Equity tranches

Strictly speaking, the FIAT 1 transaction does not generate excess spread. This explains the high level of credit enhancement from the unrated class M notes (usually, unrated tranches are either privately sold or kept as an equity tranche by the originator). On the closing date, an amount of notes was issued which was equal to the net present value of all future cash payments due from the collateral (as opposed to the principal balance of the collateral). The discount rate used was the fixed rate payable to the swap counterparty (swap rate plus coupon on the class A notes and all fees associated with the transaction). Structured this way, the receivables always yield the discount rate, leaving no excess spread in the transaction. However, losses on the FIAT 1 portfolio can be covered to a certain degree from interest collections because the structure provides for delinquent principal and defaults to be covered before interest is paid on the class M notes. 

The static, no-loss return of the various tranches in this case might have the profile shown in Exhibit 22.6. Here the equity tranche constitutes the first 50 million of risk, and is compensated for its position in the capital structure with a very high notional spread of 20.5%, or 10.25 million per year on 50 million notional. This spread represents the annual return to the equity holder in the scenario where no losses are incurred. Conversely, the most senior tranche of risk receives only 1.05 million per year on a notional position of 700 million. The low spread return of only 15 bps ( 1.05 million/ 700 million) underscores the perceived safety of the super-senior tranche. 

Equity tranche 50,000,000 Residual spread 10,250,000 Equity coupon 20.5%... 

Recovered asset payment to equity holder + 3,000,000 Remaining equity tranche, post-loss 43,000,000... 

Step 5 Rate and Price Tranches. Evaluate the probability-weighted losses in each scenario to generate an overall expected loss for each tranche, and from this expected loss calculate an implied rating for the tranche. Price the tranche based on spreads for comparably rated investments. Having determined the cost of each ratable liability tranche, estimate the available excess spread applicable to the (unrated) equity tranche. 

For our portfolio, the analysis of expected losses to the first loss equity tranche might look like that shown in Exhibit 22.13. Our binomial distribution indicates that there is a 29.7% chance of 1 default occuring. This default would generate a 70% loss (30% recovery) on Vm of the portfolio, or about 1.43% of the total notional amount. How-... 

Because the SPV now owns the assets, it has an asset-and-liability profile that must be managed during the term of the CDO. The typical liability structure includes a senior tranche rated Aaa/Aa, a junior tranche rated Ba, and an unrated equity tranche. The equity tranche is the riskiest, since it is the first to absorb any losses in the underlying portfolio. For this reason, it is often referred to as t c first-loss tranche. 

In the case of a CLO, the originating bank commonly continues to service the underlying loan portfolio and retains the equity tranche. 

The return required by a potential purchaser of the equity tranche may be too high. 

The multitranche structure, with its prioritization of cash flow payments to investors, provides the CDO with a credit enhancement. To enhance the credit of the senior notes, the originating bank may also use other mechanisms, such as credit insurance on the underlying portfolio, known as a credit wrap, and reserve accounts that absorb a loss before the equity tranche. 

Subordination. Each tranches rights to and priority in receiving interest and principal payments are set out in an issues offering circular, which provides a detailed description of the notes and their legal structure. In allocating cash flows, typically, fees and expenses are subtracted from the cash flows, then the most senior tranches are serviced, followed by the junior tranches, and finally the equity tranche. This method of cash flow is sometimes referred to as a cash flow waterfall. 

Reserve accounts. The banks may also set aside cash reserves from the note proceeds in accounts, usually mantled by the servicing agent or a specialized cash manager, which provide first-loss protection to investors by absorbing losses before the equity tranche. 

LBO financings require a healthy cash flow for interest payments and repayments of debt tranches. The net debt position also determines the equity value that can be realized for financial sponsors on exit. The two major levers for improved cash flow management are working capital management and a disciplined capital expenditure program. 

Funds used to purchase the assets are raised through the issue of bonds into the debt capital market, which may be in more than one tranche and include an equity piece that is usually retained by the originator ... 

On the liability side, the structure will have tranches whose allocations of income and loss are predefined. From most junior to most senior, the tranches include equity, mezzanine, senior, and super-senior. Equity, or first loss, is analogous to the equity in a company s balance sheet, and represents the residual interest remaining after other liabilities are paid off. The mezzanine, or middle tier of risk, typically represents low-rated tranches all the way up to AA risk. Senior usually refers to AA and AAA risk. Super-senior represents a level of risk that is deeply subordinated (usually by at least 10%) to AAA, and as its name implies is regarded as extremely safe. In a structure that is not uncommon, we will assume all of the liability tranches are unfunded except for the equity. ... 

In fact, the position of the 5% funded equity holder is exactly equivalent to an investor that has purchased 1 billion of assets with 20 times the nonrecourse leverage. The implied borrowing rate of such leverage is equivalent to the blended spread of the tranches that are senior to the equity. In our case the premiums due to the three tranches above the equity total 4.75 million, and the total tranches of risk that they represent equal 950 million. The annual spread due is 0.50% of the notional on these liability tranches and, thus, in this case the equity holder has borrowed 950 million at a blended borrowing cost of 50 bps. 

With this analysis, the synthetic CDO looks much like any operating company, as shown in Exhibit 22.7. The equity holders have purchased assets of 1 billion. Those assets are predicted to generate a return of 15 million (the asset spread ). To purchase those assets, the equity holders have put up 50 million, and borrowed 950 million. They must pay 4.75 million per year in a regate (the liability spread ) to service their debt, and if it all goes bad they will not lose any more than the 50 million that has been put up. Any losses in excess of this amount will begin to accrue to other tranches according to predetermined rules, which are discussed below. 

The cumulative benefits to synthetic CDO structures versus cash structures, if they are all in play, amount to dramatically improved economics. For instance, if all of the asset side (flexibility, ramp-up, basis) benefits sum to only 10 bps, and the liability benefit is 40 bps on 70% of the capital structure, the savings would amount to 38 bps (= 40 x 0.7 + 10) on a 1 billion transaction. For a 5-year synthetic CDO, the PV of those 38 bps amounts to over 17 million. In a leveraged structure, of course, these benefits will primarily accrue to the equity and their impact will be magnified as shown in Exhibit 22.8. Clearly, the synthetic CDO may be an efficient vehicle for investors to use in accessing diversified tranches of risk. 

However, the very flexibility of synthetics mean that there are a variety of other important decisions to be made regarding the allocation of cash flows. For example, in a traditional structure, the equity holder in our deal would undergo what is shown in Exhibit 22.9 upon the experience of a loss. The tranche size is reduced by the amount of the loss. The coupon will remain at the same spread, but the spread will be paid only on the reduced notional amount. 

If the underlying portfolio performs well and its loss profile is more attractive than projected, because of better-than-expected default and recovery rates, the return to the equity holder after payments to the senior and junior tranche will be higher than expected. If, however, the underlying portfolio performs poorly and default and recovery rates are worse than projected, perhaps because of adverse economic conditions, the tranche returns will be lower than expected. Poor investment management will also have an adverse impact on the return to investors. 

As illustrated in Figure 15.1, in a securitization the issued notes are structured to reflect specified risk areas of the asset pool, and thus are rated differently. The senior tranche is usually rated AAA. The lower-rated notes usually have an element of overcollateralization and are thus capable of absorbing losses. The most junior note is the lowest rated or nonrated. It is often referred to as th.t first-loss piece, because it is impacted by losses in the underlying asset pool first. The first-loss piece is sometimes called the equity piece or equity note (even though it is a bond) and is usually held by the originator. 

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