Get the habit of analysis—analysis will in time enable synthesis to become your habit of mind.
—Frank Lloyd Wright
6.1 RISK FACTORS
In this section the risks affecting returns on a securitized structure are reviewed. The primary example is mortgage securitization, but many of these concepts apply to various types of asset-backed securities.
- For a prefunded deal, if the prefunded amount is not fully spent by the prefunding deadline, say three months after settlement, then the excess prefunding cash is effectively a prepayment that pays down the bonds. This will shorten the bonds and may lessen their yield. In general, if a bond is purchased at a premium and pays down faster than anticipated, then the yield will be lower than anticipated.
- When prefunding assets, the assets purchased may differ slightly from the characteristics stipulated in the the prospectus. This difference should be small and not impact the performance of the deal. A similar risk is inherent in an actively managed collateralized debt obligation (CDO).
- A prepayment option is the ability of a borrower to pay down his loan faster than the scheduled amortization. Various ABS loans have prepayment risk to different degrees: mortgages, student loans, auto loans, and the like. In general, prepayment risk is the relative devaluation of a prepayable bond compared to a nonprepayable bond. Consider a par bond. Interest rates ↓⇒ prepayments ↑⇒ excess cash needs to ...