Liabilities of Investment

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The model described accommodates alternative liability structures and their controls, known as priorities of payment or waterfalls. A general liability structure is comprised of tranches or classes. Some tranches may be kept on the books of the seller/securitizer. However, most tranches correspond to bonds or notes that are sold to investors. Generally, bonds promise (fixed or floating) interest and principal payments each period. However, the aggregate periodic payment is not fixed as in mortgage loans. In addition, a bond might be guaranteed by a third-party insurer. In this case, payments cannot be late or lost, unless the guarantor defaults. If a bond is not guaranteed, then there is the chance that a bond payment is late or lost because an asset defers interest or defaults. Still, the servicer may agree to advance missing payments to the extent deemed recoverable, to be potentially reimbursed by later, excess cash flows.

Tranches are broadly categorized as senior or subordinate, corresponding to their rating quality and credit enhancement. Seniors have higher ratings due to more credit enhancement. Subordinates have lower ratings due to less credit enhancement. In general, the asset and liability balances are equal. The situation when the assets exceed the liabilities is known as over-collateralization (O/C). Tranches are enhanced by O/C. There are more assets than liabilities, so the excess assets can absorb loan defaults before interest and principal payments to the tranches get lost. Tranches can also enhance other tranches: They are prioritized in some order of payment. Thus missing payments (due to asset losses) are absorbed by the lowest-priority tranche first. Seniors are enhanced by both O/C and subordinate tranches. In broad strokes, seniors get paid in higher priority than subordinates, so the only way a senior would experience a missing payment is if all the subordinates failed to get paid. Hence seniors achieve higher ratings than subordinate tranches as judged by the rating agencies.

These concepts are also known as credit tranching (having lower-rated tranches absorb losses prior to higher-rated tranches) and sequential tranching (having a lower-priority tranche absorb losses prior to a higher-priority tranche). Both ideas help make bond cash flows more stable and predictable than a given mortgage loan cash flow, the key advantage of securitization.

The senior/subordinate categorization is clumsy—in fact, tranches rated AAA down to B- can be carved out of the structure, as we shall see in this chapter. Usually, seniors are rated AAA only. Highly rated (around AA+ to A-) subordinates are called mezzanine tranches. In this book, low-rated (around BBB+ and below) subordinates are called junior tranches. In addition to standard bonds that pay both interest and principal, there are alternative bonds, for example, IO, PO, Z, PAC, and NAS bonds (e.g., Fabozzi and Modigliani ). The framework described can support these bonds, although they are not emphasized.

An “I” structure represents the sequential ordering of the tranches, from most senior to most subordinate. Figure 4-1 shows an example of an “I” structure. There is one collateral group supporting eight issued bonds, followed by a NIM (Net Interest Margin) and OTE (Owner’s Trust Equity) (these latter notes are discussed in sections Residuals: NIMs and Post-NIM and 5). All the issued bonds are floaters. By “sequential” it is meant that A1 is paid interest before M1 and so on. If there is sufficient collateral interest for all bonds, then one would observe interest cash flows to all outstanding bonds “simultaneously.” If there were insufficient collateral interest, then some more senior bond would be paid interest at the expense of some more junior bond missing interest.

The model described accommodates alternative liability structures and their controls, known as priorities of payment or waterfalls. A general liability structure is comprised of tranches or classes. Some tranches may be kept on the books of the seller/securitizer. However, most tranches correspond to bonds or notes that are sold to investors. Generally, bonds promise (fixed or floating) interest and principal payments each period. However, the aggregate periodic payment is not fixed as in mortgage loans. In addition, a bond might be guaranteed by a third-party insurer. In this case, payments cannot be late or lost, unless the guarantor defaults. If a bond is not guaranteed, then there is the chance that a bond payment is late or lost because an asset defers interest or defaults. Still, the servicer may agree to advance missing payments to the extent deemed recoverable, to be potentially reimbursed by later, excess cash flows.

Tranches are broadly categorized as senior or subordinate, corresponding to their rating quality and credit enhancement. Seniors have higher ratings due to more credit enhancement. Subordinates have lower ratings due to less credit enhancement. In general, the asset and liability balances are equal. The situation when the assets exceed the liabilities is known as over-collateralization (O/C). Tranches are enhanced by O/C. There are more assets than liabilities, so the excess assets can absorb loan defaults before interest and principal payments to the tranches get lost. Tranches can also enhance other tranches: They are prioritized in some order of payment. Thus missing payments (due to asset losses) are absorbed by the lowest-priority tranche first. Seniors are enhanced by both O/C and subordinate tranches. In broad strokes, seniors get paid in higher priority than subordinates, so the only way a senior would experience a missing payment is if all the subordinates failed to get paid. Hence seniors achieve higher ratings than subordinate tranches as judged by the rating agencies.

These concepts are also known as credit tranching (having lower-rated tranches absorb losses prior to higher-rated tranches) and sequential tranching (having a lower-priority tranche absorb losses prior to a higher-priority tranche). Both ideas help make bond cash flows more stable and predictable than a given mortgage loan cash flow, the key advantage of securitization.

The senior/subordinate categorization is clumsy—in fact, tranches rated AAA down to B- can be carved out of the structure, as we shall see in this chapter. Usually, seniors are rated AAA only. Highly rated (around AA+ to A-) subordinates are called mezzanine tranches. In this book, low-rated (around BBB+ and below) subordinates are called junior tranches. In addition to standard bonds that pay both interest and principal, there are alternative bonds, for example, IO, PO, Z, PAC, and NAS bonds (e.g., Fabozzi and Modigliani ). The framework described can support these bonds, although they are not emphasized.

An “I” structure represents the sequential ordering of the tranches, from most senior to most subordinate. Figure 4-1 shows an example of an “I” structure. There is one collateral group supporting eight issued bonds, followed by a NIM (Net Interest Margin) and OTE (Owner’s Trust Equity) (these latter notes are discussed in sections Residuals: NIMs and Post-NIM and 5). All the issued bonds are floaters. By “sequential” it is meant that A1 is paid interest before M1 and so on. If there is sufficient collateral interest for all bonds, then one would observe interest cash flows to all outstanding bonds “simultaneously.” If there were insufficient collateral interest, then some more senior bond would be paid interest at the expense of some more junior bond missing interest.

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