Describe a waterfall structure in securitzation

[kik92]

Hi David,

Regarding AIM: Describe a waterfall structure in securitization (Malz, Chapter 9 Structured Credit risk)

On page 34 of our notes could you kindly explain how the principal of 85 for senior tranche and principal of 10 for the mezzanine tranche in the example were calculated please?

Many thanks.

 

[David Harper CFA FRM]

Hi @kik92 They are not calculated, they are merely given assumptions for the hypothetical securitization (it is Malz' example). The exhibit has a mistake: it should have those cells colored yellow, as below, to signal they are inputs (if you are interested, here is the XLS https://www.dropbox.com/s/5m2hfwpxw3byvn1/0523-malz-91.xlsx?dl=0). So in this example, nothing about the capital structure of the (assets & liabilities) SPE/SPV is calculated: the collateral (i.e., loans) is $100 and then we just assume senior bonds ( = 85) and mezzanine bonds ( = 15) are issued to investors with the intention that S + M < 100 to assume some overcollateralization, I hope that explains!

A securitization can be thought of as a mechanism for securing longterm 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. Overcollateralization provides credit enhancement for all of the bond tranches of a securitization." -- Malz

 

[kik92]

Hi @kik92 They are not calculated, they are merely given assumptions for the hypothetical securitization (it is Malz' example). The exhibit has a mistake: it should have those cells colored yellow, as below, to signal they are inputs (if you are interested, here is the XLS https://www.dropbox.com/s/5m2hfwpxw3byvn1/0523-malz-91.xlsx?dl=0). So in this example, nothing about the capital structure of the (assets & liabilities) SPE/SPV is calculated: the collateral (i.e., loans) is $100 and then we just assume senior bonds ( = 85) and mezzanine bonds ( = 15) are issued to investors with the intention that S + M < 100 to assume some overcollateralization, I hope that explains!

Thank you David

 

[Jaskarn]

@David Harper CFA FRM

Can you please help me understand common types of structured products. I could not find the difference between 3 categories mentioned in notes.

Generic class of asset-backed securities (ABS): This I understood. Various loans are pooled together to form CDOs
Securitizations that repackage other securitizations: Didn't understand at all. What the difference between this and the above category?
Third-level securitizations (CDO-squareds (CDO^2): What I understood is- The bank takes their collateralized debt obligations and structures them into tranches with different maturity and risk profiles. These tranches then fund the payments to the investors in the CDO-squared special purpose vehicle. This means that Investment bank will make tranches of many CDO's and then one particular tranche will be made into new CDO- which they call CDO squared. Because it is essentially a CDO on CDO.

Thanks a lot

 

[David Harper CFA FRM]

Hi @Jaskarn this is a whole topic and I don't have current time to write a large fresh essay, but your good question reminded me actually of a great assignment from actually the 2009 syllabus (when this topic was super-hot, you can imagine!). It is one of the best things I've read in terms of simply explaining the difference between these three securities to which you refer. It is called "A Primer on the Role of Securitization in the Credit Market Crisis of 2007" and it is located here https://www.dropbox.com/s/v2l41b4muoydzej/SSRN-id1324349..pdf?dl=0 It contains the helpful images below.

I also have a 10-year old video here at https://trtl.bz/2HOwKeR

For me, an understanding depends on this general idea: the SPV has a balance sheet. On the left are credit-sensitive assets; on the right are liabilities in the form of debt/notes issued to investors. At all levels the SPV is issuing liability notes to investors. The distinctions here are essentially on the asset side. In the first layer (aka, generic ABS), the assets are mortgages albeit mortgage pools (the pools bestow diversification benefits, yay!), so that the issued liabilities are claims on a pool of mortgages; in the second layer, the liabilities are claims, not on the mortgages directly, but rather on tranches of the mortgage-backed securities that are issued in the first layer. The difference is really, what are the assets? Are they (pooled) mortgages? Securities issued against mortgages? Or, securities issued against securities issued against mortgaged? (In terms of CDOs, my view is that they are merely a specific type of ABS per my video).

John Martin (the paper) explains it well I think:

Complexity and Loss of Information: Earlier we described the creation of mortgage backed securities and the securitization process. However, this is not the complete story since there is yet another layer of securitization for these mortgage backed securities themselves. Specifically, collateralized debt obligations (CDOs) are special purpose vehicles that purchase structured products such as mortgage backed securities by issuing long term liabilities in the form of tranches. In the context of Figure 2 CDOs are inserted between the investment bank and the financial institution that purchases the mortgage backed securities. Now we have two special purpose vehicles that issue securities in tranches and ultimately share claims against the same pool of mortgages. The increasing complexity of the structures and opaqueness of the connection of the financial claim on a specific mortgage is illustrated in Figure 4. In the first tier of securitization SPVs are formed to invest in mortgages and to issue claims (RMBSs) that are based on a portfolio of mortgages. In the second tier of securitization the RMBS claims are dispersed among a different set of SPVs that issue CDOs. Finally, in the third tier of securitization an additional set of SPVs are formed that invest in the CDO securities from the second tier securitization. The net result as you can see is a dispersal of claims against specific mortgages that makes it extremely difficult to trace a third tier securitization CDO back to a particular mortgage on which it has a partial claim."

I hope that's a good start, oh geez, I guess that's me being "brief" lol

 

[Jaskarn]

@David Harper CFA FRM

You are the best. Thanks for such a detailed clarification.