represented the purchase price of
merchandise, services, or insurance qualified--auto and credit card ABSs used this. It did not
apply (except for small amounts) to cash advances on credit cards. Under Rule 3c-5(c), assets that
represented an interest in mortgages or real estate qualified--home equity loans used this. Issuers
could also apply for special exemptions under Rule 6-c, but these were largely limited to "partial
pool" agency issues backed by mortgages. The new Rule 3a-7 expands the definition of assets:
eligible assets now cover "financial assets, either fixed or revolving, that by their terms convert
into cash within a finite time period, plus any rights or other assets designed to assure servicing
or timely distribution of proceeds to the security holders." By this definition, the only thing
clearly excluded is stock.
1993 (H.R. 2065) (ASR, June 28, 1993). FASIT would extend the tax benefits of the
Real Estate Mortgage Investment Conduit (REMIC) to assets other than real estate.8
Third, there has been legislative effort to encourage a secondary market for business loans
via the securitization technology. The sponsor, Representative Paul Kanjorski, said that
the "ultimate goal is to allow the private sector, through the new secondary market, to
take business, commercial, and community development debt and equity investments,
place them in securitized pools, and create investment products which are attractive to
pension funds and insurance companies."9 Whatever the political or economic merits of
these legislative proposals, it is clear that securitization is being pushed forward as if it
were a panacea for the credit crunch.
Given the significant growth of the ABS market and its future potential, a rigorous
evaluation of the factors that determine ABS pricing is important. This analysis finds that
ABS pricing (absolute and relative yield spreads) is rational and prices reflect premiums
for default risk, interest rate and reinvestment risk, and marketability. Spreads are found
to have widened over time due to market recomposition. But spreads for homogeneous
S"Under the proposal, the FASIT, a legal entity, could issue multiple classes of securities and
substitute assets. The latter action is essential for the securitization of revolving and short-term
assets like credit cards and trade receivables, home equity lines of credit and small business loans"
(ASR, June 21, 1993, p. 1).
'ASR, July 6, 1993, p. 1. This bill does not propose the creation of a new government
sponsored enterprise. Rather, it proposes a chartering process to allow a private entity to create
a market. The securities issued under the charter would be exempt from certain regulations, much
like securities issued by Fannie Mae and Freddie Mac. (According to ASR [April 26, 1993, p.
1] "This implies that small business loan securities would gain the benefits of the Secondary
Mortgage Market Enhancement Act of 1984, including favorable risk weighting.") However, it
also requires chartered entities to agree to goals to "promote lending to businesses in low to
moderate-income areas or enhance 'employment opportunities'."
securities show no trend. As one would expect in a rapidly evolving market, institutional
forms have changed frequently, and new ones have been added, over the sample period.
To some degree, the market has required premiums for the unfamiliar or new and
discounted for experience. ABSs in general do not exhibit negative convexity and are not
subject to excessive prepayment risk. Although the complicated structures utilized to
separate the risk of the collateral from the risk of the originator are effective, as indicated
by the preponderance of AAA rated issues, investors nonetheless require information in
addition to credit rating concerning an issue's pool and/or servicing when pricing the
Chapter 2 reviews the institutional features of the asset-backed market. First the
market for the securities is described, including its pattern of growth, range of assets
securitized, and buyers and sellers. Then the asset-backed security itself is examined in
some detail. This section provides background and impetus for the empirical study to
follow. Chapter 3 reviews the relevant pricing literature, drawn primarily from corporate
bond and mortgage-backed security (MBS) pricing studies. It concludes with a discussion
drawn from the ABS literature of additional ABS pricing considerations. Chapter 4
motivates the regression pricing model by examining the sources of priced risk and lists
the hypotheses under investigation. The methodology and data are presented in Chapter
5, while Chapter 6 analyzes the results of ordinary least square (OLS) regressions.
Chapter 7 concludes.
Appendix A contains a glossary of ABS terminology, and Appendix B defines the
variables and abbreviations used in the regressions. Absolute spreads are used in the
primary regressions in Chapter 6; Appendix C contains parallel regressions for the
relative spread model.
INSTITUTIONAL FEATURES OF SECURITIZATION
The Market for Asset-Backed Securities
The growth of credit securitization has been truly astounding (see Figure 1). New
public issues of securities backed by assets other than mortgages were over $60 billion
in 1993 and may be as high as $70 billion in 1994 (ASR, January 10, 1994, p. 1).'
There is room to grow; by the end of 1990, for example, 40% of 1-4 family residential
mortgage debt was securitized, only 10% of consumer debt (Dreyer, 1991).
The variety of ABS collateral associated with 1992 issues is shown in Table 1.
All categories, with the exception of home equity loans and credit cards, increased over
1991.2 Although the market has been and continues to be dominated by just a few
collateral types, there has been an interesting variety of collateral involved in
securitization in the private and/or public markets. Among these are tenant leases (ASR,
March 22, 1993), payments due on travellers checks (ASR, October 5, 1992), cash flows
'"The asset-backed securities market, overall, has been the fastest-growing segment of the
fixed-income market." (Mitchell and Adler, 1991, p. C19). The ABS market, however, is still just
a fraction of the older mortgage-backed market. Outstandings of residential mortgage-backed,
pass-through securities went over $1 trillion by year-end 1990 (Dreyer, 1991). This popularity,
of course, has been due in large measure to the credit enhancements provided by government
agencies responsible for creating a secondary market for residential mortgages.
2Home equity backed issues dropped a whopping 40% from 1991, primarily due to the
sluggish economy and, especially, the increase in mortgage refinancing in 1992. Homeowners
often consolidate second mortgages and home equity loans into a new first lien mortgage.
from service contracts (ASR, November 23, 1992), third world debt (ASR, March 20,
1989), and U.S. military sales debt (by the Kingdom of Morocco, ASR, October 30,
The largest collateral category, the auto loan sector, offers a helpful
characterization of the market. While the market is broadening over time--a larger
number of smaller issuers--it is still dominated in dollar terms by a small number of high
volume issuers. In 1992, the top five issuers of auto ABSs originated 53% of the auto-
backed dollar volume (ASR, April 26, 1993), with General Motors the dominant issuer
(replacing Chrysler from 1991).3
Examination of the types of collateral points out a major characterization of credit
securitization. Some loans are more amenable to credit securitization than others. Loans
that are pooled must have similar characteristics so that the pool can be relatively easy
to evaluate by investors, rating agencies, and insurers. Residential fixed rate mortgages
used as collateral in mortgage-backed issues are relatively homogeneous and thus make
excellent pooled assets. Auto loans and credit card receivables are also relatively
homogeneous and thus form the bulk of nonmortgage asset-backed issues. Commercial
loans tend to be much less homogeneous and often must be evaluated individually. They
tend to be fairly large and complex and have terms that vary across borrowers. Thus they
are usually not pooled and are sold whole or in part by loan participation. Of course,
as the ABS technology develops and market conditions vary, this characterization is
'General Motors suffered a rating downgrade, which was its impetus for expanding in the ABS
changing. For example, adjustable rate loans were generally considered less favorable
candidates than fixed rate loans for securitization because they do not have a fixed
payment stream, making them difficult to value and structure as an ABS. In addition, the
market preferred fixed rate issues until recently. But variable rate ABS issues have
become quite common since the fall of 1992, due to advances in the ability to structure
these issues and due to market demand because of cyclically low interest rates. Likewise,
some commercial loans have been securitized.
The largest sellers (originators) of ABSs are presented in Table 2. In dollar terms,
Citicorp is the largest originator, with over $30 billion of securities sold in 36 issues.
Chrysler, however, had 39 issues through the end of 1992, the most number of issues,
although Sears was not far behind with 37 issues. The top ten originators include five
banks and three automobile manufacturers, echoing the collateral types in Table 1 and
indicating the dominance of these two industries in the ABS market Banks, in fact, are
the largest originators with over $83 billion issued (see Table 2). But the captive finance
companies are not far behind with $80 billion sold. The captive finance companies
include primarily the consumer finance arms of the automobile manufacturers, as well as
providers of retail credit cards (e.g., department stores) and mobile homes (e.g.,
Fleetwood). The largest buyers of ABSs are pension funds, insurance companies, mutual
funds, thrifts, and commercial banks. Foreign buyers have become increasingly active,
especially with the increase in variable rate ABSs in late 1992, which are usually pegged
to LIBOR (London interbank offered rate). Recently, some ABS issues have tried to
attract money market funds by including a short-term money market tranche.4
The Framework of an Asset-Backed Security
The basic process of creating a nonmortgage asset-backed security involves six
steps: (1) pooling, (2) credit enhancement, (3) establishment of a special purpose vehicle
to own the assets, (4) repackaging cash flows, (5) rating the issue, and (6) selling the
securities to investors. There can be a large number of participants, with separate entities
possibly originating, issuing, structuring, distributing, servicing, insuring, monitoring, and
rating. The process is illustrated in Figure 2.
A large number of homogeneous assets (in terms of credit quality, maturity, and
interest rate risk) are pooled together by the originating firm in order to diversify credit
risk and to reach the minimum size required to justify a public securities offering. A
special purpose vehicle (SPV) is established to own the underlying securities. This trust
or corporation is set up to separate the risks of the pool of assets from all other risks of
the originator or fund raiser; the special purpose vehicle's business is usually restricted
4The first such ABS was a John Deere issue in September 1992, which included a money
market tranche with an expected average life of 0.42 years. It was structured as a pay-through
rather than a pass-through in order to create the short-term tranche (these terms are defined in the
next section). This issue has been successful, but other issues' money market trenches face
problems. The problem is that most money market trenches are fixed rate with expected average
lives of 4 to 8 months and with legal final maturities of 1 year. Because the exact maturity is not
sure, mutual funds must book these investments as 1 year holdings--i.e., to the final maturity date.
Because the SEC requires money funds to maintain an average maturity of 90 days, 1 year
holdings may increase the average too high. John Hollyer, manager of Vanguard's Prime
Portfolio money fund, rarelyey [makes] a one-year investment." The Deere tranche avoided this
problem by resetting the rate (against LIBOR) every three months. Money market funds are
permitted to book such resets as 90 day holdings (ASR, March 29, 1993, p. 3).
to the purchase of the assets and the issuance of securities backed by those assets.5
Because the assets in the pool are totally separated from the credit risk of the originator,
even should the originator default, investors have uninterrupted access to the underlying
assets. Thus, this is an improvement even over secured debt, where bankruptcy would
probably delay repayment. Removing the assets from the balance sheet via a true sale
to the SPV also has important regulatory advantages, especially for a bank, which thereby
reduces its required capital as well as the necessity of funding these loans with deposits
subject to reserve requirements. A nonbank also benefits by sale, because it lowers its
GAAP (Generally Accepted Accounting Principles) leverage which can affect debt
covenant compliance and/or pricing.6
Rights to receive the repackaged cash flows are sold to investors. An investment
banking firm typically underwrites the new securities. A rating agency will rate the issue.
A service, most often the originator, is responsible for collecting interest and principal
payments on the assets in the underlying pool and transmitting these funds to the
investors. The service is obligated to "manage and maintain control of the assets and
[the issue's] payment stream" (Watson and Joynt, 1989, p. 234). This is a key role.
These can be extremely complicated securities, and transaction management can be a
difficult task; it is important that it is done well and for the life of the issue. The
service must be of sufficient credit standing because among its functions is to collect and
5See Rosenthal and Ocampo (1988, pp. 48-63) for details on the tax considerations,
advantages, and limitations of various kinds of special purpose vehicles such as grantor trusts,
owner trusts, and debt
'Details on GAAP are provided in the next section on credit enhancement.
hold payments till passed on to the investor and to make advances on delinquent
payments. Also, the service, through collection procedures and policies, maintains pool
quality and can influence payment behavior.
Monitoring is performed by a trustee as well as accounting firms (periodic audits)
and the rating agencies. The trustee of an ABS, as with any security issue, represents the
interests of the investors. The trustee authenticates the issue's legality at the time of
issue, watches over the financial conditions and behavior of the issuer, and makes sure
all contractual obligations are carried out (Standard & Poor's, 1988, p. 19). The rating
agency continues to monitor the issue over its life as it reaffirms or changes the tranche
Two apects of the securitization process demand special attention--credit
enhancement and the cash flow structure.
Credit enhancement is added to the issue in order to raise the rating of the
resulting securities to investment grade. To be marketable and competitive with federal
agency-backed mortgage issues (i.e., government guaranteed), private issues need a
default risk comparable to that of Agencies'. The problem, of course, is that the
underlying securities to whose cash flows the ABS purchasers have claims are too
difficult or expensive for many market participants to evaluate for themselves. Hence,
successful securitization depends on the issuer devising a mechanism to separate the risk
of the ABS cash flows from that of the underlying securities. The credit enhancement
can occur in a variety of ways including a senior-subordinated structure, a recourse
provision, overcollateralization, letters of credit, surety bonds, spread accounts, or cash
collateral accounts. Many of these forms of enhancement can be provided by either a
third party or the originator.7
One way to divide the credit enhancement methods is between those primarily
provided by a third party and those that create a self-supporting structure. Third party
insurance was the primary form of enhancement throughout the 1980s; still very popular,
it includes surety bonds or guarantees by (primarily) insurance companies and letters of
credit issued by (primarily) large commercial banks. When the credit risk is shifted from
the pool quality to the balance sheet of the third party enhancer, risk analysis by the
ratings agencies focuses on that third party enhancer. For example, when insured by a
letter of credit, the Duff and Phelps credit rating on the tranche is determined by the
providing commercial bank's senior debt rating (see Gold and Schlueter, 1993, p. 156).8
Both letters of credit and surety bonds protect some stated percentage of principal
and interest payments, often up to 100%. The letters of credit must be irrevocable (not
standby) to avoid discretionary action by the providing bank at the time of need. Surety
bonds are "guarantees placed on the assets (i.e., student loan guarantees) or on the
individual notes or certificates (i.e., financial guarantees) to provide for payment of
principal and interest on the defaulted assets or securities" (Gold and Schlueter, 1993, p.
7Credit enhancement is a very important cost factor in credit securitization. Nine banks that
had issued card-backed securities in 1991 did not have any issues in 1992, partly because the cost
of credit enhancement had become too high (Kleege, 1993).
8S&P echoes this reliance on the third party enhancer's credit rating. However, Griep points
out that the failure of a few banks involved in the ABS business and the weakness of several
others have led to an increased examination of the underlying projects (Griep, 1993, p. 144).
156). That is, in the event of a borrower default, the insurer will immediately pay out
the remaining principal (a prepayment) and any interest due. A 100% "surety wrap" is
a guaranty of principal and interest on both A (the senior) and B (the subordinate) pieces.
The primary providers are financial guaranty firms, property-casualty insurers, and
banks.9 The originator may also be the enhancer if its corporate rating is high enough.
The use of self-supporting credit enhancement structures increased throughout the
late 1980s and into the 1990s for two important reasons. First, the credit quality of the
banking and insurance industries declined, accenting the event risk that the insurer could
have its rating lowered. An ABS can be rated no higher than that of the third party
insurer. Second, the banking industry experienced "the imposition of more conservative
bank regulatory treatment and risk-adjusted capital guidelines have increased the capital
charges for recourse" (Griep, 1993, p. 145). Banks withdrew from the ABS LOC (letter
of credit) business. Self-supportive structures include senior/subordination,
overcollateralization, spread account, and cash collateral structures. These enhancement
methods eliminate reliance on third parties, but they also reduce third party review of
A senior-subordinate structure can have two or more trenches, with at least one
subordinate. In a typical deal, principal on the junior notes (the "B" class or tranche) is
not paid until the senior portion (the "A" class or tranche) is retired. If the amount of
subordination is 5% of the issue, the subordinate tranche absorbs the first 5% of any
9The financial guaranty firms are also known as monoline insurers and include MBIA
(Municipal Bond Investors Assurance Corporation), CapMac (Capital Markets Assurance
Corporation), and FGIC (Financial Guaranty Insurance Company).
losses on the underlying collateral, and thus provides the senior portion with credit
enhancement. The junior portion can be sold or retained by the issuer. If sold, the B
class requires a higher yield to compensate for this increased risk. In addition, the market
for these subordinate trenches is less liquid than the market for the senior trenches, also
contributing to a higher required yield. (Griep  points out that these B securities
are increasingly being bundled and securitized themselves, increasing their liquidity.) A
potential problem with the senior/subordinate structure is a cash flow availability problem.
That is, with third party support, as soon as a loss is realized, a claim can be made to the
enhancement provider and funds are immediately forthcoming. However, a subordinate
class can only give up cash flows currently due to it, and these funds may not be able to
cover every loss in a timely manner.
With overcollateralization, the value of the underlying assets exceeds the face
value of the securities. The amount of overcollateralization thus provides a cushion for
the security holders and amounts to an equity layer in the SPV. This form of
enhancement is not usually a primary form of enhancement. It is usually used when
enhancement is "difficult to obtain but assets are plentiful" (Millard, 1993, p. 130).
A cash collateral account is basically a cash loan to the issuing trust (SPV) of an
ABS by the originator or a third party. The cash, often between 5% and 10% of the
issue, is invested in high quality securities and commercial paper. This highly liquid
account is then available to cover any borrower defaults. The cost for the SPV is the
difference between the rate charged on the loan and the rate earned on the cash collateral
investments. Cash collateral accounts have become a more prevalent form of credit
enhancement in recent years for two reasons--they are effective in eliminating the "event
risk" that the third party insurer may be downgraded, and they have been a way for banks
with less than triple-A ratings to get back into the credit enhancement business, since the
cash is provided up front and is therefore not dependent on the provider's rating.'0
Banks who previously acted as third party insurers by issuing letters of credit now
provide loans for cash collateral accounts. Cash collateral accounts are said to be more
expensive to provide than LOCs because they are funded assets, but it is felt that cost for
the SPV is made up in a reduced yield because of the event risk protection."
The type of credit enhancement utilized depends to some degree on the originator.
The goal of securitization in most cases is to remove the assets from the balance sheet
of the originator, i.e., to effect a true sale. Banks face stricter requirements than do
nonbanks in qualifying a transfer of assets as a sale. Under RAP (Regulatory Accounting
Principles), which banks must satisfy, sales with recourse are not "true" sales and the
securitized assets generally cannot be removed from the balance sheet (for regulatory
purposes)." However, GAAP (Generally Accepted Accounting Principles), which
'eThere is another way for less than triple-A banks to remain in the enhancement business and
still provide letters of credit, the rarely used "hybrid" structure. With this method a double-A
bank, say, provides a letter of credit with the stipulation that if the bank is further downgraded,
the letter of credit will be converted into a cash collateral account
"For example. Bank of New York, in a credit card deal in March of 1991, "saved 10 to 15
basis points in yield by using the cash backing, [said] market sources" (ASR, April 8, 1991, p.
8). The first issue to use a cash collateral account as a replacement for a letter of credit was
MBNA, also in March of 1991.
'However, a major exception to this rule applies to transfers of pools of residential mortgages
(not considered here) with a recourse feature. Such transfers can be reported as sales as long as
the originating bank does not retain any "significant risk of loss." The amount is vague, but
general consensus is that some amount less than 10% of the principal is not significant.
nonbanks must satisfy, does allow sales with recourse." This means that banks are
much more likely to employ third party guarantors, via a surety bond, a standby letter of
credit, or a third party cash collateral account. Nonbanks, on the other hand, are more
likely to employ the senior/subordinate structure and retain the junior position in the pool.
This junior position allows the originator to absorb the "usual" level of default risk
associated with the particular type of asset. These first loss obligations under the recourse
provision or the senior/subordinated structure make the sale one with recourse--a sale
under GAAP, not under RAP. Thus there could be no equity savings for banks using a
senior/subordinate structure where the subordinate position is retained. Instead, the
transfer would be treated as borrowing.
There is one exception, for banks, that allows them to offer additional credit
support themselves for nonmortgage collateral and still make a sale under RAP. This is
the "spread account" structure (also referred to as a reserve account). The spread account
is simply a type of escrow account. The way it works is simple: asset-backed certificates
carry promised payments below those on the underlying assets. The proceeds from this
spread, less a servicing fee, are collected in the spread account up to a stated level. After
that, the spread goes to the originator. The funds in this spread account provide credit
support for the asset-backed securities. After the securities are completely paid off,
"Asset transfers with recourse are treated more liberally under GAAP, where sales or
financing treatment are specified by Financial Accounting Standards Board Statement No. 77.
Three criteria establish a transfer of receivables with recourse as a sale: (1) the transferor
surrenders control of the future economic benefits relating to the receivables; (2) the transferor can
reasonably estimate its obligation under the recourse provisions; and (3) the transferee cannot
retum the receivables to the transferor except pursuant to the recourse provisions. Regulatory
Accounting Procedures (RAP) require (for there to be a sale) no risk of loss from any cause and
no obligation to any party for the payment of principal or interest for any cause.
anything left in the spread account will revert to the originator. Only at that time will the
originator take the funds in the spread account as income. Because it is not income until
that time, any use of the account to cover payment defaults will not result in a loss to the
bank. Consequently, regulators have determined that asset sales with spread accounts do
qualify as sales under RAP. Spread accounts are especially common with credit card
It is quite common for issues to use a combination of credit enhancement
techniques to achieve the desired rating. A spread account may exist in tandem with a
third party guarantee, for example, thus lowering the cost of the third party insurance.
Cash Flow Structure
There are four major cash flow structures employed by ABSs: pass-through,
controlled amortization, bullet, and bond.14'1 These structures or similar predecessors
were developed in the mortgage-backed security market and are more familiar to many
"A passive grantor trust is the legal form of the entity (SPV) that will typically issue pass-
through securities. Controlled amortization and bullet structures (pay-throughs) and asset-backed
bonds are issued by corporations and owner trusts. For further discussion of these legal forms see
Pavel (1986, 1989) and Frankel (1991). Note that a passive grantor trust does not allow
transformation of cash flows, i.e., the cash flows are passed on to the ABS security holder when
and as received. Bonds and pay-throughs do allow transformation (e.g., monthly payments to
quarterly or semiannual payments).
"sWhile these are the major structures, commercial paper and preferred stock have also been
issued backed by pools of assets. Usually the commercial paper issuer or SPE is a conduit
established for the sole purpose of purchasing assets and issuing commercial paper. Preferred
stock ABSs are issued when the issuer has no tax liability because of tax-loss carryforwards, a
foreign tax credit, or an investment tax credit. Neither of these structures will be included in the
tests; commercial paper is not included in the sample, and preferred stock is different because of
the corporate dividend exclusion rule.
in that context.'" Credit securitization effectively began in 1970 with the Ginnie Mae
pass-through, developed by the Government National Mortgage Association (GNMA).
This is a mortgage-backed security collaterized by single-family Federal Housing
Administration (FHA) and Veterans Administration (VA) mortgage loans. A pass-through
represents direct ownership in a portfolio of loans that are similar in term to maturity,
interest rate, and quality." Certificates of ownership of the portfolio, which is placed
in trust, are sold to investors, who essentially have an equity position in the pool. The
loan originator services the loan by collecting interest and principal and passing them on,
minus a servicing fee, to the investors. There is often a second middleman, such as
GNMA, which receives the principal and interest from the originator and passes it on.
Because ownership lies with the investor (buyer), pass-throughs are removed from the
balance sheet of the issuer. GNMA is a direct agency of the federal government; the
government guarantees timely payment of principal and interest Investors therefore face
virtually no default risk, and an active secondary market provides a high degree of
liquidity for these securities.
Other pass-through mortgage-backed securities followed. The Federal Home Loan
Mortgage Corporation (Freddie Mac) developed the participation certificate (PC) in 1971
and the Federal National Mortgage Association (FNMA, i.e., Fannie Mae) developed the
mortgage-backed security (MBS) in 1981. Both are backed by portfolios of uninsured
'"The discussion here of the mortgage-backed market and its innovations is necessarily limited
in scope. For a more complete description of the securities and the historical perspective, see
Fabozzi and Modigliani, 1992, Chapters 2 and 11.
'7It is not permissible to substitute assets in this structure and usually there can only be a
single class, except for an additional single subordinate class retained by the issuer.
and privately insured mortgages. As indirect agencies of the federal government, there
is an indirect government guarantee of interest payments and full repayment of principal.
These mortgages tend to be paid off faster than Ginnie Maes. FNMAs have been
successful in part because of their swap program, where a mortgage lender can swap
whole mortgage loans for MBSs. The Mortgage-backed bond (MBB) is much less
common than the other types because the mortgages used as collateral remain on the
books of the issuer. The MBBs are reported as liabilities. The cash flows from the
mortgage collateral are not dedicated to the payment of interest and principal on MBBs;
rather, MBBs have a stated maturity and interest is usually paid semiannually. Credit
enhancement is provided by overcollateralization. The advantage to the issuer is that
through MBBs the loans are funded with long-term liabilities (usually between five and
The pay-through bond, like an MBB, remains on the issuer's books. However, the
cash flows are dedicated to servicing the bonds as with a pass-through. The collaterized
mortgage obligation (CMO), first issued by Freddie Mac in 1983, is a familiar example
(the volume of CMO issuance had become $59.9 billion by 1987). Typically, each CMO
issue is divided into a number of different maturity classes; four is common but there
have been as many as ten. The first (shortest maturity) class receives the first
installments of principal payments and any prepayments until class 1 bonds are paid off.
Then these payments go to class 2, and so on. These can be characterized as sequential-
pay classes. In this way the terms of the maturities are more certain and prepayment risk
is mitigated. Almost half of all CMOs are collaterized with federal agency pass-throughs
(a process referred to as resecuritization). The primary advantages of CMOs are the
creation of shorter maturities and the prepayment protection.
Despite these innovations, many potential investors did not participate in the MBS
market because of what they still perceived as significant prepayment risk. Thus,
structures were developed to create even more certainty in cash flows. In 1987, M.D.C.
Mortgage Funding Corporation issued the first Planned Amortization Class (PAC) bonds.
A PAC bond provides a fixed monthly payment as long as the prepayment rates on the
underlying collateral fall within a predetermined range. This cash flow stability is
achieved by giving principal payments of the PAC bonds higher priority than other CMO
classes, the companion or support classes which thus absorb a disproportionate share of
the overall prepayment risk. Rather than a sequential-pay characterization, as with the
earlier CMOs, these bonds are characterized as simultaneous-pay. Faster- or slower-than-
expected prepayment risk is absorbed by the companion trenches as long as prepayment
rates remain between the prepayment "collar" (generally between 80% and 300% PSA,
the Public Securities Association standard prepayment benchmark [Fabozzi and
Modigliani, 1992, p. 254]). A Targeted Amortization Class (TAC) is similar to a PAC,
but this class only offers protection from faster than expected prepayments. Their
expected average life can lengthen if prepayments are slower than expected.
Nonmortgage asset-backed securities utilize many of the same structures. The
pass-through is the most common structure and has been backed by auto loans, credit card
receivables, boat loans, and RV loans.'8 Despite their freedom from credit risk (due to
various types of credit enhancement), these securities still expose investors to interest rate
risk and prepayment risk. The latter is the risk that the investor who paid a premium for
the ABS will receive a lower than expected return because of faster than expected
repayment (generally occurring with a decline in interest rates) or that the investor who
bought the ABS at a discount will receive a lower than expected return because of slower
than expected prepayments.
Controlled amortization, bullets, and bonds offer progressively more certainty as
to the timing of cash flows and offer a reduction in prepayment risk. This is a result of
a transformation of cash flows not allowed with the pass-through structure. With
transformation of cash flows, not only can the payments be changed from monthly to, say,
quarterly, different classes of the liabilities can have different expected maturities and
payment schedules, such as interest only and principal only streams, or sequential classes
where prepayments of principal are first applied to one class, then the next, and so on.
Some of these securities may even have a stated maturity.
This restructuring of cash flows is advantageous for many institutional investors,
who prefer the more certain maturity and payments that match the frequency of their own
obligations. For example, thrifts prefer the shorter trenches, which match up better with
the short maturities of their liabilities. Pension funds have longer horizons. It also has
advantages for the issuer; by tailoring cash flows to meet investor demands, it may be
"Automobile loans were first pooled and sold in 1985 and are known as CARS (Certificates
of Automobile Receivables). Securitized credit card receivables are known as CARDS
(Certificates of Amortizing Revolving Debts).
possible to achieve a lower blended yield than with a single secured debt issue.
Rosenthal and Ocampo (1988, p. 55) claim that properlyry managed, several trenches of
securities of different maturities may be designed that produce a lower weighted average
interest rate than the interest rate that investors would receive for a single maturity
instrument." Presumably this translates to a net cost savings for the issuer.
Controlled amortization developed from the simultaneous-pay trenches of the PAC
structure. Controlled amortization refers to a cash flow structure with an initial revolving
period of uniform interest-only payments, followed by an amortization period of preset
length where interest and principal are paid to investors until the principal is paid off."
A typical structure might have a 36 or 48 month revolving period followed by a 12 month
amortization period (although there have been amortization periods as long as 24 months).
This differs from the PAC structure because instead of companion or support classes, the
usual structure uses some kind of reinvestment account or "principal funding account,"
whereby principal payments received before the amortization period are reinvested so as
to make likely sufficient cash flow to make all principal payments during the amortization
period. Similarly, if payments are slower than expected, the provider of the principal
funding account advances funds to make necessary principal payments. This is an
affordable option with nonmortgage asset-backs because prepayment risk is not as serious
a potential problem with the shorter maturity, less refinanceable collateral. Investors are
not totally free of prepayment concerns, however. Excessive prepayments could trigger
'There is a new variation on the controlled amortization structure, referred to a managed
amortization. In this structure, there is a managed amortization period, where principal is partly
paid out to investors and partly reinvested, followed by a rapid amortization period or payout
period. See ASR, December 14, 1992.
an "early amortization event," where the security immediately begins to amortize in the
interest-only period as a protection of principal. Such event "triggers" are described in
the issue's prospectus.
A bullet maturity structure is a refinement of the controlled amortization structure.
It implies a stated date where principal is paid off all at once, like a bond." Principal
payments received by the SPV before this date are invested in high quality short-term
investments until the expected maturity date. A soft-bullet is a variation on the bullet
structure; principal is paid off over a short period near the expected maturity date, thus
giving the issuer some flexibility.21
The advantage to the issuer of a controlled amortization structure is the ability to
pay out principal gradually. In a steep yield curve environment, a controlled amortization
structure is less appealing to an investor than a bullet, which has a single principal
payout, because investors face reinvestment risk, i.e., the possibility of reinvesting at a
"But note the difference from a bond--it need not be paid off at that time. To delay would
not imply default. "If the PFA [principal funding account] is not fully funded, a maturity
guarantor or the PFA provider will guarantee the investors' principal bullet repayment up to a
specific percentage of the initial offering" (Raab, 1990, p. 12).
""On the stated maturity date, the PFA may not be fully funded ... the current PFA balance
would be distributed to investors with the remainder of the outstanding balance amortizing until
the certificates are retired" (Raab, 1990, p. 11). One way that these principal repayment dates are
made more certain is through a "minimum principal repayment agreement," first used by GMAC
in 1987 (ASR, August 3, 1987, p. 1). Under this scenario, the security is issued under an assumed
prepayment rate. An up-front fee is paid to a guarantor (Morgan Bank in the GMAC issue) so
that (1) if the loans pay off faster than expected, the principal payments will be deposited with
the guarantor, who pays an agreed retum that is high enough to meet future principal and interest
payments; and (2) if the prepayment rate is slower than anticipated, the guarantor will advance
needed funds by acquiring issuer debt obligations.
lower rate. In a flat rate environment, controlled amortization is usually preferred, because
of the possibility of investing at a higher rate if the curve changes.
Even subordinate (B) trenches can have their cash flows made more certain. One
method is some form of "tail protection," i.e., a method used to shorten the payout period
on the security. This prevents an overly drawn out life for the subordinate tranche. An
example of "tail protection" is the "accelerated defeasance technique," which uses excess
cash flows from the deal to pay down the B securities after Class A has been paid. Or,
a stated maturity guaranty bond might be employed to "swap out the tail," that is, redeem
the remaining B securities at some predetermined date. Another method used is the
auction call option. In the case of a 1991 Household Finance home equity deal, for
example, after five years a call option takes effect if the original issue outstanding fall
below 25%. The trustee for the issue holds accepts bids for the option. If successful, the
B security holders are paid their principal. If the auction is not successful, the class B
holders receive a boost in yield to compensate them for the extra holding period (see
ASR, September 2, 1991).
Implications for Pricing
A few facts emerge from this discussion that could greatly affect the pricing of
an ABS. The collateral underlying these securities is broad-ranging, although there are
a few major categories. The originators vary as well--banks may be the most common,
but there are other financial companies as well as nonfinancial firms heavily involved.
These securities are typically credit enhanced to ameliorate default risk, but there are a
myriad of ways to accomplish this. The payment characteristics of the security can vary--
by different cash flow structures and by frequency. These are factors that will be added
to the traditional bond and mortgage-backed pricing models from previous studies. The
following chapter reviews this literature.
1985 1986 1987 1988 1989 1990 1991 1992
FIGURE 1: ASSET-BACKED SECURITY NEW ISSUE VOLUME ($ BILLION)
(Annual Public Domestic Issues)
Pass-through, asset-backed securities: structure and cash flows
principal -id "Passes through" principal and
interest Tsee interest payments
--- payments Tstee -------- --------
principal and I
interest | Initial cash Initial cash Initial cash
payments proceeds proceeds purchase
from from of
Origminator/ securities securities securities
Sponsor/ Trust Underwriter Investors
Service Transfers Issues Distributes
loans on securities securities
P hareceivables Provides credit
credit enhancement for the
enhancement asset pool, for example,
by a letter of credit
Credit nCash flows -
enhancer Scure _______
Source: Boeuctureo and Edwards, 1989
Source: Boemio and Edwards, 1989
FIGURE 2: THE ASSET SECURITIZATION PROCESS
TABLE 1: 1992 NONMORTGAGE ABS ISSUANCE, BY COLLATERAL
COLLATERAL $ (MILLIONS) %
Auto Loans 816.205 31.7%
Credit cards $15,677 30.6%
Home equity Loans $5,786 11.3%
Auto dealer floorplan Loans $3,500 6.8%
Manufactured Housing $2,645 5.2%
Leases computer, Railcar) $1,241 2.4%
Farm Equipment Payments $1,050 2.1%
Student Loans $373 0.7%
Exim Bank $352 0.7%
Smll Business Loans $350 0.7%
Home improvement $220 0.4%
RV, Boat Loans $198 0.4%
Other $3.603 7.0%
Source ASR, Fenruary 3.1993
TABLE 2: TOTAL ISSUE DOLLARS
BY LARGEST ORIGINATOR AND INSTITUTIONAL FORM
TEN LARGEST ORIGINATORS NUMBER TOTAL ISSUE MEAN
OF ISSUES DOLLARS MILL) SIZE
Citicorp 36 $30,133.6 $837.0
General Motors 27 $26,343.5 $975.7
Chrysler 39 $22,750.5 $583.4
Sears 37 $17,599.3 $475.7
Household Finance 21 $12,193.6 $580.7
Ford 8 $8,646.9 $1,080.9
Security Pacfic 24 $7,653.9 $318.9
Firlt Chicago 10 86,900.0 $690.0
Maryland National Corp 10 $5,024.7 $502.5
Chas Manhattan 8 $4,652.0 $581.5
Bank 190 $83,781.8 $441.0
Captive Finance Co. 149 $80,731.2 $541.8
Other Financial Institution 80 $28,609.7 $357.6
Savings and Loan 55 $9,127.4 $166.0
Non-Financial 29 $6,468.7 $223.1
There has been no pricing study of ABSs. This study's analysis is anchored in
prior studies of the determinant yield spreads on corporate bonds and mortgage-backed
securities. This chapter contains a review of that literature and concludes with a
discussion of other possible ABS risk factors described in the ABS descriptive literature.
Bond Pricing Studies
The seminal bond pricing paper was by Lawrence Fisher (1959), whose basic
model is still employed in most studies today. Fisher's model states that a bond's risk
premium depends on a number of risk factors under the rubrics of risk of default and
marketability. The risk of default is captured by three factors: a measure of volatility
(Fisher uses the coefficient of variation of the issuing firm's net income), a leverage
measure (market value of equity to book value of debt), and the length of time the firm
has been operating without a default. Marketability is proxied by the market value of all
bonds outstanding by the firm. Fisher uses these four variables, all in log form, and
specifies a linear relationship. (He does examine some alternative measures.) The risk
premium depends positively and significantly on default risk, negatively and significantly
on marketability. The model has developed somewhat over time, especially in the
inclusion of variables for special characteristics such as call provisions, sinking funds, and
so on. But it is still common to assume a linear relationship between yield (risk premia)
and a number of risk measures or indicators.
The current study will use primary market issue prices. A number of bond pricing
papers have used primary market issue prices. Among them are Allen, Lamy, and
Thompson (1987), which examines alternative call provisions (call protection versus
refunding protection); Fung and Rudd (1986), which looks at the seasoning effect (new
issues versus existing issues) and the cost of underwriting; Sorensen (1979), which
examines the method of underwriting and bidder competition; Kidwell, Marr, and
Thompson (1984), which examines the effect of shelf registration on pricing; and
Billingsley, Lamy, and Thompson (1986) which looks at the pricing of convertible bonds.
All find that spread or yield measures (the dependent variable) depend positively
and significantly on default risk as measured by rating dummies and positively and
significantly on interest rate volatility. There are mixed results for issue size (a proxy for
marketability), call provisions, and maturity. The size of the issue enters negatively and
significantly except for Billingsley, Lamy, and Thompson (1986) and Kidwell, Marr, and
Thompson (1984), where the coefficient is negative but insignificant, and Fung and Rudd
(1986), where the coefficient is positive and insignificant. A call provision is generally
positive and significant, but shows no significance in Billingsley, Lamy, and Thompson
(1986) and, again, has the opposite sign in Fung and Rudd (1986). Maturity of the bond
generally has a positive, significant coefficient, except in Sorensen (1979) who uses an
"expected maturity" coefficient akin to the expected average life of an ABS. That is, he
averages time to maturity and time to call and this measure enters the regression equation
with a negative, significant sign.
The dependent variable in these models ("yield") can reasonably be measured in
several ways, and this choice has been shown to affect the stability of the regression
coefficients. The return on the bond, the dependent variable, can be expressed as the
absolute yield, the difference between the bond's yield and some index (the absolute
spread), or as a relative measure of yield which involves deflating the difference from the
index by the index (the relative spread). The concern that results in the latter
specification is that the absolute amount of the yield spread may somehow depend on the
level of the index.'
Lamy and Thompson (1988) present evidence that the relative yield spread model
is a superior specification. The authors refer to theoretical work by Bierman and Hass
(1975) and Yawitz (1977) that produce expressions that predict that risk premia are
positively related to interest rate levels.2 Lamy and Thompson empirically test this
'Lamy and Thompson (1988) review the use of these measures in the previous studies.
Studies that use the absolute yield include Marr and Thompson (1984) and Sorensen (1979).
Studies that use the absolute spread (and the index employed) include Kidwell, Marr, and
Thompson (1985; comparable maturity Treasury issues on the day of sale) and Fung and Rudd
(1986; a one day lagged Treasury Securities Index). Finally, studies using the relative spread
include Benson and Rogowski (1978), Cook and Hendershott (1978), and Billingsley, Lamy, and
2Notice that this contrasts with the theoretical work of Merton (1974). Utilizing an option
pricing framework, he found the term premium or spread of a corporate bond to be a "decreasing
function of the riskless rate of interest." In a regression of absolute spread of corporate bonds on
(among other variables) an interest rate proxy, Fung and Rudd (1986) find a negative and
significant relationship. Rothberg, Nothaft, and Gabriel (1989), examining mortgage-backed
securities, find a similar result, which they find "anomalous" (see their note 7). Sorensen (1979),
again with corporate bonds, finds a positive and significant relationship.
concept. The absolute spread model demonstrates structural instability as the level of
interest rates change--especially the coefficients on default risk premia. The relative
spread specification is more stable.
Contrasting with this argument is the argument of Cook and Hendershott (1978).
In their example, assuming a constant risk factor, both absolute spreads and relative
spreads (the ratio of rates here) move with interest rates. The absolute spread rises as
interest rate level rises, the ratio of rates falls. But since the rise in spreads is
"approximately linearly related to the rise in yields.... an appropriate procedure when
estimating risk premium regressions is to use the spread as the dependent variable and the
level of rates as an independent variable to capture the effect on the spread of a constant
level of risk as yields rise" (p. 1180). Both specifications will be tried in this study.
Mortgage-Backed Security Pricing Studies
A mortgage-backed security such as a GNMA differs from a bond because it is
an amortizing security and because it is callable via prepayment or borrower default.
Thus, mortgage-backed security pricing models can be viewed as an expansion of bond
pricing models. That is, the basic linear model can still be used, but with different
independent variables which reflect the special nature of the securities. Credit risk,
because of the government guarantee, can be virtually ignored. Prepayment risk is a
major factor in these models and modelling or proxying for it is a major concern of
Lacey and Chambers (1985) demonstrate empirically the existence of an option
premium in mortgage backed security returns. While GNMA security returns are
dominated by a fixed payment component, a separate option component coexists. Their
principal components methodology identifies the existence of the option premium by
examining four types of securities; it is found that returns from GNMA futures contracts
share orthogonal return characteristics with returns of futures contracts on fixed price
securities and futures contracts of option securities.
Given its existence, the pertinent question is how to proxy for prepayment risk in
the specification. Because the right to prepay can be viewed as a call option owned by
the borrower--the borrower has the right to call (buy) the mortgage at par--researchers
have looked to option theory to suggest proxies for prepayment risk. Hendershott (1986)
has reviewed the evidence and suggests that prepayment can be reasonably explained by
the observed term structure of interest rates and the volatility of spot rates.3 The intuition
is straightforward. A steeper (upward) slope of the term structure implies that lenders
(and investors) expect interest rates to rise in the future. The prepayment option on a
fixed rate mortgage is not as valuable in a rising interest rate environment. Thus, we
should expect an inverse relationship between slope of the yield curve and spread. This
3"[K]nowing the yield curve and the approximate variance of spot rates is sufficient to price
alternative mortgage features" (p. 505). It might seem preferable to use option pricing
methodology to price the call. Theoretical mortgage-backed valuation models do employ option
pricing theory to price the prepayment and default options (see, for example, Kau, Keenan, Muller,
and Epperson (1990) or Schwartz and Torous (1992)). The problem is that most popular models
are enormously complex, do not have closed form solutions, and require extensive numerical
simulations. In truth, according to Hendershott and Van Order (1987), "few studies attempt to
obtain realistic price estimates and even fewer compare estimates with market prices." Also,
Milonas (1987) has contrasted option pricing methodology with linear regression models. He
notes that option pricing techniques overestimate the value of the call because such techniques
assume an optimal call policy not practiced by these borrowers. Schwartz and Torous (1989)
allow for non-optimal prepayment in their valuation model and show that it fits the data better
than assuming an optimal call policy.
relationship follows from option pricing theory, which indicates that the value of a call
increases with the market value of the underlying security or asset. The market value of
a mortgage is equivalent to the present value of future payments, which is inverse to
interest rates. Thus the negative relation between interest rates and the value of the call.
Also, option theory tells us that volatility increases the value of a call. Intuitively, a more
volatile interest rate environment increases the probability of low rates in the future, thus
increasing the probability of prepayment, the value of the call, and the risk premium in
The theoretical models from the mortgage pricing literature generally support
Hendershott and have implications for this study. Among the more important are Dunn
and McConnell (1981), Brennan and Schwartz (1985), and Hall (1985). Dunn and
McConnell (1981) attempt to document the effects of the amortization and call
(prepayment) features on the pricing of mortgage backed securities in comparison to non-
callable, non-amortizing bonds. They utilize an interest contingent pricing model with
a single state variable based on models developed by Brennan and Schwartz (1977) and
Cox, Ingersoll, and Ross (1978) in order to model GNMA securities. Specifically, they
model the effects of the call feature (optimal prepayments), amortization structure, and
suboptimal prepayments (caused by default, refinancing for equity, or sale without the
buyer assuming the mortgage) on the pricing, returns, and risk of GNMA securities.
GNMA's are, of course, default free. GNMAs differ from ABSs in several areas; for
example, all loans in a pool are required by GNMA to have the same coupon interest rate
and term to maturity and each is insured by the FHA or VA. However, Dunn and
McConnell's model and simulations are directly relevant to this study because of the light
they shed on the differences between amortizing and non-amortizing and between callable
and non-callable securities. Non-optimal prepayments are not truly an issue because
Dunn and McConnell assume that all suboptimal prepayments (including default) are
uncorrelated with all relevant market factors, are therefore unsystematic, and can be
costlessly diversified away.
Dunn and McConnell's model suggests that as the slope of the term structure goes
from negative to positive,4 the price (yield) of an amortizing, non-callable security
decreases (increases) relative to a non-amortizing, non-callable security. This occurs
because the later cash flows of a non-amortizing security are discounted more at higher
interest rates, likely in a flatter yield curve environment (the instantaneous risk free rate
is used as the discount rate in their model). This suggests, contrary to the negative
relationship between spread and yield curve slope suggested above, that the spread of an
amortizing, non-callable security from a non-amortizing, non-callable security such as a
Treasury bond should be a positive function of yield curve slope. Thus, if the call option
is not a dominant concern in pricing of an ABS, we should expect to find a positive
relationship between the slope and the ABS pass-through spread from Treasury. The
prepayment call option implies a negative relationship between spread and slope of the
4Although Dunn and McConnel employ a single state variable model, they run simulations
under different term structure environments. They can do this because the absence of arbitrage
in their model implies that the expected excess retum per unit of risk is the same for all interest-
dependent securities and thus their risk adjustment term (qr) is the same for all maturities,
including infinity. Thus they can assume various long-term interest rates R(-) and solve for q,
a risk-adjustment parameter that is in their model. However, as Brennan and Schwartz indicate,
this method assumes the variance of R(-) is zero.
term structure; the amortization feature implies a positive relationship between spread
and slope. For ABSs, we have to see empirically which dominates.
Also, their model predicts that amortizing securities are slightly less sensitive to
interest rate fluctuations than non-amortizing securities, again because the cash flows
come sooner for an amortizing security. Furthermore, the value of callable securities are
less sensitive to interest rate fluctuations than non-callable securities with the same
maturity. This interesting phenomenon occurs because the values of the call option and
a noncallable security both decrease as interest rates increase. The value of a callable
security is simply the value of an equivalent non-callable security less the call. This
difference is moderated because the two differencing values move together with interest
rates. Thus, according to the Dunn and McConnell model and simulations, the pass-
through structure, which is fully amortizing and exposes the investor to more prepayment
risk, would be expected to possess a less positive relation with interest rate volatility than
the more protected structures of controlled amortization, bullet, or bond.
Lacey and Chambers (1985), discussed above, point out that Dunn and
McConnell's one state variable model (instantaneous riskless rate of interest) is too
restrictive; Lacey and Chambers' results indicate that the return generating process of the
mortgage backed security responds to more than one source of uncertainty. Although the
principal components methodology they employ does not identify such a state variable,
the author's suggest interest rate variability as a likely candidate.
Brennan and Schwartz (1985) echo Lacey and Chambers by showing with
simulations that the two state variable model values the option better than the single state
variable model (i.e., Dunn and McConnell). Brennan and Schwartz use the instantaneous
riskless rate and the return on an infinite maturity consol (the authors are specifically
implying that yield curve slope is important). In comparison to their two state variable
model, the single state variable model underestimates the value of the call option.
Brennan and Schwartz's more accurate valuing of the call option properly simulates what
occurs as the slope of the term structure increases--the GNMA gains in value (reduces
promised yield) relative to the Treasury. This supports the negative relation between
slope and spread that we expect when the call feature dominates the amortization feature.
Further, Brennan and Schwartz's simulations support Dunn and McConnell's notion that
amortizing, callable securities are less sensitive to interest rate fluctuations than a
Treasury bond (non-amortizing, non-callable)--but only if the interest rate being measured
is the long-term interest rate. If it is the short-term rate that is measured, "quite the
opposite relation holds" (Brennan and Schwartz, 1985, p. 224). This is because the
GNMA behaves more like a short-term security. This is important, because ABSs would
be expected to behave even more like short-term securities. Thus, according the Brennan
and Schwartz's model and simulations and contrary to Dunn and McConnell's, the pass-
through structure would be expected to possess a more positive relation with interest rate
volatility than the more protected structures of controlled amortization, bullet, or bond.
Hall (1985) uses a two-state option pricing (binary) model to value the prepayment
option on a mortgage. He finds in simulations that the current level of interest rates has
little impact, but that the value of the option is negatively affected by the market's view
of the "direction of drift" of interest rates and especially and positively by the volatility
of expected future interest rates.
Empirical studies have supported the notion that interest rate volatility and yield
curve slope do proxy for the value of the prepayment call. Rothberg, Nothaft, and
Gabriel (1989) have utilized these proxies for prepayment risk in their study of the
relative yield spreads on mortgage pass-throughs. They find that both interest rate
volatility and the slope of the term structure significantly affect the magnitude of the
spread and are of the proper sign. In fact, they are the primary determinants (their
measure of marketability is not significant), thus lending some support to Hendershott's
conclusion that these two proxies effectively capture the prepayment risk.
Milonas (1987), like Rothberg, Nothaft, and Gabriel, utilizes a linear pricing model
to assess the determinants of the GNMA-Treasury spread. He utilizes both absolute
spreads and relative spreads with similar results. His pricing factors include proxies for
the prepayment option (current interest rate level, secondary market rates on FHA
mortgages, slope of yield curve (10 year Treasury less 3 month Treasury), and interest
rate volatility) and supply and demand variables (applications for GNMA's, number of
GNMA pools issued in a month, and new housing starts). He also finds the term
structure to be negative and significant However, the volatility measure is only used in
a regression not shown, and is insignificant Interestingly, the level of interest rates has
a negative coefficient and is "the major determinant of the yield spread," presumably for
both the absolute spread model (shown) and the relative spread model (not shown). The
number of GNMA pools issued in a month is not significant and is positive, not the
Arak (1986) finds that the factors that significantly affect GNMA-Treasury
absolute spreads are the slope of the yield curve (negatively), interest rate volatility
(positively), and the amount of adjustable rate versus fixed rate mortgages issues, a supply
proxy (negatively, i.e., as the amount of variable rate increases relative to fixed rate, the
yields on fixed rate GNMA decline). Arak hypothesizes that prepayment risk may be
linked to interest rate levels (the sign would vary depending if it was a premium or a
discount security), but the coefficient on this variable is insignificant. It should be noted
that the borrower, in addition to the option to prepay, also has the (put) option to default.
In a guaranteed mortgage-backed setting, when the mortgagor defaults on the mortgage,
the issuer is obligated to prepay to the mortgage-backed investor. This is a timing risk
that to the investor looks identical to regular prepayment risk. Optimally this option
should also be priced. Unfortunately, as Hendershott (1986) points out, valuing this
option in reality is very difficult because of unobserved values (the house price), unknown
rents (the value of future "dividends" in option pricing parlance), and an unavailable
series representing the volatility of individual house prices.
Epperson, Kau, Keenan, and Muller (1985) attempt to price the default risk in
mortgages themselves. The prime determinants are the volatility of the house (collateral)
price and the volatility of the spot interest rate. Kau, Keenan, Muller, and Epperson
(1987) include the value of the default option in their pricing model for commercial
mortgages and mortgage-backed securities. (Other independent variables include
uncertain future property values, a continuous term structure of interest rates, the value
of the scheduled payments, and the value of the prepayment option.)
Schwartz and Torous (1992) include the possibility of default on the underlying
loans in a two state variable, proportional hazards model of mortgage pass-through
securities. Default is important to the value of the mortgage backed security even when
principal is insured ("default free") because it affects the timing of cash flows.
Prepayment and default by the borrower result in an identical outcome to the insured
mortgage backed security holder--prepayment of principal. However, Schwartz and
Torous emphasize that such decisions by the borrower are taken under different economic
circumstances. Specifically, default dominates prepayment when both of the following
conditions hold: the value of the underlying collateral is less than the value of the
mortgage and the value of the underlying collateral is less than the principal outstanding.
The value of the mortgage is the present value of all future scheduled payments, which
is different than the principal remaining. If these conditions do not hold, prepayment
dominates default. The mortgage value is dependent on time to maturity, the value of the
collateral, and interest rates (here the instantaneous riskless rate of interest); the mortgage
value is inverse to interest rates, ceterus paribus. Thus default would be expected to
increase as the value of the collateral decreases (declining neighborhood conditions, "bad"
economic conditions, etc.) or as interest rates decline. In simulations, Schwartz and
Torous show that as interest rates increase, the value of the mortgage, insurance (the put
option), and the mortgage-backed security all decrease, all else equal. However, at high
interest rates the value of the mortgage backed security may not decline if the value of
the collateral is low enough. This is because security holders desire default and the
resulting prepayments because of reinvestment opportunities. Nonmortgage asset-backed
securities, where collateral value is much less likely to hold its value (consider mobile
homes or automobiles), may be likely to exhibit such a relation to interest rates. Interest
rate level and a measure of economic conditions, then, may be important to yield spreads.
In bad economic conditions, as the probability of default increases, investors would
require a higher yield to compensate for earlier than expected (or modelled by the issuer)
cash flows; but at high interest rates, such defaults may be desired, lowering required
Empirically, Vandell and Thibodeau (1985), using a logit model, more specifically
try to identify the factors which increase the probability of mortgage default. Their data
consists of a cross-sectional time series of 348 conventional fixed rate loan histories from
the Dallas area covering 1972-83. Explanatory variables include specific loan variables
(such as loan to value, payment to income), financial variables (such as corporate bond
returns, prime rate), borrower characteristics (such as marital status, employment history),
and housing market and general economic conditions (rental costs, neighborhood rating).
In addition to the specific loan variables, the only other significant factor was their proxy
for general economic conditions--specifically a "neighborhood" rating (a 1/0 indicator
variable). Thus, there is some evidence that economic conditions, although in this study
fairly localized, contribute to the probability of default
Pricing default risk or more specifically proxying for it is difficult at an aggregate,
non-individual level. Fortunately, as Hendershott points out, empirical work has shown
that the call dominates the put, indicating that ignoring the put option is less serious than
ignoring the call would be. However, the above studies indicate or at least suggest the
possibility that general economic conditions may proxy somewhat for default risk.
In summation, the mortgage-backed pricing literature provides indications of how
prepayment (call), default prepayment (put), and amortization should affect the ABS
spread from Treasury. Effective proxies for prepayment risk have been shown to be the
slope of the term structure and the volatility of interest rates. If prepayment is an
important concern, the spread should have a negative relation with the slope of the term
structure and a positive relation with interest rate volatility. However, the amortization
feature implies a positive relation between spread and the slope. For MBS, the call
(prepayment) has been found to dominate. The empiric results here will illuminate the
importance of prepayment risk with ABSs. Default caused prepayment risk may be
proxied by a measure of economic conditions; such a proxy should have a negative
relation with spread. There are some arguments that both prepayment risk (Arak, 1986)
and default caused prepayment risk (Schwartz and Torous, 1992) may depend on interest
rate levels, but there has been little empirical support for either argument.
Asset-Backed Security Literature
While the bond pricing literature and the mortgage-backed literature provide a
useful base for developing a pricing model for ABSs, nonmortgage asset-backs are more
complex than either bonds or mortgage-backs and require additional pricing
considerations. While there have been no pricing studies of ABSs, there is an extensive
literature on ABSs which illuminate these additional considerations.
Bryan (1988) describes ABSs in revolutionary terms; he sees ABSs as a key to
transforming the entire banking industry:
[Securitization] is better on all counts than the traditional lending system. It is
growing very rapidly precisely because it is the superior technology--one that, in
fact, is rendering traditional banking obsolete.... We estimate that it will take
10 to 15 years for structured securitized credit to displace completely the classic
banking system (Bryan, p. 65).
Further, "[s]ecuritized credit combines elements of traditional lending with elements of
traditional securities, but it also involves processes and structures not conceived of in
either traditional system" (Bryan, p. 70).
Specifically, he identifies four financial innovations that have been used to convert
loans into ABSs. The first, the creation of special purpose vehicles (the entity established
to purchase the pool from the originator and actually issue the securities), is important
because the SPV's "purpose is to isolate the risks inherent in the loans placed in it from
all the other risks of the funds raiser [i.e., the originator]" (Bryan, p. 72). This innovation
is significant, because if true than the financial condition of the originator should not
matter to investors in the securities. This separation or "bankruptcy remoteness" is an oft-
cited advantage of ABSs. However, as will be further explored in the next chapter,
investors may be concerned about the financial condition of the originator if this condition
affects the pool quality and the credit rating does not capture all pool quality effects, or
if the originator is also the service of the pool.
The second innovation is the pooling of borrowers, which diversifies credit risk.
This pooling, of course, is also an attribute of MBS. However, the third innovation,
credit structuring and enhancement, is more unique to ABSs because there is usually no
government guarantee of any sort. The guarantor assesses, underwrites, and guarantees
the credit risk, usually with the intent of raising the security to investment grade. This
allows investors, such as pension funds or individuals, to invest in these securities even
though they may have neither the skill nor desire to assess the credit risk themselves.
This would imply that if the resulting rating is a sufficient indicator of credit risk,
investors would not care about the amount or specific form of the enhancement.
However, investors may care about the enhancement if the rating does not capture all of
the potential risks to the investor resulting from underlying pool quality or type of
The final innovation is the repackaging of cash flows. This is most familiar in
MBS with the CMO, a sequential-pay series of trenches, or the senior-subordinate
structure. This allows the packager (investment banker who structures the issue) "to tailor
the cash flows of the different trenches to particular investor preferences ... [and] also
allows the packager to create trenches with different prepayment risk characteristics"
(Bryan, p. 73). However, MBS pricing studies have not attempted to model these
different tranches--they concentrate on the more homogeneous GNMA pass-throughs.
The ABS sample in this study (described in Chapter 5) allows a separation of trenches
into pass-through, controlled amortization, bullet, and bond. We would expect the more
structured and certain cash-flow structures to exhibit different responses to the prepayment
Thus, Bryan's discussion of securitization innovations has illuminated three
additional areas of concern in developing a pricing model for ABSs. The effective
separation of originator and issuer, the sufficiency of credit rating, and the ability of the
various cash flow structures to combat prepayment risk.
Boemio and Edwards (1989), both members of the Federal Reserve Board's
Division of Banking Supervision and Regulation, delineate the risks that investors in
ABSs face. Investors face credit risk, that obligors may default on principal and interest
payments. More importantly in the current context, investors face "the risk that various
parties in the securitization process, for example, the service or trustee, will be unable
to fulfill their contractural obligations" (Boemio and Edwards, p. 663). To the extent that
a single organization performs several roles in the securitization process, investors face
a concentration risk of overexposure to a single organization. Boemio and Edwards also
indicate the possibility of "moral recourse," where originators, especially banks, may face
pressure to repurchase "securities backed by loans or leases they have originated that have
deteriorated and become nonperforming" (Boemio and Edwards, p. 664). Thus,
implications of the authors' analysis are that credit rating will be important to ABS
investors, but also that the originator may matter either because of its role as service
(operational and concentration risk) or because of some implicit moral recourse.
Goldberg and Rogers (1988) offer three areas of concern for investors when
evaluating an ABS: the characteristics of the collateral, the structural features of the
security, and the type and amount of credit enhancement provided. Collateral may matter
because of geographic diversity of the pool, whether the loans are secured by assets (auto
loans versus credit card receivables, for example), and because of different prepayment
risk profiles. While "virtually all ABS collateral have some degree of prepayment
uncertainty" (Goldberg and Rogers, 1988, p. 22), the gains from prepayment on ABSs are
limited by the short maturity and relatively small size of most ABS loans. However,
some ABS collateral, such as credit card receivables, have inherent payment uncertainty
because of a lack of fixed payment schedules.
The security structure is important to investors because of the independence of the
seller from the originator, the restructuring of cash flows, and the possible elimination of
prepayment risk. The creditworthiness of the originator should not affect the rating of
a properly structured ABS. However, the authors feel that investors "should distinguish
between external credit enhancement and internal credit enhancement" (Goldberg and
Rogers, p. 23). This is because with external or third party credit enhancement, the rating
of the ABS is subject to the "same risk of downgrade as the provider of the credit
enhancement." ABSs with internal credit enhancement, on the other hand, "will be
downgraded only if the quality of the collateral deteriorates significantly in relation to the
remaining credit support." Thus, the Goldberg and Rogers discussion suggests that at
least some types of collateral may be priced differently from others, that cash flow
structure is important, especially as regards prepayment risk, and that investors may
distinguish among types of credit enhancement
Similarly, Keighley (1993) lists four major areas of risk in an ABS issue: credit
risks, structuring risks including "the effectiveness of legal transfer of title of the assets"
(Keighley, p. 99), operational risks such as the continuing effective functioning of the
service, and financial risks "deriving from unexpected cash flows, such as pre-payments,
delinquencies" (Keighley, p. 99). Thus, Keighley echoes the above studies, and suggests
that investors may price default risk, prepayment risk, and default prepayment risk. In
addition, pricing of the originator's condition may reflect concern with operational risk
(if the originator is the service) and/or a concern over the effectiveness of the legal
separation of originator and issuer.
A final aspect that may be expected to effect ABS pricing is the newness and
maturation of the market. Barmat (1990), for example, feels the pricing of ABSs "has
evolved since the earliest issues. Initially, due in part to their novelty and similarity to
certain types of mortgage-backed debt, the yield of asset-backed securities in terms of
spread to Treasury bond yields was relatively high .... these spreads have trended down
since mid-1987 ... reflecting, among other things, increasing investor acceptance of this
type of security" (Barmat, 1990, p. 20). Some investors agree that wide spreads reflect
some premium for inexperience. Money manager Lawrence Harris of Alliance Capital
says: "Maybe that's why spreads are so attractive. They're paying us to take the risk of
inexperience" (in Sweig, 1989, p. 537). Thus, anecdotal evidence would imply a
narrowing of spreads over time. However, Barmat also points out that many new issuers
have entered the market and there has been a "significant broadening of the asset-backed
market according to asset type" (Barmat, 1990, p. 20). This broadening process might
imply a widening of spreads over time because these new originators and collateral types
are probably less well known to investors. Lawrence Harris also said, "There's a sort of
knee jerk reaction on the part of a lot of people ... these things are new and I'm not sure
I understand them ... It just takes time to overcome that" (in Sweig, 1989, p. 546). It
may be in fact that investors didn't completely understand them, that the "true" risks of
ABSs may have been greater (or lesser) than the inexperienced market first estimated.
Thus, detangling the time trend may prove of interest in understanding the development
of this market.
ASSET-BACKED SECURITY RISK FACTORS AND HYPOTHESES FOR PRICING
As was made clear in the earlier discussion, ABSs are a rather heterogeneous
collection of securities, varying by collateral, cash flow structure, expected average life,
issue size, and type and amount of credit enhancement. This heterogeneity adds a level
of complexity to a pricing model. Like mortgage-backed securities, ABSs differ from
Treasury securities because of the additional call/prepayment option, because of payment
frequency, and because of their amortizing features. Like corporate bonds, ABSs differ
from Treasuries because they are not guaranteed by the government and carry varying
credit/default ratings. However, the basic risk factors in ABS pricing are familiar from
the previous literature discussion; the model's complexity derives from accounting for
the varying cash flow structures, subordination, and collateral.
ABSs can be viewed as amortizing bonds with embedded options; thus it is useful
to analyze the pricing factors of ABSs by first examining the option components of the
securities. These options, held by the insurer and the borrowers, are valuable and expose
investors to default risk and option induced interest rate or reinvestment risk. Then,
because ABSs involve the repackaging of illiquid assets into liquid assets, the features of
the issues and of the market that might influence marketability or liquidity are analyzed.
SPREAD, measured as either the absolute spread (the difference between the
expected yield on an ABS tranche and a Treasury of like maturity (i.e., equal to the
expected life of the tranche)) or the relative spread (absolute spread divided by the
Treasury of like maturity), would be expected to increase with an increase in default risk
(DEFRISK) or option induced interest rate or reinvestment risk (OPTRISK), and decrease
with an increase in marketability (MKT). In addition, the absolute spread (+), and
possibly the relative spread (-), may be a function of interest rate level (I) (Cook and
SPREADi =f(DEFRISKb OPTRISKb MKTi, I. (1)
A discussion of these factors (and proxies included in the model) follows. In
addition, the complexity of these securities and the heterogeneity of the market suggest
other factors or characteristics may matter to pricing. Therefore, this chapter contains
discussions of the sufficiency of credit rating, what other features may be important, and
possible effects of differences in collateral. Credit rating may be an important but not
sufficient statistic for credit risk and investors will seek additional information. Similarly,
investors may seek additional information regarding non-credit effects such as undesired
cash flow timing changes or interruptions.
Default Risk (Part 1): Credit Rating
The exposure of ABS holders to default risk is reduced by the forming of a
diversified portfolio of assets to collaterize the security and the addition of private
(nongovernment) insurance in the form of some sort of credit enhancement. Thus, the
default risk of the tranche depends on the credit of the insurer for the amount of the
guarantee and the amount of enhancement relative to the true quality of the pool (i.e., the
percentage of principal guaranteed relative to the level of expected losses). ABSs are
sufficiently enhanced for the credit rating received. But even for a Triple A security,
default risk remains. ABS certificate holders are exposed to the risk that the credit
enhancer could default. Moody's and Standard & Poor's credit ratings of the trenches are
the proxies employed for measuring this default risk. While most ABSs are credit
enhanced, the ratings do vary and would be expected to be a major determinant of
pricing. A highly rated tranche (AAA) has a small probability of default; lower ratings
decrease the value of the security, and increase required yield.
There is evidence that financial risk premia will vary over time. (See, for
example, Cook and Hendershott (1978), Engle, Lilien, and Robins (1987), Ferson and
Harvey (1991), and Flannery, Hameed, and Harjes (1992) and the literature reviews
therein). This is a source of concern in this study because data are aggregated across a
seven year period. To help alleviate the problem, a control variable will be employed to
proxy for the changing price of risk. This proxy is the difference between Moody's daily
seasoned bond yields for BAA corporate bonds minus the yield for AAA corporate bonds.
This spread is indicative of the fluctuating price of risk (see Figure 3).
Thus, the amount of default risk (DEFRISK) is a function of the credit rating of
the tranche (RATE -) and the price of that risk is proxied by the corporate bond spread
DEFRISK, = f(RATE, CSPR). (2)
One is tempted to take the issue credit rating as a definitive, all-inclusive measure
of risk. However, with an issue as complicated as an ABS, other factors could matter as
well. Robert E. Pruyne, managing director of Scudder Stevens and Clark, says about
Some investors may rely very heavily on ratings, but we don't look at the
service ratings that closely. We're not tied to them. We rely on our own
homework and assign our own ratings .... we tend to be a little harsher
than the rating agencies. (in Zweig, 1989, pp. 541-42).
The rating agencies themselves explicitly do not evaluate some aspects of the
repayment flow. When rating a structured issue, S&P "ignores the obligor's
creditworthiness. Instead, a structured financing rating directly addresses the ability of
a specified asset or pool of assets to service payment obligations to the investor"
(Standard & Poor's, 1988, p. 19). They examine credit risk (including an evaluation of
portfolio quality that includes a review of the originator's credit and underwriting
practices, the service, and the trustee), cash flow (the ability to fulfill the "promise to
pay"), and legal issues (asset ownership and risks associated with the bankruptcy of the
seller/servicer). Credit enhancement is assessed in light of these risks.
But payment obligations for a pass-through, say, do not include the timing of the
cash flows, because the timing is not an obligation. Stress tests on the issue are run to
ensure that in worst case scenarios, principal will be protected. Further, while S&P does
consider that there should be "redemption provisions" in case of certain negative events
(Standard & Poor's, 1988, p. 23), it does not assess the probability of these provisions
being enacted. Redemption provisions include payout events and are viewed by S&P as
"safety valves" that minimize credit concerns. They end a nonamortization period prior
to schedule if the quality of the portfolio deteriorates substantially. Examples of payout
events include a substantial decline in yields, a significant increase in losses, a change in
borrower payment or borrowing habits that could adversely affect portfolio performance,
and issuer, trustee, or service default. "[T]he rating S&P assigns to a credit card
transaction generally does not address the likelihood of any of these early amortization
events and their resulting cash flow implications. the rating only addresses the
likelihood that investors will receive full return of principal by the 'final' maturity
date" (Griep, 1993, p. 138). Moody's ratings are similar: "Moody's further points out
that its ratings do not reflect the probability of occurrence of pay-out triggers" (Buerger
and Isely, 1989, p. 527, from ASR 8-31-87).
Thus, the agency ratings concentrate on the likelihood of principal repayment and
not on the timing of those payments. Whether these features of ABS cash flows not
considered in the credit rating matter to pricing depends on how investors feel about the
timing of their cash flows. The MBS literature identifies two features of timing, interest
related prepayments and borrower default related prepayments. These prepayments affect
MBS value because the cash flows are correlated with overall market conditions and thus
the effects cannot be diversified away. With insured ABSs, principal payments also occur
in connection with "early amortization events" mentioned in the quotations above. If
these cash flows are correlated with market conditions, market expectations about them
will be impounded in the initial ABS price (spread).
We now turn to an examination of these timing events using a simple option
perspective. Using the option framework hopefully leads to a better understanding of the
risks actually faced by an ABS investor by (1) separating the risks faced by the investor
and by the insurer, and (2) distinguishing the options owned by the borrower from that
owned by the insurer. Then we return to the discussion of the sufficiency of credit rating
and what other pieces of information may be utilized by investors to supplement the
Option Characteristics of an ABS
Like a corporate bond, an ABS can be valued as the difference between a riskless
bond (present value of future certain cash flows) and the value of embedded options.
B = PV(F) V(embedded options) (3)
In an ABS, these options belong to both the insurer and to the borrowers:
B, = PV(F) V,(embedded insurer option) V2(embedded borrower options) (4)
where B, is the value of an ABS.
In terms of loss of principal, the insurer faces the actual default risk from the
borrowers (up to the amount of credit enhancement); the investor faces the possibility
that the insurer may default on its promise to pay to the investors the defaulted principal
(exercise a put option). Thus, the embedded insurer put option represents to investors the
possibility of default effects after considering pooling and credit enhancement.
The embedded borrower options are the right to prepay without penalty and the
ability to default. The right to prepay is an American call option owned by the borrower
to purchase the loan at the face value of remaining principal (exercise price). The ability
to default is equivalent to an American put option to sell the collateral to the holder of
the loan (insurer of the ABS) for the face value of remaining principal. Because the
asset-backed securities are credit enhanced, the resulting cash flows from these two
options are identical to investors (once a loan is classified as in default, the guarantor
pays out the remaining principal (assuming the enhancement level is sufficient for the
level of defaults), which to the investor appears as a prepayment of principal). However,
as Schwartz and Torous (1992) point out, such decisions are taken under different
economic conditions. Thus, even though the result may appear the same to the investor,
regular prepayment risk and default prepayment risk must be differentiated in the pricing
Only the borrower put option has relevance for the insurer. If the borrower
defaults, the insurer pays the borrower's unpaid principal to the security holder. When
the borrower exercises the call option to prepay, the payments are simply passed through
to the investor in a pass-through structure, or, in a controlled amortization, bullet, or bond
structure, placed in the guaranteed reinvestment account to earn interest hopefully
sufficient to make the future scheduled principal payments.
But both borrower options have relevance to the investor. The call is of concern
because prepayments are likely to increase when interest rates decline and the borrower
has cheaper refinancing opportunities or, likely with real assets such as automobiles,
trucks, manufactured homes, boats, and the like, the borrower pays off the loan when
he/she purchases a new similar asset at attractive financing rates. The investor in a pass-
through thus faces the interest rate risk of having to reinvest at lower rates. Similarly,
prepayments are likely to decline when interest rates rise and the investor would desire
prepayments with the resulting opportunity to reinvest at attractive rates. But even
investors in a non-pass-through structure have reason to be concerned. Excessive
prepayments faster or slower than expected can affect the timing of the cash flows in the
principal payout period of a controlled amortization structure and even extend the single
principal payment of a bullet structure into an amortization period. Furthermore,
excessive prepayments can trigger an early amortization event for either of these
structures, resulting in a payout of principal to investors much earlier than expected.
Since these prepayments are likely to be linked to interest rate levels, investors cannot
diversify away this risk.
Similarly, borrower defaults that result in insurer paid prepayments to investors
will matter to investors if they are linked to market-wide conditions and cannot be
diversified away and if these early payments of principal are undesired by the investors.
Finnerty (1993, p. 37) suggests that "general economic factors" and "general state of the
economy" influence the level of these defaults--a "bad" economy increases defaults. If
borrower default probability is linked to the overall economy, it cannot be diversified
away. If unexpected cash flows in a "bad" economy cannot easily be reinvested because
of a lack of investment opportunities or if the cash flows are received when interest rates
are low, then the borrower default put should require a premium by ABS investors.
Valuing the Borrower Options
We know from the comparative statics of the Black and Scholes option pricing
model that the value of a call is an increasing function of the value of the assets, the
volatility of the asset value, the risk-free rate of interest, and time to maturity. It is a
decreasing function of the strike price. And, the value of a put is an increasing function
of asset volatility and the strike price, and a decreasing function of the value of the assets
and the risk free rate of interest. Because this is an American put option, the value of the
option is a positive function of time to maturity (see Merton, 1990, p. 279). Of course,
we do not know the value of the underlying assets or their volatility. Thus pricing the
options using Black-Scholes pricing formulas is not possible. However, the previous
work in the MBS literature offers insight.
Borrower call option. As evidenced by the considerable work done in the
mortgage pricing literature, capturing the prepayment call option is of great importance
in mortgage backed pricing models. Whether prepayment is as important to ABSs is an
empirical question of this study. Regular prepayment risk (hereafter simply prepayment)
is the risk that cash flows may be received earlier or later than expected, i.e., than the
prepayment history of the pool or the prepayment model or algorithm used in the yield
calculations by the underwriter. When prepayments run higher than expected, security
holders face the risk of reinvesting elsewhere the early cash flows received, possibly at
a lower rate. The ex ante premium for prepayment arises because they tend to occur
precisely when rates are low. Thus, the security holder faces interest rate risk. When
prepayments run slower than expected, the security holder faces the problem of
liquidating outstanding securities at a lower value. That is, expected payments have not
been realized; if the investor has cash requirements (for example a pension fund), then
the securities must be sold. Thus prepayment is a valuable option held by the borrower
and has costs for the security holder.
Acceptable proxies for pricing this call option have been identified in the
mortgage-backed literature: the volatility of interest rates and the slope of the yield
curve. The value of the option increases with interest rate volatility and decreases with
an increasing yield curve slope as the probability of prepayment in the future decreases
if interest rates rise. For MBS, the link between market interest rates and mortgage rates
is fairly strong. Thus, the slope and volatility of Treasury rates effectively captures the
movement of mortgage rates. For ABSs, the connection is more tenuous, but still viable.
The movement of Treasury rates still proxies for the volatility of asset value and provides
a yardstick for future refinancing opportunities.
For an ABS, expected average life, akin to the maturity of a bond, could affect the
security's initial price and expected yield.' MBS pricing studies utilize similar maturity
securities (e.g., Milonas  uses 30 year GNMA's). Thus, expected life is the same
for all securities and is not in the models used. But, the ABS sample contains trenches
of different maturities. Since a call option increases in value as time to expiration
increases, expected life should enter positively.
Thus the value of the prepayment call option (CALL) is a function of interest rate
volatility (VOL +), the future direction of interest rates (SLOPE -), and the expected life
'The average life is "the average time to receipt of principal payments (projected scheduled
principal and projected principal prepayments), weighted by the amount of principal expected
divided by the total principal to be repaid" (Fabozzi and Modigliani, 1992, p. 273). The average
life in years is:
average life= t (principal expected at time t)
12 ,. totalprincipal
where n is the number of months remaining.
CALLi =f(VOL,, SLOPE, LIFE). (5)
Borrower put option. The default prepayment option is much more difficult to
capture than the call. As with pricing the call, pricing the put directly with option
valuation formulas is impossible due to the lack of information on the underlying assets.
We can proxy for asset volatility with interest rate volatility. And, as with the call, the
value of the option should increase with expected life. However, most other parameters
The mortgage pricing literature does provide limited evidence that economic
conditions provide some indication of borrower default risk. But these economic factors
tend to be localized, such as the neighborhood condition of Vandell and Thibodeau (1985,
see MBS literature review in Chapter 3). Asset-backed pools tend to be geographically
broad, making the collateral value less dependent on location. Thus a broader economic
measure is needed, akin to Finnerty's (1993) "general state of the economy." Note that
general economic conditions might influence both regular prepayment (call) and the
prepayments resulting from borrower default. But the effects should be opposite--a "bad"
economy lowering prepayment incentive and increasing defaults. Thus a negative relation
between the state of the economy and spreads may imply a premium for default
prepayment risk if the unexpected cash flows cannot be easily reinvested because of a
lack of investment opportunities in a poor economy.
The proxy employed here will be the previous six month percentage change in the
index of industrial production, although numerous national indexes and time periods
perform similarly.2 The problem with such a measure, of course, is that it presumably
captures much more than a default effect, but also especially supply and demand effects.
But if those effects are sufficiently captured by the other variables (issue dollars, interest
rate volatility, interest rate level, and so on) then this economic condition proxy may be
The value of the borrowers' option to default (BPUT) depends on economic
conditions (ECON -) and expected life (LIFE +):
BPUT =f(ECON, LIFE.). (6)
Effects of Cash Flow Structure
Amortization level. Adding complexity to the functional relationships of the
borrowers' call and put is that not all ABSs have pass-through structures. Controlled
amortization, bullets, and bonds have progressively more certain cash flow streams.
These structures should be less affected by prepayments, but they are not immune to the
effects, as discussed earlier. The principal payment stream over the controlled
amortization period could be affected by prepayments. The principal payout date for any
bullet--soft or hard--could be affected as well, resulting in an amortization period
2Other proxies tried were the composite index of leading indicators, the University of
Michigan Index of Consumer Expectations, the ratio of consumer installment debt to personal
income, the unemployment rate, percentage capacity utilization, and the change in the NYSE
composite price index. All of these were available in Kolb and Wilson, 1993. While most of
these proxies performed similarly, the percentage change in the Index of Industrial Production
entered with more significance and performed consistently. Logically it might seem that a
measure more inclined toward measuring consumer confidence might be an effective proxy,
because so many ABSs are collateralized by consumer loans. But it was felt that it is not
consumer confidence or expectations that matter so much as the aggregate consumer economic
situation, which might be effectively captured by industrial production.
following the predicted payout date (see Chapter 2, fn. 20). In order to account for these
perhaps differing prepayment effects on the various structures, interactive variables are
created by using structure dummies for controlled amortization, bullet, and bond
combined with the prepayment proxies.
However, we would not necessarily expect prepayment risk to be as important to
the pricing of an ABS as to an MBS. This is because the expected lives are generally
much shorter and because the incentives to refinance are not nearly as significant.
Prepayment patterns for auto loans and credit card receivables "are generally more stable
than residential mortgage prepayment patterns" (Finnerty, 1993, p. 36). In fact,
prepayment risk may not be an important factor at all, although this may depend on the
collateral involved. (Home equity loans, for example, are often refinanced when the
home is refinanced.) Dunn and McConnell's (1981) simulations show that as the slope
of the yield curve increases, the yield of an amortizing, non-callable security increases
relative to a non-amortizing, non-callable security. If an ABS pass-through is considered
an essentially non-callable security (i.e., the prepayment option is not a significant pricing
factor), then we would expect to find a positive relation between the slope of the yield
curve and the spread between an ABS pass-through and a Treasury security. This is
simply a way of saying that ABSs might exhibit positive convexity, like corporate debt,
rather than negative convexity like mortgage-backed securities. By extension, there
should be a predictable relation between the fully amortizing ABS pass-through and the
progressively less amortizing ABS structures of controlled amortization, bullet, and bond.
That is, the slope coefficients for these structures should be progressively less positive.
This is really a reinvestment risk problem due to the predicted cash flows, as
opposed to the unpredicted prepayments. In the trade press, bullet structures are said to
"roll down the yield curve" (ASR, November 16, 1992, p. 4) faster than a controlled
amortization structure, for example, and pass-throughs "roll down" slower (ASR,
November 23, 1992, p. 1; March 22, 1993, p. 1). The idea is simply that in a steep
positive yield curve environment, investors prefer receiving the principal farther out in
time, where it produces interest at the higher rate for a longer period. There is less
reinvestment/interest rate risk and a greater overall return for a bullet than for a similar
controlled amortization issue where principal is received earlier and must be reinvested
at a potentially lower rate. In a flat yield curve environment, there is little reward for
going long term and investors prefer receiving the principal earlier and facing the prospect
of reinvesting at potentially higher rates. Pass-through is preferred to controlled
amortization; controlled amortization is preferred to bullet. Thus, because we expect
opposite signs on the slope of the yield curve variable, the relative importance of
prepayment risk versus reinvestment risk for an ABS or, in other words, the convexity
of the security, is a testable hypothesis.
The proxy for default risk will be dummied by structure similarly to the call
proxies. In addition to pass-through, controlled amortization and bullets could pay out
principal early if an early amortization event is triggered. One early amortization event
typically occurs if defaults increase sufficiently to reduce portfolio yield below a base rate
set in the prospectus. Since neither Moody's nor Standard and Poor's considers the
possibility of these early amortization events when assigning their issue ratings, this type
of "default" risk should indeed be priced separately from ratings.
Subordinate and sequential-pay trenches. In effect subordinate (B) trenches have
negative leverage because B security holders own some small percentage of the pool yet
face 100% of the loss. The securities might be expected to be more sensitive than senior
trenches to the prepayment call option and the default prepayment put option proxies. 'A'
trenches in a multiple A tranche issue also face a possible sequential payment situation,
and some of them may be more sensitive than others to both types of prepayment. If the
splitting up of cash flows into multiple trenches is a more efficient distribution of risk,
then A trenches from a multiple A tranche issue may have a yield discount. Thus, both
B trenches and multiple A trenches will be represented by indicator variables in the
regression, and VOL, SLOPE, and ECON will be dummied to provide interactive
There is one additional option sometimes present in an ABS issue. The issue may
be subject to a call. Callability should matter, as long as the call is not a simple clean-up
call which occurs only at the end of the life of an issue when principal outstanding is
quite low. Investors should require a premium for callability.
To sum up, option induced risk (OPTRISK) is expected to be a function of interest
rate volatility (VOL +), the slope of the yield curve (SLOPE -), overall economic
conditions (ECON -), the expected life of the security (LIFE +), and the callability of the
tranche (CAL +):
+ + +
OPTRISK, =f(VOLi, SLOPE,, ECON, LIFE,, CAL). (7)
VOL, SLOPE, and ECON will be dummied by structure indicator variables to provide
interactive variables for different amortization structures and for differences in trenches.
Default Risk (Part 2): The Sufficiency of Credit Rating
Earlier, it was suggested that credit rating of the tranche proxied for the default
risk faced by the investor. But, it is not clear that tranche rating is sufficient to assess
risk in a complex, heterogeneous market such as the ABS market There are, potentially,
risks not captured by credit rating that may result in default, or more likely, in an early
amortization event or some other timing change. "Here, a transaction structure may
unwind (i.e., an early amortization event or event of default) due to even the most obscure
credit related problem" (Gold and Schlueter, 1993, p. 153). Due to these complex
structures, investors may utilize other information in addition to ratings that may be used
in the assessment of default risk specifically or, more likely, in the assessment of the
probability of undesired cash flow timing changes. Investors are likely to seek additional
information that indicates the current and future pool quality and/or that indicates the
probability of some sort of structural failure or early amortization event with an issue.
A low quality pool or a deteriorating pool increases the probability of future tranche
default, prepayments resulting from borrower default, and early amortization events.
Structural failure increases the probability of issue default, as well as increases the
possibility of an interruption of cash flows. The rating of the originator, the institutional
form of the originator, and the type and amount of credit enhancement may all be
The "bankruptcy remote" structure of an ABS would imply that the originator's
credit rating should not be important to the pricing of an ABS if the legal separation
between originator and actual issuer is believed to be effective. After all, unlike a bond
issue where the rating generally cannot be higher than the originating corporation's credit
rating, the "bankruptcy remote" structure of asset-backed issues allows this to commonly
occur. In fact it is an important reason a number of large originators such as Chrysler
or Citicorp have used the ABS market to fund assets. But despite the claims of
"bankruptcy remoteness," there may be legal risks associated with these asset transfers:
"experienced investors know that some of these provisions (e.g., nonpetition agreements)
may not be enforceable, that no entity can be made truly 'bankruptcyproof,' and that
consolidation cannot be judged by some 'safe harbor' checklist alone" (Buerger and Isely,
1989, p. 525). Due to ambiguities in the language of U.S. Bankruptcy Code and an
absence of definitive case law relevant to legal transfer, there is "the potential of a
bankruptcy court to recharacterize the legal transfer which in most transactions had been
intended as a sale of assets, to a pledge of assets, or in some cases, void the transfer
altogether" (Griep, 1993, p. 136). Thus, there is the risk that "bankruptcy remoteness"
may not be effective in all cases.
But even if the issue is "bankruptcyproof," the condition of the originator might
still be important for three reasons. First, bankruptcy of an originator might trigger an
early amortization event. Second, the originator has value to the pool after the sale of the
assets. The originator's financial condition is important to receivable collateral value,
borrower behavior, credit quality, and possibly the quality of servicing. Consider
warranties and product servicing. These can be important factors in resale value and
recovery value of collateral. (Buerger and Isely, 1989, offer the example of the depressed
resale value for Chrysler products during that firm's financial difficulties.) So a
bankruptcy by the originator could have repercussions on the value of a pool of assets.
Consider also credit card portfolios. Because of the nature of these receivables, the pool
consists of revolving credits and depends on new receivables being added to the pool.
If an originator is in trouble, it may be difficult to add receivables of the same quality or
any receivables at all. The problem is even worse for retail credit cards (issued by a
department store, for example) because if a bank fails, the credit card business would
most likely be divested and card usage continue. But with a retail card, when the
business fails most likely the credit card business would also shut down, resulting in no
Third, the originator is very often the service, and in "a single originator
transaction, it is likely that the originator may manage the SPV," i.e., "managing its debt,
interest rate swaps and foreign exchange payments, effecting cash movements, and
managing its accounts" (Keighley, 1993, p. 105). The servicing role is especially
important. A bankruptcy by the service could result in an interruption in the transaction
management duties and possible cash flow effects for investors. Worse, it could result
in a "permanent diminution in overall credit quality" (Buerger and Isely, p. 517.) These
would be effects beyond the historical experience used to estimate delinquencies, defaults
and recoveries. This is because the service, through collection procedures and policies,
maintains pool quality and can influence payment behavior. Efficient and effective
collection procedures are very important. Short of bankruptcy, it is still possible for
performance to deteriorate over time. Griep (1993) points out that troubled banks and
thrifts experience an increase in delinquencies and defaults. Service credit quality is
important for an additional reason: the service makes cash advances on delinquent
receivables and it collects and holds payments. This cash function could be affected by
There is evidence that the originator's institutional form--bank, savings and loan,
captive finance company, and so on--might also matter to pricing. Previous studies have
found some evidence that banks, for example, are different. They may possess special
information or ability that other market participants do not, may structure loans
differently, or attract (or choose) different consumer clientele.3 Investors, then, may price
issues differently depending on the type of originator.
Finally, how an issue attains its rating may be important. Credit enhancement can
be provided via subordinate trenches, outside guarantees, inside guarantees, and many
other ways. Can the investor distinguish among these methods and does it matter to
3See Lummer and McConnell (1989) on the positive market response to bank loan renewals.
Billet, Flannery, and Garfinkel (1993), in an examination of commercial bank loans, find that
while loans from all originators (banks and non-banks) elicit a positive market response, the
quality (credit rating) of the lender, rather than the type, positively influences the market's
response to a loan announcement. Thomas Zimmerman of Prudential Securities researched home
equity loan prepayment speed. He found that the key to prepayment speed was where the
borrower is financing. Bank borrowers prepay faster, presumably because they are higher quality,
more sophisticated borrowers than those who borrow from finance companies (ASR, May 3,
pricing? Does the particular form and amount of the credit enhancement tell the market
anything in addition to what the credit rating indicates?
There is reason to believe the type of credit enhancement should matter. It has
been suggested that certain forms of enhancement are less sensitive to event risk, such
as a rating downgrade of the insurer. For example, unlike banks, the most common
provider of a letter of credit, no monoline insurer has ever been downgraded (see
Mortimer, 1993, p. 179). Also unlike banks, "monoline" insurers are not subject to
potential losses from other risk-carrying lines of business. Thus there may be some
pricing distinction between letters of credit and outside insurance. Also, a cash collateral
account has frequently been lauded as being without event risk altogether, because once
the cash has been provided it cannot be downgraded. Finally, a retained subordinate class
may offer advantages in either direction. Compared to third party enhancement, the
retention of a subordinate piece of the pool might be expected to decrease moral hazard.
On the other hand, Bhattacharya (1989) points out that a subordinate piece is not a perfect
substitute for other credit enhancement devices:
In the event of default or foreclosure, other credit enhancement alternatives
provide immediate coverage up to the limit protection. However, the ability of
the subordinated cash flows to meet shortfalls in the senior class cash flow is
limited by the balance of any fund created specifically for the purposes of such
contingencies and any current cash flow due to the subordinated holders. (p. 479)
The amount of credit enhancement may be important as well. It may be important
to the market if the credit rating does not assess the complete risk of a low quality pool.
The rating process on an ABS differs from the process with more traditional securities
because it "starts with the rating desired" and the rating agency tells the issuer what is
needed to achieve that (Watson and Joynt, 1989, p. 213). Thus the amount of
enhancement may be a direct indicator of pool quality. The quality of the pool, likely to
move with the economy and thus be undiversifiable, may be an indicator of the
probability of early payout events, and the amount of credit enhancement may be a signal
of this quality.
If originator rating, originator institutional form, or credit enhancement are
significantly priced, then the sufficiency of credit rating for assessing risk in an ABS
might be questioned. Such findings would indicate that credit rating of an ABS issue
does not assess all the implications of a low quality pool or weak structure, and therefore
the market seeks additional information. The market's assessment of credit risk
(DEFRISK), then, may be more than a function of issue rating (RATE -); it may also be
a function of originator rating (ORIGRT -), originator type (ORIGTP +/-), and credit
enhancement (CE +):
DEFRISK. -f(RATE,, ORIGRT,, ORIGTP CE). (8)
A prime motivation for the restructuring and repackaging involved in an ABS
issue is to transform illiquid assets into liquid or marketable assets. Marketability may
be affected by the size of a particular issue or the size of the ABS market, by the
experience of investors with ABS structures, collateral, or originators, and by particular
issue characteristics such as frequency of payments.
The issue size is a common proxy for the marketability of any particular issue in
corporate bond studies (e.g., Billingsley, Lamy, and Thompson (1986), Kidwell, Marr, and
Thompson (1984), Fung and Rudd (1986), Allen, Lamy, and Thompson (1987), and
Sorensen (1979)). As the issue size increases, it is likely that the breadth of the market
for the securities will expand--there will be more investors holding the securities in their
portfolios and thus more regular trading. The expectation, then, is that larger issues are
more marketable and require lower yields. There has been a commonly found size effect
in bond pricing studies--size usually enters negatively and significantly (e.g., Allen, Lamy,
and Thompson (1987) and Sorensen (1979)). Alternative proxies for issue marketability
employed in this study are logged dollar value of an issue and the dollar value of the
issue deflated by the dollar value of corporate bond issues in the month of issue
(corporate bond issues were used because of the obvious time trend in ABS issues over
As a young, maturing market, the ABS market offers an opportunity to explore
the relative importance of market deepening versus market broadening over time, and to
determine if inexperience in these securities resulted in an initial overestimation or
underestimation of risks that was corrected over time. On the one hand, from its
beginnings as a public market in 1985, the ABS market might be expected to undergo a
deepening process as the instruments in the market get better understood by more
investors and the increase in the number of issues increased liquidity.4 This market
deepening would imply a narrowing of spreads over time. Spreads would also narrow if
the market's initial estimation of risk was overestimated due to inexperience.
4Money manager Lawrence Harris says: "It's been the same way with every new kind of
security that we've seen. It takes a while for liquidity to develop" (in Zweig, 1989, p. 535).
Similarly, two forces might widen spreads over time--a "market broadening"
process and a maturation process that reflects a correction for an initial underestimate of
risks due to inexperience. Over a relatively short period, the ABS market has absorbed
a tremendous increase in supply, has seen a large number of new, perhaps lesser known
originators enter the market, has broadened the types of collateral underlying the issues,
and has seen introduced a variety of instruments. Because of the rapidity of this growth,
the tendency toward the new and unusual, and possibly average collateral quality decline,
this broadening trend would be characterized by a widening of spreads over time. If ABS
risks were initially underestimated, spreads would also widen over time.
Two alternative proxies for a maturation or time trend that would capture the
dominant trend are a simple time count--this study uses a count by quarter with one being
the first quarter of 1985--and the logged total dollar value of issues in the entire ABS
public market prior to the day of a particular security's issue. Reasons for a significant
time trend include a changing composition of issuers, and/or collateral types, and/or
security designs, as well as changing risk assessments of stable issuer, collateral, or
security designs. Whether any trend holds for individual major originators and
homogeneous tranche types as well as the entire market should help determine whether
the effect is due to market deepening or broadening, whether it is due to an initial market
over- or under-estimation of ABS risk, or whether it is simply due to changes in market
A closely related marketability issue is that of "market saturation" or "hotness,"
that is, the dollar value of ABS securities currently available in the market. Because
secondary market information is not available, a proxy for market hotness is the logged
dollar value of ABSs issued in the previous three months from the day of a particular
issue. This quarter issue figure tends to follow an increasing time trend much like the
quarter count or logged total issue dollars. Most previous MBS studies expect a negative
relation with spread for such a supply variable (see Milonas  and Rothberg,
Nothaft, and Gabriel ), but find a positive, insignificant one.
The importance to pricing of investor "experience" with aspects of ABSs can be
illuminated more clearly, perhaps, by proxying for experience or inexperience more
specifically. First issues by a particular originator or of a particular collateral might
require a higher yield.5 Dummy variables for these issues will be included. The private
market, which tends to lead the public market, may mute the negative pricing effect of
this type of inexperience in the public market.6 Similarly, a very familiar, established
issuer who has established a reputation might be rewarded by issuing securities with
lower required yields. Proxies will include the logged dollar value of all previous issues
by an originator and, alternatively, a dummy variable for five or more previous issues.
Using either approach, experience may be a priced marketability factor.
5Ken Degen, Vice President of Structured Finance for MBIA, a major insurer, said "... we're
very cautious in taking on new asset types. To do a new asset type takes a long time.... A lot
of research and development go into new asset types-on all sides" (ASR, April 12, 1993, p. 6).
6Information on private transactions is more difficult to obtain. But Acheson and Halstead
(1988) note that a number of public issuers continue to use the private market, including Ford and
Chrysler. Also, Pavel indicates in the collateral category of lease receivables, for example, that
by June of 1988, there had been almost $1 billion issued publicly. Private issues at that time
totalled $500 million, a substantial percentage. ASR reports that private placement ABS issues
were $13.06 billion in 1993, a 12% increase over 1992. For 1993, that figure would place private
issues at 21.7% of the public market (ASR, February 28, 1994, p. 1).
Finally, specific tranche characteristics may increase or decrease tranche
marketability. For example, most ABSs have payments 12 times a year. However, some
trenches pay out only two or four times a year. If there is a demand for these less
frequently issued payment frequencies, perhaps because of a reduction in reinvestment
transaction costs or a better matching of required cash flows for some investors (a
clientele effect), then these securities may have a reduction in required premium. On the
other hand, if less frequent cash flows are not in demand, we may see the opposite effect.
Marketability (MKT) is a function of market maturation over time (TIME +/-),
market saturation or hotness (HOT +-), issue marketability (SIZE -), experience (EXPER
+/-), and payment frequency (FREQ +/-):
MKT =flTIME,, HOTS, SIZE,, EXPERT FREQ). (9)
Collateral may reflect a great number of differences among issues. Unlike
mortgage assets, ABS pools are "characterized by an absence of standardized underwriting
and servicing. Consequently, portfolio quality and performance will vary widely"7
(Standard & Poor's, 1988, p. 71), perhaps across collateral type. Further, underwriting
standards could be affected by competition, growth strategies, and marketing methods
within an industry. Some industries/collateral-types may face different risks. For
example, competition in the credit card industry could affect pool cash flows if
competition forces a change in rates or fees. Or government legislation might change
7Mastercard and Visa, for example, unlike FNMA, FHLMC, or GNMA, do not require
adherence to specific underwriting standards.
pool behavior, for example the change in the tax treatment of interest expense that
occurred a few years ago. Goldberg and Rogers (1988) made the further point that some
distinctions may be made among collateral types because some securities are
collateralized by real assets (e.g., autos) while some are not (e.g., credit card receivables).
Thus, collateral type may be significantly priced because of different
characteristics or because they face risks omitted from the model and not captured in the
credit rating of the issue.
Summary: Hypotheses Concerning the Determinants of ABS Yield Spreads
Substituting (7) through (9) into (1) and including collateral and interest rate level,
we obtain the following model for ABS spreads.
SPREAD, =f(l, TIME,, HOT,, SIZE,, EXPER,, RATE., COLLAT,,
+ + + +
ORIGRT,, ORIGTP,, CE,, VOL,, SLOPE,, ECON,, LIFE,, FREQ, CAL). (10)
The conflicting signs on SLOPE and TIME should be clarified. For SLOPE, a negative
sign indicates that prepayment concern dominates, a positive sign indicates that the
amortization effect dominates. Zero would indicate that the slope is an ineffective proxy
or that the two effects net out. A negative sign on TIME would indicate that the market
deepening effect dominates and/or ABS risks were initially overestimated; a positive
coefficient would indicate that the broadening effect dominates and/or ABS risks were
The discussion of the ABS risk factors lead to several testable hypotheses which
are evaluated in this study. Except where noted, the null hypothesis is "no effect."
(1) Prepayment risk is a significant pricing factor with ABSs, and this risk diminishes
as cash flow structure becomes more certain. Thus, ABSs exhibit negative convexity and
the sign of the SLOPE coefficient is expected to be negative. The alternate hypothesis
is that ABSs exhibit positive convexity--prepayment risk is not a dominant concern while
concern over reinvestment of expected cash flows dominates. The slope coefficient sign
is positive and becomes less positive as expected principal payments are pushed out
further in the life of the tranche.
(2) Default prepayment risk is an important pricing factor and moves countercyclically
with the economy.
(3A) In a new and developing market, market "deepening" dominates and results in a
narrowing of spreads over time and/or ABS risks were initially overestimated.
(3B) Market "broadening" dominates and results in a widening of spreads over time
and/or ABS risks were initially underestimated.
(4) The market requires a premium for a lack of familiarity or experience such as a first
time originator or a new collateral type and discounts for an established reputation.
(5) Investors require information on pool quality in addition to tranche credit rating. In
(5A) Originator rating affects spread,
(5B) Originator institutional form affects spread,
(5C) Type and amount of credit enhancement affects spread.
BAAAAA -- RELATIVE SPREAD BAA-AAA
0.5 -+--- -1- --d -l --iN --I- 0.06
FIGURE 3: CORPORATE BOND YIELDS
SPREADS AND RELATIVE SPREADS
METHODOLOGY AND DATA
The challenge of this study is to construct a model and develop a procedure to
price the relevant risk factors that acknowledges the heterogeneous nature of ABSs. The
model must allow for possible pricing differences among the different cash flow
structures, the level of subordination, the multiple tranche structures, and possibly the
major collateral groups. The plan of the study is to present an initial model that
highlights the relevant risk factors discussed earlier and, in particular, studies the
interaction between cash flow structure and proxies for prepayment and default
prepayment risk. Collateral type, subordinate B trenches, multiple trenches, payment
frequency, and first by an issuer or first by a collateral type are factored into the model
through the use of dummy variables. A time trend is included because this is a new,
developing market OLS regressions are used.
The initial regression establishes the ability of the model to explain a significant
portion of the variability in the spread from Treasury. It also assesses the importance of
prepayment and prepayment default risk to ABS investors and examines the ability of
different cash flow structures to ameliorate the effects of prepayment, prepayment default,
and reinvestment risk. Then, similar interactive effects are studied with regard to
subordinate trenches and multiple (sequential) trenches.
Further specific hypotheses are then addressed concerning the role of reputation
and the originator. The value of experience or reputation is expanded upon (from the
"firsts" of the initial regression) by proxying for previous experience in the market. The
role of the originator is first examined by adding originator rate to the model. It is
further studied by dividing the sample into three major collateral types. Dummies for
institutional form are added to the specification. The isolating of collateral not only
allows conclusions about why institutional form may be important, it also allows us to
assess the degree to which different collateral types face similar risks.
Finally, the role of credit enhancement is studied. Whether how an ABS attains
a certain rating matters to investors is analyzed by adding variables representing amount
and type of credit enhancement. The market may value enhancement differently by who
provides it or by the specific form of the insurance.
The analysis is conducted using both absolute spreads and relative spreads,
illuminating the effectiveness of each in capturing the above effects, and perhaps, as well,
offering insight into the stability of these different specifications (see discussion in
This study provides the first extensive examination of a large, fairly complete
sample of asset-backed securities. Data on the offer pricing and characteristics of ABSs
(seller (originator), issuer, class (tranche), principal, expected average life, collateral,
rating, yield, and lead manager) were collected from Asset Sales Report, a weekly
industry publication devoted to loan sales and asset-backed securities.' This information
was supplemented by detailed data on each issue's call, payment frequency, and payment
structure. These data were obtained from two sources: the Warga/Lehman Brothers
Fixed Income Data Base2 and Moody's Bond Record. The latter source also provided
tranche cusips (with which to access the Warga dataset), as well as issue ratings and
limited information on credit enhancement (usually just indicating the name of an insurer)
and payment frequency.3 Additional information, where required, is sought from the
"New Securities Issues" section of the Wall Street Journal and Dow Jones News Retrieval
Searches, including unpublished press releases from the various rating firms, insurers, or
Ratings for originators were based on the senior unsecured debt rating from
Moody's Bond Record at the time of issue. If unavailable in Moody's, Standard &
Poor's was consulted. In just a few cases, where bond ratings were unavailable, Moody's
thrift or bank long-term deposit rating was used. Originator ratings are for the parent
corporation, not the subsidiary (in consultation with Dunn and Bradstreet's annual Who
'Information from ASR was collected in two ways. Lexis/Nexis carries ASR from 1991 on.
Unfortunately, not all of what are called "New Issue Scorecards" are on Lexis (probably because
before mid 1992 they were considered tables or charts). Also, the editorial offices of ASR
allowed the author to examine their past issues. The author would like to thank Jeanne Burke,
editor, for her assistance. ASR is published by the American Banker.
2Developed by Arthur Warga of the University of Wisconsin--Milwaukee and based on the
Lehman Brothers Bond Indices, this new dataset contains structural information and monthly
pricing on fixed income securities. Even though asset-backs are not a primary component, this
served as an important source of data for this study.
3Until December, 1990, asset-backs were listed (sporadically) with regular bond issues. After
this date, ABSs are listed in a section titled "Structured Finance Issues." This section contains
no issue yields or secondary market pricing information.
Own's Whom), but in all but a few cases there is no conflict between the ratings of the
parent and the subsidiary (e.g., General Motors, not GMAC; Citicorp, not Citibank,
Credit enhancement information was gathered primarily from ASR, supplemented
by Dow Jones News Retrieval searches of the Wall Street Journal and the various press
releases included on this service. This information included type (letter of credit, surety
bond, cash collateral, etc.) and amount of enhancement (dollar and/or percentage), the
tranche(s) to which it applies, and the provider of the coverage. Moody's Bond Record
does not provide dollar or percentage of issue amounts of enhancement, but it does often
indicate the type of credit enhancement and the name of the insurer. Thus, this is
valuable supplemental information. In general, the credit enhancement information is
more complete for 1991 and 1992 (when ASR is carried on Lexis). The information that
is contained in the dataset created here is generally accurate and complete, except that
details on overcollateralization are scarce. Overcollateralization is commonplace, although
usually modest in amount. But details on the overcollateralization are generally available
only in the prospectus, which we do not have for most of these issues. Thus generally
we do not know the amount of overcollateralization. In two cases only, we know that
overcollateralization was the only form of credit enhancement utilized and we know the
amount. The overcollateralization amounts for these two issues only are included in the
credit enhancement sample.
Treasury rates are from constant maturity Treasury daily series as reported in
Table 1.35 of the Federal Reserve Bulletin. Spreads are calculated using a Treasury
security of comparable maturity, creating a term-structure adjusted risk premium. The
spreads utilized here will not exactly match the spreads quoted in the press for an issue.
There are two reasons for this. (1) Most spreads are quoted as the difference between the
ABS yield and the closest available Treasury. By contrast, the spreads in this study use
an linear interpolated Treasury rate for the maturity equal to the tranche's average
expected life. (2) Yields on ABSs are quoted as CBE (corporate bond equivalent) yields,
which are based on semi-annual interest and a 360 day year. Accordingly, constant
maturity Treasury rates, based on a 365 day year, are adjusted to CBE by multiplying by
360/365, thus yielding a slightly larger spread. Treasuries shorter than one year are
quoted as discount yields. These treasuries are first converted to BEY (bond equivalent
yields) based on 365 days and then adjusted by the 360/365 factor.
Yield curve slopes and interest rate volatility are calculated using rates reflecting
a 365 day year. The slope of the term structure is calculated as the difference between
the yield on the 5 year constant maturity Treasury and the six month treasury bill.
Interest rate volatility is calculated as the standard deviation of the yield of the 5 year
constant maturity Treasury for a period 30 business days before issue date.
The Index of Industrial Production is produced by the Bureau of Economic
Analysis of the U.S. Department of Commerce. It is published in The Survey of Current
Business and was collected through mid-1992 on computer disk in Realdata (Kolb and
The following section contains a discussion of the sample of ABSs created for this
Sample Description: Entire ABS Sample
Tables 3 through 6 present descriptive statistics on the entire ABS sample
collected. As previously indicated, asset-backed securities are a rather heterogeneous lot--
which differentiates them strongly from the mortgage-backed market, for example. The
full sample (although not the regression sample) is a virtually complete representation of
the entire domestic, publicly issued ABS market from its inception in 1985 through the
end of 1992, including preferred stock issues, tax exempt issues, and interest-only
trenches. The sample contains 503 issues with 725 trenches totalling almost $209
billion.4 The impressive growth over time of the market is reflected in Table 3. From
7 issues (($1.2 billion) in 1985, the market grew steadily to 111 issues ($54 billion) in
The majority of the trenches are fixed rate (608), although variable rate branches
(117) have increased in recent years (see Table 4). Few of the trenches are callable (31)5
and most make interest and/or principal payments monthly. There are 97 subordinate (B
class) trenches and 606 non-subordinate (A class) trenches.6
4This figure is as close as possible to representing the actual public market for these issues.
For example, Gorton and Pennacchi (1992) have issue totals complete through 1988 provided by
Goldman, Sachs & Co. My figures compare exactly with their figures for 1985 and 1986. My
sample contains six more issues for 1987 and nine more issues for 1988.
'The call information, as with the payment structure and frequency information, is from the
Warga/Lehman Brothers dataset.
6Also categorized are interest-only trenches and preferred stock, which will be dropped from
the regressions, and mezzanine. A mezzanine tranche is senior to a B tranche, but subordinate
to an A. There are only 5 such identifiable trenches. Mezzanines are included (with B) as credit
enhancement to senior trenches.
There are five identifiable payment structures. The majority are simple pass-
through (310), but there are also a significant number of controlled amortization (113) and
bullet structures (88). There are 12 identifiable soft-bullet trenches; these are combined
with the bullets for the regressions. There are only 7 regular bonds. As expected, most
trenches (including many B classes) are rated Aaa, but tranche ratings range as low as B2.
Although much of the publicity for ABSs has centered on the variety of collateral
being securitized, in truth this is still a market dominated by just a few types of
underlying assets. While collateral (Table 5) is wide ranging, three types clearly
dominate--credit card receivables, auto and truck loans, and home equity lines or loans.
Together, these three collateral categories comprise over 80% of the market. Notice that
"credit card retail," such as department store cards, have been distinguished from "credit
card receivables" or general purpose credit cards, such as Visa, Mastercard, or Discover.
In 1992, credit cards comprised 30.1%, auto loans 31.7%, and home equity 11.3% of the
The largest originators over this time period by dollars of securities issued were
Citicorp, with 36 issues totalling $30.1 billion, Chrysler with 39 issues totalling $22.8
billion, and Sears with 37 issues totalling $17.6 billion (see Table 2, Chapter 2). Note
that all three of these firms have seen some financial turmoil over the sample time period.
Chrysler, especially, has clearly been a major player in the ABS market in order to issue
securities at a higher credit rating than was available to them in the commercial paper or
bond markets.7 Banks (more precisely bank parent companies) have been the most active
single type of originator, with 190 issues. Captive finance companies, which include
GMAC, Ford Credit, and the like, are the second most active type with 149 issues.
The largest single issue was by GMAC for $4 billion in 1986, an issue containing
3 trenches. The largest single tranche was for $2.2 billion, a single tranche issue by Ford
Credit in 1989. The average issue (tranche), however, is much smaller at $415 million
($297 million). The average expected average life is 3.4 years, with a range from 0.2
years to 20.5 years. The average expected yield at offer is 8.09%, reflecting a spread
over similar maturity Treasury of 1.16%. A trenches, as would be expected, are larger
than B trenches ($337 million versus $60.3), have shorter lives (3.1 versus 5.2 years),
have lower yields (8.14% versus 8.3%), and have tighter spreads (1.1% versus 1.6%).
The slope of the yield curve, as measured by the difference between the 5 year
and 6 month Treasury rates, and interest rate volatility, as measured by the standard
deviation of the 5 year Treasury rate over the 30 trading days before an ABS issue, have
fluctuated quite widely over the sample period (Table 6, Panel D, and Figure 4). The
slope, in fact, ranged from a high of almost 3% in April of 1992 to barely negative slopes
in 1989 and 1990. Figure 5 illustrates the movement of the 5 year Treasury rate with the
slope of the term structure. They moved more or less together through early-1988
(correlation = 0.81) and they tended to move in opposite directions after this point
7See ASR, May 11, 1992, p. 1. "Though it is among the strongest finance companies, CFC
[Chrysler Financial Corp.] has been hampered by ratings downgrades attributable to the weakness
of its parent, effectively precluding CFC from funding itself in the unsecured commercial paper
and debt markets, said Stephen G. Moyer, high yield analyst at Kemper." At the end of 1989,
Chrysler had $10.1 billion of commercial paper outstanding, which had plummeted to $339
million by year end 1991.
(correlation = -0.75). Finally, Figure 6 traces the index of industrial production over the
sample period. The economy showed steady growth into 1989, where it began levelling
off. There were some dramatic fluctuations through the end of 1992, including a steep
drop in the second half of 1990 and into 1991.
The sample used for the initial regression is limited by the requirement for cash
flow structure information and the exclusion of preferred stock trenches (15), variable rate
trenches (117), interest only trenches (2), and tax exempt issues (5). These were excluded
because it is likely that the pricing behavior of these securities would exhibit different
characteristics than the remaining sample.8 For most of the affected trenches, in fact, we
lack one or more of the required parameters--expected life or yield. Table 7 presents
summary statistics on the regression sample. The data are not significantly different and
indicate no systematic exclusion patterns from that presented on all ABS issues in Tables
3 and 6. The regression sample appears representative. Once branches with missing data
are excluded, the regression sample contains 452 trenches, down from the 725 total
trenches issued in this period.
'A preferred stock dividend rate is lowered by the 70% dividend exclusion enjoyed by
corporate purchasers of preferred stock. Tax exempt issues also have an obvious tax advantage.
Variable rate yields are expressed as a spread from some index, generally LIBOR, and they are
generally reset every three or six months. Thus, any link between the expected life of the tranche
and the expected yield will differ from fixed rate issues. They are effectively a series of short-
term securities (with a single transaction cost) which roll-over at the reset intervals. For more on
the valuation of floating-rate instruments and their differences from fixed rate instruments, see
Ramaswamy and Sundaresan (1986).
The specification of the initial model is
SPREAD, =a, + a, + ctVOL, + aSLOPE, + aSIZE, + axLIFE, + aTIME, (1)
+ aIP, + asRATE, + aCOLLAT + a,,FIRST + a,CALL, + a,,FREQ,
+ aoBDUM, + a,,MULTA, + asCSPR, + a INTERACTIVE,
SPREAD = Absolute spread calculated as expected yield on issue i minus the
yield on a U.S. Treasury issue with a comparable maturity at the
time of issue. When no matching maturity is available, linear
interpolation is used. For the relative spread specification, the
spread is divided by the interpolated treasury yield.
I = Interest rate level, five year constant maturity Treasury bond on the
day of issue. The coefficient is expected to be negative.
VOL = Interest volatility, the standard deviation of the annualized yield of
the five year constant maturity Treasury for a period 30 days
before issue date.9 The coefficient is expected to be positive.
SLOPE = the slope of the term structure calculated as the difference between
the yield on the 5 year constant maturity Treasury and the six
month Treasury bill.o1 The coefficient would be expected to be
negative if prepayment risk is a significant factor.
9The 30 day period is somewhat arbitrary. Rothberg, Nothaft, and Gabriel (1989) used this
period and found it significant in explaining the spread on mortgage pass-throughs. It assumes
market expectations of interest rate volatility are based on recent experience. The measure
employed here was chosen because it is simple, direct, and produced adjusted R Squares at least
as good as any altemative measure. Five other measures were substituted with very little effect
on the model. They were the absolute mean variation in the 5 year Treasury for periods of 10
and 30 days previous to issue; those absolute mean variations deflated by the five year Treasury
rate on the issue day (as employed by Chatfield and Moyer ); and the standard deviation
using log differences for 30 days previous (as employed by Rothberg, Nothaft, and Gabriel
11989]), again using the 5 year Treasury.
1"In mortgage studies, the 10 year treasury is most often used. However, the rule of thumb
there is average life of 12 years for mortgages. ABSs have shorter expected average lives, so 5
years was selected as the far end of the pertinent yield curve. Slopes measured as the difference
between the 10 year and 6 month Treasuries and the difference between the 5 year and 3 month
Treasuries were also utilized with similar results.
LIFE = Expected average life, logged, measured in years." If risks such
as prepayment and default increase with time to maturity, the
coefficient will be positive.
SIZE = The dollar size of the issue, logged, a proxy for liquidity--larger
issues are expected to be more liquid. It has been demonstrated
generally in bond pricing studies that large issues tend to carry a
TIME = A numeraire to indicate time trend for market deepening or market
broadening, measured by a quarter count with one being the first
quarter of 1985."
IP = The state of the economy, represented by the previous six month
percentage change in the index of industrial production. The
coefficient is expected to be negative.
RATE = Dummy (1,0) variables for the issue's credit rating, a proxy for
default risk. The higher of either Moody's or S&P is used, if there
is a conflict.14 Aaa is the omitted rating (captured in the
intercept). Dummy rating groups are Aal/Aa2, Aa3/A1, A2, A3
and lower. The rating dummies should enter positively.
COLLAT = Dummy (1,0) variables for the type of underlying asset of the
issue. The sample is divided into 8 groups, with credit card
receivables the omitted group (i.e., captured in the intercept). The
other categories are credit card retail, auto/truck loans, home equity
loans, manufactured housing/mobile home loans, miscellaneous
commercial, and miscellaneous retail.
"There are two maturity dates for every class--expected maturity date and final maturity date.
The final maturity date is the actual final maturity of the underlying collateral. This ignores
prepayments which are expected and fairly predictable. The expected maturity date incorporates
expected prepayment and is the date, on average, investors can be expected to be repaid. This
date will be used in the analysis.
12An alternate proxy employed is the dollar value of the issue deflated by the dollar value of
corporate bond issues in the month of issue. There is no change in the results.
"'The logged dollar volume of all issues in the market up to, but not including, the day of
issue was also used, with very similar results.
"Note that Ederington, Yawitz, and Roberts (1987, p. 225) cannot reject the hypothesis that
"Moody's and S&P's ratings [are] interchangeable and equally reliable indicators of an issue's
FIRST = Two dummy (1,0) variables to indicate the first issue for an
originator or the first use of a type of collateral. It is expected that
the coefficient on FIRST will be positive, as the market will be
unfamiliar with something about the issue.
CALL = Dummy (1,0) variable with 1 indicating some type of call
provision. We expect a positive coefficient.
FREQ = Dummy (1,0) variables signifying interest and/or principal payment
frequency. 2, 4, or 12 times are possible in this reduced sample,
with 12 the omitted frequency. Signs may go either way;
reinvestment risk may be offset by a sort of preferred habitat effect
where buyers (mostly institutional) invest in securities with
payment frequencies to suit their needs.
BDUM = Dummy (1,0) variable to indicate that the tranche is a subordinate
B tranche. The sign is expected to be positive.
MULTA = Dummy (1,0) variable to indicate that the tranche is an A tranche
in an issue with multiple A trenches. Because of the possible
sequential pay nature of these trenches, they may exhibit different
characteristics than a single A tranche.
CSPR = The corporate bond spread between Baa and AAA, a control
variable for the time varying price of risk. In the absolute model
the absolute spread is used. In the relative spread model it is a
relative spread, the spread divided by the AAA rate. This ratio is
multiplied by 100 to put it in basis point form like the other
independent variables. Figure 3 showed the two move virtually
In addition, interactive variables are formed from cash flow structure dummy variables
multiplied by VOL, SLOPE, and IP, in order to investigate the interactions between
structure and prepayment and default risk. The indicator variables are for the structures
of controlled amortization, bullet, and bond. Pass-through is the omitted group. Later,
similar interactive variables will be formed using BDUM and MULTA, interacted with
VOL, SLOPE, and IP.
Variations on this initial pricing model, with five subsequent specifications ((2)-
(6)), constitute progressively smaller samples available. Variables added to the regression
ORIGRT = Dummy (1,0) variables for the senior bond rating of the originator.
Originators were divided into five groups: Aaa to Aa3 (omitted),
Al to A3, Baal to Baa3, Bal to Ba3, and Bl to Caal.
REP = Reputation of the originator, proxied by the log of the total dollar
value of public ABS issues previous to the current issue.1
Reputation should enter negatively.
ORIGTP = Originator type. Dummy (1,0) variables for the type (bank, thrift,
non-bank financial, captive finance company, other). Banks are the
omitted group. Originator type may matter to investors if there is
some differences in origination standards, clientele, or servicing
and monitoring abilities.
INSURE = A vector of 13 credit enhancement variables, as logged percentages
of total issue, capturing the various types of enhancement available.
These factors should only be significant if investors require
additional information on pool quality beyond that contained in the
All regressions are repeated using the relative spread instead of the absolute spread. The
relative model is identical to the absolute model, with the exception that the interest rate
level is dropped for fear of spurious correlation with the dependent variable, and the
relative CSPR is used. Results will be discussed where relevant along with the relative
spread specification results. The results for the absolute spread regressions are contained
in Tables 8-16, and those for the relative spread specification in Appendix C.
"SAltematively, a dummy variable is utilized: 1 if the originator had 5 or more previous issue,
FIGURE 4: YIELD CURVE SLOPE AND TREASURY VOLATILITY 1985-92
5 YEAR TREASURY SLOPE
9 ifii i IN
I 1.5 S
4 I1 1' --+ 1-l- -I -i 0.5
FIGURE 5:5 YEAR TREASURY AND SLOPE OF YIELD CURVE
(SLOPE = 5 YR TREASURY 6 MONTH TREASURY)
INDUSTRIAL PRODUCTION INDEX 6 MONTH % CHANGE IN INDEX
100 -- / ~^ l ij V
FIGURE 6: INDEX OF INDUSTRIAL PRODUCTION (1987 = 100)
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