Assets LiabilitiesEquityMezzanine d

Assets Liabilities
Equity
Mezzanine debt
Senior debt
Underlying
debt instruments
The boundary between two tranches, expressed as a percentage of the
total of the liabilities, is called the attachment point of the more senior
trancheand detachment pointofthemorejuniortranche.Theequitytranche
only has a detachment point, and the most senior only has an attach-
ment point.
The part of the capital structure below a bond tranche is called its
subordination or credit enhancement. It is the fraction of the collateral pool
that must be lost before the bond takes any loss. It is greater for more senior
bonds in the structure. The credit enhancement may decline over time as
the collateral experiences default losses, or increase as excess spread, the
interest from the collateral that is not paid out to the liabilities or as fees
and expenses, accumulates in the trust.
A securitization can be thought of as a mechanism for securing long-
term financing for the collateral pool. To create this mechanism, the senior
tranche must be a large portion of the capital structure, and it must have
a low coupon compared to the collateral pool. In order to create such a
liability, its credit risk must be low enough that it can be marketed. To
this end, additional features can be introduced into the cash flow structure.
The most important is overcollateralization; that is, selling a par amount of
bonds that is smaller than the par amount of underlying collateral. Overcol-
lateralization provides credit enhancement for all of the bond tranches of a
securitization.
There are typically reserves within the capital structure that must be
filled and kept at certain levels before junior and equity notes can receive
money. These reserves can be filled fromtwo sources: gradually, fromthe ex-
cess spread, or quickly via overcollateralization. These approaches are often
used in combination. The latter is sometimes called hard credit enhance-
ment, in contrast to the soft credit enhancement of excess spread, which
accrues gradually over time and is not present at initiation of the securitiza-
tion. Deals with revolving pools generally have an early amortization trigger
that terminates the replenishment of the pool with fresh debt if a default
trigger is breached.
Typically, the collateral pool contains assets with different maturities,
or that amortize over time. Loan maturities are uncertain because the loans
can be prepaid prior to maturity, possibly after an initial lockout period has
elapsed. The senior liabilities in particular are therefore generally amortized
over time as the underlying loans amortize or mature; while they may have
legal final maturity dates that are quite far in the future, their durations are
uncertain and much shorter. Risk analysis therefore generally focuses on
the weighted average life (WAL) of a securitization, the weighted average
of the number of years each dollar of par value of the bond will remain
outstanding before it is repaid or amortized. A WAL is associated with a
particular prepayment assumption, and standard assumptions are set for
some asset classes by convention.
As noted above, the sequential-pay technology can be combined with
credit tranching in securitizations. This creates multiple senior bonds with
different WALs, to better adapt the maturity structure of the liabilities to
that of the collateral pool. This feature is called time tranching to distin-
guish it from the seniority tranching related to credit priority in the capital
structure. The example presented in the rest of this chapter abstracts from
this important feature. Thus, in addition to the credit risk that is the focus
of this chapter, securitizations also pose prepayment and extension risk aris-
ing from loans either prepaying faster or slower than anticipated, or being
extended past their maturity in response to financial distress.
In any securitization, there is a possibility that at the maturity date,
even if the coupons have been paid timely all along, there may not be
enough principal left in the collateral pool to redeem the junior and/or se-
nior debt at par unless loans can be refinanced. The bonds are therefore
exposed to the refinancing risk of the loans in the collateral pool. If some
principal cash flows are paid out to the equity note along the way, refi-
nancing risk is greater. Time tranching of the senior bonds, and their grad-
ual retirement through amortization, is one way securitizations cope with
this risk.