Senior notes credit enhancement

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. 

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. 

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. 

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. 

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. 

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