Senior notes

The cash flow waterfall encapsulates the subordination of the junior classes of notes. As all cash received is used to pay items on the senior notes first, this will inevitably mean that any loss that cannot be covered through trapping excess spread or from the reserve fund will result in a shortfall in the funds available to redeem the most junior class of notes. 

The calculation of credit enhancement for notes in a master trust transaction seems more complicated than in a traditional pass-through transaction because subordinated notes from an earlier series are expected to be redeemed before the senior notes of later series. However, if the mortgages were to perform poorly, the trigger events ensure that all outstanding junior notes would only be repaid after all the senior notes. So the credit enhancement can be calculated as the aggregate balance of subordinate notes as a proportion of the total notes outstanding. 

In the following review of some of the fundamental auto and consumer loan ABS mechanics, we will use three transactions as practical examples two auto ABS transactions, FIAT 1 and Globaldrive B, and one consumer loan ABS transaction. Paragon Personal and Auto Finance (No. 1) (PPAF 1). The FIAT 1 transaction was completed by Fiat in July 2000 and at that time it represented the largest European auto transaction completed. Globaldrive B was completed by FCE Bank in March 1999. PPAF 1 was completed in 2001 by Paragon Finance PLC. In Exhibit 14.7 we outline the structural details for the senior notes of FIAT 1, Globaldrive B and PPAF 1. 

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. 

Overcollateralisation the overcollateralisation level vis-a-vis the issued notes must remain above a specified minimum for instance, it must be at 120% of the nominal value of the senior note. 

The Senior Notes and Class B Notes will bear floating-rate interest plus a margin. The margin steps np after 12 years and this is designed to incen-tivise the Jnnior Noteholders to opt to redeem the Senior Notes and call the whole transaction, otherwise their returns will be diminished. 

The Senior Notes are also pickable, which means that if fnnds are not available on an Interest Payment Date to pay the full amount of interest owing to the Class A or Class B Notes, such amount will be deferred and therefore not dne and payable on such Interest Payment Date bnt will be ontstanding on the applicable Notes and payable with funds available in fntnre Interest Payment Dates. The ratings by the rating agencies will therefore be based on ultimate payment of principal and interest and not timely payment of the same. 

Payments of interest on the Jnnior Notes are subordinate to the payment of interest on the Senior Notes and therefore the holders of the Junior Notes are only entitled to the funds that are available for distribution after having made the payment under the Senior Notes. In this transaction, the Class C-1 Noteholders requested their Notes to be amortizing and so wanted their interest amount to be divided into a fixed interest portion. This will need some tax planning as described in the section Tax Issues below in order to prevent increasing the tax liability of the Issuer. 

The Senior Notes shall be redeemed (in whole but not in part) by the Issuer at the direction of the holders of more than 50% of the aggregate principal amount outstanding as at the Final Closing Date of the Junior Notes. Any such redemption is subject to the following conditions (a) no such redemption may occur on any date other than an Interest Payment Date (b) other than as a result of the occurrence of certain tax events, no such redemption may occur prior to the end of the Reinvestment Period and (c) no optional redemption of the Senior Notes may occur unless there are sufficient proceeds to repay all the Senior Notes and any accrued and unpaid fees and expenses. 

On any Interest Payment Date on or after payment in full of the Senior Notes and any accrued fees and expenses, the Junior Notes shall be redeemed (in whole but not in part) by the Issuer at the direction of holders more than 50% of the aggregate principal amount outstanding as at the Final Closing Date of the Junior Notes. 

Senior/subordinated structures are the most common type of internal credit enhancement encountered in the market. Essentially, the CMO is divided into two classes of bonds, one senior and the other subordinated. The latter absorbs all the losses arising from default or other cause, leaving the senior class unaffected. The subordinated bonds clearly have higher risk than the senior class and so trade at a higher yield. Most senior/ subordinated arrangements incorporate a shifting interest structure, which redirects prepayments from the subordinated to the senior class. This alters the cash flow characteristics of the senior notes, whether or not defaults or similar events occur. 

This transaction features an unusual feature in that the underlying pool of mortgages is split into two groups, Loan Groups 1 and 2. Classes A-1 and A-3 are supported by Loan Group 1, and classes A-2A, A-2B, and A-2C are supported by Loan Group 2 however, there is also cross-collateralization for the senior notes. 

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. 

Senior Junior note classes credit enhancement is provided by subordinating a class of notes ( class B notes) to the senior class notes ( class A notes). The class B note s right to its proportional share of cash flows is subordinated to the rights of the senior noteholders. Class B notes do not receive payments of principal until certain rating agency requirements have been met, specifically satisfactory performance of the collateral pool over a predetermined period, or in many cases until all of the senior note classes have been redeemed in full. 

All securitization structures incorporate a cash waterfall process, whereby all the cash that is generated by the asset pool is paid in order of payment priority. Only when senior obligations have been met can more junior obligations be paid. An independent third-party agent is usually employed to run tests on the vehicle to confirm that there is sufficient cash available to pay all obligations. If a test is failed, then the vehicle will start to pay off the notes, starting from the senior notes. The waterfall process is illustrated in FIGURE 15.2. 

Bonds rarely get the same attention. When a company issues an IPO, there are the expected bell-ringing and associated festivities on Wall Street. When a company issues senior notes, it isn t usually met with the same fanfare. 

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