Explain the securitization process and the role of a special purpose vehicle (SPV), then judge how risky the various bank business models for securitized products are.
The idea
Securitization pools loans and sells claims on the pool's cash flows. The originator sells the assets in a true sale to a special purpose vehicle (SPV), a separate legal entity that is bankruptcy remote. Investors therefore depend on the pool and not on the originator's solvency. The SPV pays for the assets by issuing tranches in a waterfall. Losses hit the equity or first-loss tranche, then mezzanine, then senior, while cash flows go in reverse order. Credit enhancement comes from subordination, overcollateralization and excess spread. A tranche loses nothing until pool losses pass its attachment point. Beyond that, Tranche loss = (pool loss − attachment) ÷ tranche width, capped at 100%. Bank models differ in risk. Originate-to-distribute keeps little credit risk but has warehouse and incentive problems. Retaining senior tranches or re-securitizing carries concentrated tail risk, plus liquidity risk when funded short-term.
Formulas
Loss on a securitisation tranche
tranche loss rate = min[max(L − A, 0) ÷ (D − A), 1]
- L
- the loss on the underlying pool, as a share of the pool
- A
- the tranche's attachment point
- D
- the tranche's detachment point; D − A is its width
Nothing is lost until L passes A, and the tranche is wiped out once L reaches D. Divide by the tranche width, not by the pool.
A practice question
What is the main purpose of a special purpose vehicle in a securitization?
- A bankruptcy-remote entity that buys the assets and issues tranches - correct
- To guarantee the investors' returns using the originator's capitalWhy not: Confuses the SPV with a guarantor; investors rely on the assets, not on the originator's balance sheet.
- To keep the loans on the originator's balance sheet so they can be servicedWhy not: Reverses the purpose; a true sale moves assets to the SPV, away from the originator.
- To pool the originator's own debt so it can issue senior bondsWhy not: Wrong direction; the SPV buys the loans and issues notes backed by that pool rather than the originator's own debt.
The originator sells assets in a true sale to a legally separate SPV, which funds the purchase by issuing tranched notes. Bankruptcy remoteness means the investors' claims depend on the pool and not on the originator's solvency.
A harder one
A securitization pool has three tranches: equity covering the first 5% of pool losses, mezzanine covering losses from 5% to 15%, and a senior tranche above 15%. Pool losses are 9%. The percentage of the mezzanine tranche's principal that is lost is closest to:
- 9%Why not: Applies the pool loss rate to the tranche and ignores subordination and tranche width.
- 40% - correct
- 80%Why not: Divides the excess loss (9 - 5 = 4) by 5, the equity width, rather than the 10 width of the mezzanine tranche.
- 4%Why not: Reports pool loss above the attachment point as a share of the pool, not of the mezzanine tranche.
Mezzanine loss = (pool loss - attachment) / width = (9 - 5) / (15 - 5) = 40%. Equity is wiped out and the senior tranche is untouched.
The hardest tier
A bank compares three securitization business models for mortgage loans: (1) originate and sell all tranches within weeks, keeping nothing but the loans temporarily held for the pipeline; (2) originate, securitize and retain only the small equity tranche; (3) buy mezzanine tranches of other issuers' mortgage securities, re-securitize them into CDOs, and keep the super-senior tranche, funded with short-term wholesale borrowing. In a severe, system-wide house price decline, which model is riskiest for the bank?
- Model 1, selling everything within weeksWhy not: Overstates the pipeline (warehouse) risk of a few weeks of loans, which is small compared with a large retained position.
- Model 2, retaining only the equity trancheWhy not: Reasons that first loss is riskiest per dollar but ignores that the equity slice is capped and small relative to model 3's leveraged tail position.
- Model 3, re-securitized mezzanine with a funded super-senior kept - correct
- All three are equally risky because each one is exposed to the mortgage marketWhy not: Ignores differences in retained size, leverage and funding, which drive the losses.
Model 3 keeps a large tail exposure that is highly sensitive to correlated losses in re-securitized mezzanine tranches, and it also carries funding (liquidity) risk. Model 1 has only warehouse risk and model 2 is limited by the small tranche size.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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