Junior tranches

Most credit card transactions completed have usually come with three tranches. The Class A Notes, approximately 90% of all European CCABS issued, are usually triple-A rated, the Class B Notes, which account for approximately 5%, are usually single-A rated and the most junior tranche, the Class C Notes, accounts for approximately 5% and is usually rated triple-B. Exhibit 13.5 shows European credit card issuance by rating since the market s inception in 1995. 

Of the total spread of the assets available to fund the tranches of liabilities in this example, fully 68.33% goes to the first loss piece even though this piece only represents 5% of the total potential loss. Meanwhile, a mere 7% of the available 15 million asset spread accrues to the most senior 70% of the capital structure. As with all CDOs, in this synthetic deal the senior tranches are providing leverage to the junior tranches in exchange for safety. 

In an ABS or CDO structure the issuer will usually issue different tranches of notes with different levels of seniority. As losses occur in the portfolio, the most junior investors will start losing their investment. The mezzanine investors will only face a loss on their investment after the junior tranche has been lost, that is, the losses on the portfolio are greater than the junior tranche. The senior tranche investors will only face a loss on their investments when the losses on the portfolio are greater than the sum of the junior tranche and the mezzanine tranche together. 

In structured ABSs and CDOs, the bonds issued by the issuer are ranked accordingly to the priority of claim it offers the investor in relation to the other noteholders for distribution during the life of the transaction and for purposes of distributing the proceeds from the realization of the Mortgaged Property in the case of acceleration of the bonds. The bonds issued in a transaction are usually divided into junior tranches (i.e., the... 

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. 

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. 

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. 

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. ... 

The deal is structured as a senior-subordinated overcollateralization, with the first three notes all rated as AAA. These are ranked further into a super-senior and junior-senior tranche. The note tranching is the principal form of credit enhancement, in addition to the overcollateralization of 0.85 percent. There is also a reserve account to trap excess spread, which is a further credit enhancement. 

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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