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Definitions A [ClearOnMoney]
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Reference

Definitions A

Adjustable Rate Mortgage

An adjustable rate mortgage (ARM) is a mortgage in which the interest rate can go up or down (“reset”) according to prevailing financial market conditions.

From Wikipedia:

“An adjustable rate mortgage (ARM) is a mortgage loan where the interest rate on the note is periodically adjusted based on a variety of indices”

From the US Department of Housing and Urban Development (HUD) website:

“Unlike fixed rate mortgages that have an interest rate that remains the same for the life of the loan, the interest rate on an ARM will change periodically. The initial interest rate of an ARM is lower than that of a fixed rate mortgage, consequently, an ARM may be a good option to consider if you plan to own your home for only a few years; you expect an increase in future earnings; or, the prevailing interest rate for a fixed rate mortgage is too high.”

Option Arm: “An 'option ARM' is typically a 30-year ARM that initially offers the borrower four monthly payment options: a specified minimum payment, an interest-only payment, a 15-year fully amortizing payment, and a 30-year fully amortizing payment.” (Wikipedia)

Alt-A

The usual definition given for an Alt-A mortgage is that it is one in which the risk falls between prime and subprime. In fact there is no standard definition, and any report on Alt-A should be read carefully to see what definition is being used. Most commonly, Alt-A means that the borrower had reasonably good credit but presented a risk in other ways.

From Calculated Risk:

“Residential mortgage lending never, of course, limited itself to considering creditworthiness; we always had “Three C's”: creditworthiness, capacity, and collateral. “Capacity” meant establishing that the borrower had sufficient current income or other assets to carry the debt payments. “Collateral” meant establishing that the house was worth at least the loan amount–that it fully secured the debt. … The difference between a prime and a subprime lender was simply how low you set the bar for one of the C's, creditworthiness. … If subprime was traditionally about borrowers with good capacity and collateral but bad credit history, Alt-A was about borrowers with a good credit history but pretty iffy capacity and collateral.”

From Investopedia.com:

“A classification of mortgages where the risk profile falls between prime and subprime. The borrowers behind these mortgages will typically have clean credit histories, but the mortgage itself will generally have some issues that increase its risk profile. These issues include higher loan-to-value and debt-to-income ratios or inadequate documentation of the borrower's income.”

From the Mortgage Metrics report:

“The OCC and OTS Mortgage Metrics Report uses standardized definitions for three categories of mortgage creditworthiness: prime, Alt-A, and subprime. These are defined using ranges of borrowers’ credit scores at the time of origination, as follows: prime—660 and above; Alt-A—620 to 659; and subprime—below 620.”

From Wikipedia:

“An Alt-A mortgage, short for Alternative A-paper, is a type of U.S. mortgage that, for various reasons, is considered riskier than A-paper, or “prime”, and less risky than “subprime,” the riskiest category.”

Asset-backed security

Asset-backed securities, which became a major force in the 1970s, lump together a number of income streams and spread the risk of default by combining them into a single security that pays a fixed rate. Because the risk is averaged over a number of assets, the credit rating of the security may be higher than that of any of the assets backing it. The revenue streams may include mortgages, credit-card receivables, car loans and royalties. Mortgage-backed securities are the most common type.

From Wikipedia:

“An asset-backed security is a type of bond or note that is based on pools of assets, or collateralized by the cash flows from a specified pool of underlying assets. Assets are pooled to make otherwise minor and uneconomical investments worthwhile, while also reducing risk by diversifying the underlying assets. Securitization makes these assets available for investment to a broader set of investors. These asset pools can be made of any type of receivable from the common, like credit card payments, auto loans, and mortgages, or esoteric cash flows such as aircraft leases, royalty payments and movie revenues. Typically, the securitised assets might be highly illiquid and private in nature.”

From PIMCO:

“Creating bonds from a pool of loans or receivables involves a process called securitization. In this process, the originator of the loans (or receivables)—which can be a bank, a finance company, a government or other lender—selects a group of loans from its portfolio. The originator then sells this pool of loans to a newly created company—a special purpose vehicle (SPV) set up solely for the ABS transaction. In turn, the SPV usually sells the receivables to a trust that issues the asset-backed securities. The payments on the underlying loans or receivables may then be passed directly onto investors as they flow into the trust, or they may collect in the trust for a specified period of time to pay principal and interest on a schedule designed to appeal to investors. Many auto loan ABS pass the monthly principal and interest payments on the loans directly onto ABS investors as monthly bond payments. The cash flows from many other asset types, including credit card receivables, usually accumulate in the trust and then pay interest quarterly or every six months and return principal at maturity—a “bullet” payment structure that resembles the payout on many corporate bonds.”

An addition from Margrabe:

“The revenue stream and collateral may support more than one “class”, “piece”, or “tranche”, just a corporation's assets may support shares and bonds. Thus, the ABS, whose value depends on the underlying revenue stream and collateral, is a Derivative Product in the same sense that financial economists have long recognized that corporate shares and bonds are Derivatives, whose prices depend on the underlying asset value and cash flow.”

A CDO is a special case of an ABS.