 9.1 STRUCTURED CREDIT BASICSWe be

 9.1 STRUCTURED CREDIT BASICS
We begin by sketching the major types of securitizations and structured
credit products, sometimes collectively called portfolio credit products.
These are vehicles that create bonds or credit derivatives backed by a pool
of loans or other claims. This broad definition can’t do justice to the be-
wildering variety of structured credit products, and the equally bewildering
terminology associated with their construction.
First, let’s put structured credit products into the context of other secu-
rities based on pooled loans. Not surprisingly, this hierarchy with respect to
complexity of structure corresponds roughly to the historical development
of structured products that we summarized in Chapter 1:
Covered bonds are issued mainly by European banks, mainly in Ger-
many and Denmark. In a covered bond structure, mortgage loans
are aggregated into a cover pool, by which a bond issue is secured.
The cover pool stays on the balance sheet of the bank, rather than
being sold off-balance-sheet, but is segregated from other assets of
the bank in the event the bank defaults. The pool assets would be
used to make the covered bond owners whole before they could be
applied to repay general creditors of the bank. Because the under-
lying assets remain on the issuer’s balance sheet, covered bonds are
not considered full-fledged securitizations. Also, the principal and
interest on the secured bond issue are paid out of the general cash
flows of the issuer, rather than out of the cash flows generated by
the cover pool. Finally, apart from the security of the cover pool,
the covered bonds are backed by the issuer’s obligation to pay.
Mortgage pass-through securities are true securitizations or structured
products, since the cash flows paid out by the bonds, and the credit
risk to which they are exposed, are more completely dependent on
the cash flows and credit risks generated by the pool of underlying
loans. Mortgage pass-throughs are backed by a pool of mortgage
loans, removed from the mortgage originators’ balance sheets, and
administered by a servicer, who collects principal and interest from
the underlying loans and distributes them to the bondholders. Most
pass-throughs are agency MBS, issued under an explicit or implicit
U.S. federal guarantee of the performance of the underlying loans,
so there is little default risk. But the principal and interest on the
bonds are “passed through” from the loans, so the cash flows de-
pend not only on amortization, but also voluntary prepayments by
the mortgagor. The bonds are repaid slowly over time, but at an
uncertain pace, in contrast to bullet bonds, which receive full repay-
ment of principal on one date. Bondholders are therefore exposed
to prepayment risk.
Collateralized mortgage obligations were developed partly as a means
of coping with prepayment risk, but also as a way to create both
longer- and shorter-term bonds out of a pool of mortgage loans.
Such loans amortize over time, creating cash flow streams that di-
minish over time. CMOs are “sliced,” or tranched into bonds or
Structured Credit Risk
tranches, that are paid down on a specified schedule. The simplest
structure is sequential pay, in which the tranches are ordered, with
“Class A” receiving all principal repayments from the loan until it
is retired, then “Class B,” and so on. The higher tranches in the
sequence have less prepayment risk than a pass-through, while the
lower ones bear more.
Structured credit products introduce one more innovation, namely the
sequential distribution of credit losses. Structured products are
backed by credit-risky loans or bonds. The tranching focuses on cre-
atingbondsthathavedifferentdegreesofcreditrisk.Aslossesoccur,
the tranches are gradually written down. Junior tranches are writ-
ten down first, and more senior tranches only begin to bear credit
losses once the junior tranches have been written down to zero.
This basic credit tranching feature can be combined with other
features to create, in some cases, extremely complex security struc-
tures. The bottom-up treatment of credit losses can be combined
with the sequential payment technology introduced with CMOs.
Cash flows and credit risk arising from certain constituents of the
underlying asset pool may be directed to specific bonds.
Securitization is one approach to financing pools of loans and other re-
ceivables developed over the past two decades. An important alternative
and complement to securitization are entities set up to issue asset-backed
commercial paper (ABCP) against the receivables, or against securitization
bonds themselves. We describe these in greater detail in Chapter 12.
A structured product can be thought of as a “robot” corporate entity
with a balance sheet, but no other business. In fact, structured products
are usually set up as special purpose entities (SPE) or vehicles (SPV), also
known as a trust. This arrangement is intended to legally separate the assets
and liabilities of the structured product from those of the original creditors
and of the company that manages the payments. That is, it makes the SPE
bankruptcy remote. This permits investors to focus on the credit quality of
the loans themselves rather than that of the original lenders in assessing the
credit quality of the securitization. The underlying debt instruments in the
SPV are the robot entity’s assets, and the structured credit products built on
it are its liabilities.
Securitizations are, depending on the type of underlying assets, often
generically called asset- (ABS) or mortgage-backed securities (MBS), or col-
lateralized loan obligations (CLOs). Securitizations that repackage other se-
curitizations are called collateralized debt obligations (CDOs, issuing bonds
against a collateral pool consisting of ABS, MBS, or CLOs), collateralized
mortgage obligations (CMOs), or collateralized bond obligations (CBOs).
There even exist third-level securitizations, in which the collateral pool con-
sists of CDO liabilities, which themselves consist of bonds backed by a
collateral pool, called CDO-squareds.
There are several other dimensions along which we can classify the great
variety of structured credit products:
Underlying asset classes. Every structured product is based on a set of
underlying loans, receivables, or other claims. If you drill down far
enough into a structured product, you will get to a set of relatively
conventional debt instruments that constitute the collateral or loan
pool. The collateral is typically composed of residential or commer-
cial real estate loans, consumer debt such as credit cards balances
and auto and student loans, and corporate bonds. But many other
types of debt, and even nondebt assets such as recurring fee income,
can also be packaged into securitizations. The credit quality and
prepayment behavior of the underlying risks is, of course, critical in
assessing the risks of the structured products built upon them.
Type of structure. Structured products are tools for redirecting the cash
flowsandcreditlossesgeneratedbytheunderlyingdebtinstruments.
The latter each make contractually stipulated coupon or other pay-
ments. But rather than being made directly to debt holders, they
are split up and channeled to the structured products in specified
ways. A key dimension is tranching, the number and size of the
bonds carved out of the liability side of the securitization. Another
is how many levels of securitization are involved, that is, whether
the collateral pool consists entirely of loans or liabilities of other
securitizations.
How much the pool changes over time. Wecandistinguishhereamong
threedifferentapproaches,tendingtocoincidewithassetclass.Each
type of pool has its own risk management challenges:
Static pools are amortizing pools in which a fixed set of loans is
placed in the trust. As the loans amortize, are repaid, or de-
fault, the deal, and the bonds it issues, gradually wind down.
Static pools are common for such asset types as auto loans
and residential mortgages, which generally themselves have a
fixed and relatively long term at origination but pay down over
time.
Revolving pools specify an overall level of assets that is to be main-
tainedduringarevolvingperiod.Asunderlyingloansarerepaid,
the size of the pool is maintained by introducing additional
loans from the balance sheet of the originator. Revolving pools
Structured Credit Risk 301
are common for bonds backed by credit card debt, which is not
issued in a fixed amount, but can within limits be drawn upon
and repaid by the borrower at his own discretion and without
notification. Once the revolving period ends, the loan pool be-
comes fixed, and the deal winds down gradually as debts are
repaid or become delinquent and are charged off.
Managed pools are pools in which the manager of the structured
producthasdiscretiontoremoveindividualloansfromthepool,
sell them, and replace them with others. Managed pools have
typically been seen in CLOs. Managers of CLOs are hired in
part for skill in identifying loans with higher spreads than war-
rantedbytheircreditquality.Theycan,intheory,alsoseecredit
problems arising at an early stage, and trade out of loans they
believe are more likely to default. There is a secondary market
for syndicated loans that permits them to do so, at least in many
cases. Also, syndicated loans are typically repaid in lump sum,
well ahead of their legal final maturity, but with random timing,
so a managed pool permits the manager to maintain the level
of assets in the pool.
The number of debt instruments in pools depends on asset type and on the
size of the securitization; some, for example CLO and commercial mortgage-
backed securities (CMBS) pools, may contain around 100 different loans,
each with an initial par value of several million dollars, while a large residen-
tial mortgage-backed security (RMBS) may have several tens of thousands
of mortgage loans in its pool, with an a