The tranche structure of a securiti

The tranche structure of a securitization leads to a somewhat different
definition of a default event from that pertaining to individual, corporate,
and sovereign debt. Losses to the bonds in securitizations are determined
by losses in the collateral pool together with the waterfall. Losses may be
severe enough to cause some credit loss to a bond, but only a small one. For
example, if a senior ABS bond has 20 percent credit enhancement, and the
collateral pool has credit losses of 21 percent, the credit loss or writedown
to the bond will be approximately
1
100−20
or 1.25 percent, since the bond
is 80 percent of the balance sheet of the trust. The LGD of a securitization
can therefore take on a very wide range, and is driven by the realization of
defaults and recoveries in the collateral pool.
For a corporate or sovereign bond, default is a binary event; if inter-
est and/or principal cannot be paid, bankruptcy or restructuring ensues.
Corporate debt typically has a “hard” maturity date, while securitizations
have a distant maturity date that is rarely the occasion for a default. For
these reasons, default events in securitizations are often referred to as ma-
terial impairment to distinguish them from defaults. A common definition
of material impairment is either missed interest payments that go uncured
for more than a few months, or a deterioration of collateral pool perfor-
mance so severe that interest or principal payments are likely to stop in
the future.