Notes tranches

The originator of Euro Zing I CDO is Zais pic. The transaction strnctnre diagram is shown at Exhibit 15.8. The overlying note tranching is shown at Exhibit 15.9. 

The transaction structure is shown at Exhibit 15.11, and overlying note tranching at Exhibit 15.12. 

The structure diagram is shown at Exhibit 15.14. The note tranch-ing is shown at Exhibit 15.15, while the expected return of the subordinated notes is shown at Exhibit 15.16. 

Credit support Note tranching, overcollateralization, excess... 

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. 

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. 

A typical issue will feature a triple-A rated tranche, a single-A rated tranche, a triple-B rated tranche and a dynamic spread account. The subordination structure for a typical credit card issue is shown in Exhibit 13.8. In this example, the class A noteholders benefit from the subordination of the class B and class C notes, which together provide 12% credit enhancement. The class B noteholders benefit from the subordination of the class C notes, which provide 7% credit enhancement. The class C noteholders benefit from a dynamic spread account. 

A typical auto or consumer loan ABS transaction features one to four tranches, generally rated between triple-A and triple-B. Exhibit 14.11 shows the credit enhancement levels for the FIAT 1, the Globaldrive B, and the PPAF 1 transactions. The three transactions are all structured differently and as such, the senior notes in each issue benefit from different levels as well as types of credit enhancement. 

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. 

These can include trapping and diversions of cash flows from some tranches to others in certain scenarios (e.g., breach of over-collateralization tests). We note but do not explore these issues. 

Note that for safer tranches, the probability of default will be grossed up by a stress factor to more accurately reflect tail risk. The stress factor corrects for the fact that the model assumes constant default rates, whereas actual default rates are stochastic. Using constant, long-term average rates of default tends to understate the possibility of severe, multiple-default scenarios. Therefore, to account for this tail risk the constant default rates are stressed upward. The stress increases for higher-rated tranches since losses in higher tranches will necessarily be farther out on the tail. 

Leveraged notes are notes that are issued by an SPV or an EMTN program and the notional amount of credit risk is larger than the capital commitment. These notes are typically issued as tranches of synthetic... 

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. 

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. 

Notes issued in synthetic structures are organized by tranche. With the proceeds from the notes it issues to investors, the SPV purchases high-quality (AAA) liquid securities—for example, U.S. Treasuries, bank asset-backed paper such as credit card ABS, and German bonds, such as Pfandbriefe —to serve as collateral. This collateral will generate LIBOR-related interest and principal cash flows that the SPV passes on to the investors together with the swap premium, which creates an additional credit spread on the notes. The cash flows from the collateral may not match the payments due on the issued notes—for example, the bonds used as collateral may pay a flxed rate and the issued notes a floating one. To remedy this, the... 

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. 

Note holders expected losses are determined by considering the impact on their cash flows of the credit losses—losses from loan defaults— occurring in various scenarios, taking into account how such losses are allocated to the issue s tranches. The cash flows to the note holders depend on whether a default has occurred and the size of the resulting loss. The severity of the loss equals the par value of the note less the recovery rate. The probability of default may be inferred from the rating of the underlying credit exposures. Expected losses are calculated using Monte Carlo techniques, which simulate thousands of scenarios and cash flows and so require sophisticated computational models. 

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. 

---