Rate tranches

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. 

Tranche Moody s Rating Tranche Size ( million) Available Subordination (%) Spread Final Maturity... 

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. ... 

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. 

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 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. 

Tranched securities are generally rated by a rating agency, with the rating reflecting both the credit quality of the underlying assets as well as any measures put in place to reduce credit risk, known as credit enhancement. 

Tranche Structure Currency Sub- ordina- tion Moody s/ S P Rating Coupon Spread Frequency WAL/ Maturity... 

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. 

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. 

Having calculated the expected loss to each tranche, we can return to the Idealized Cumulative Default table to generate a rating for them. In our hypothetical portfolio, we find implied ratings of Aa3 for the second loss tranche because of its expected loss of 0.039%, and Aaa for the third loss tranche, where the probability of loss is negligible. The most... 

At this point, a structurer would normally look at the spreads of similarly rated credits to price each tranche, then fine-tune and modify the attachment points until he could place them all to complete the transaction. In doing so, he might evaluate many possibilities for tranching the same underlying portfolio as shown in Exhibit 22.14. 

CDO Investor combines analytic tools with a historical database of publicly available CDO transactions. Investors can analyze their existing investments, as well as perform relative value analysis between different transactions. CDO Investor allows users to model projected cash flows, find current and historical ratings on CDO tranches, review details on underlying collateral, and make internal rate of return (IRR) projections. 

A collateralized mortgage obligation, or CMO, differs from a passthrough in that the underlying mortgage pool is separated into different maturity classes, or tranches, and the cash flow distributions to investors are prioritized based on the class of the tranche they hold. It is possible to have two tranches of the same rating, but one more senior than the other. Typically, each tranche also pays a different interest rate and appeals to a different class of investors. 

All classes of a single CMO receive an equal share of the interest payments it is the principal repayments received that differ. Consider an issue with a nominal value of 100 million, 60 million of which is allocated to the class A tranche, 25 million to the class B, and the rest to class C. Holders of class A bonds receive all the principal repayments until the bonds retire, after which class B holders get all the repayments, and so on. The class A bonds thus have the shortest maturity and the highest credit rating, and the class C bonds the longest and usually the lowest. A level of uncertainty is still associated with the maturity of each bond, but it is lower than that associated with a pass-through security. CMOs are discussed in more depth below. 

In the PAC structure, the uncertainty of principal payments is directed to another class of security, i.e., another tranche in the CMO, known as the companion, or support, class. When prepayment rates are high, companion issues support the main PACs by absorbing any principal prepayments that are in excess of the PAC schedule when the rate falls, the companion amortization is delayed if principal prepayments are not sufflcient to reach the minimum stipulated by the PAC band. Accordingly, when prepayment rates are high, the companions average life shortens when rates are low, their average life lengthens. Within the set of PACs and the set of companions, the principal cash flows can be allotted sequentially, as in the sequential-pay structure. 

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. 

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. 

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... 

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. 

The senior tranches of a synthetic CDO, however, may be delinked from the bank s rating by using AAA-rated collateral and default swaps, as described above. The final rating is influenced by the credit rating of the default-swap provider and the extent to which the cash flows to investors are exposed to the risk of default by the asset pool. 

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. 

The index tranche market trades in both a standardized format and in a bespoke format. Bespoke format means that investors can customize their investment by selecting the portfolio constituents (select reference credits, number of credits, sector diversification, etc.), the attachment and detachment points, currency, maturity, and target rating. 

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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