Outline the usual kinds of structured products.
The idea
Structured credit products repackage the credit risk of a pool of debt into securities with different risk profiles. The main families are asset-backed securities (ABS) backed by auto loans, credit cards or student loans, mortgage-backed securities (MBS) in residential and commercial form, and collateralized debt obligations (CDOs). CDOs include collateralized loan obligations (CLOs) backed by leveraged loans, and CDO² structures whose collateral is itself tranches of other securitizations. A pass-through simply shares pool cash flow pro rata, while a tranched product redistributes it by seniority. Cash structures own the assets. Synthetic structures take credit exposure through credit default swaps and are largely unfunded. The usual mistakes are assuming every securitization is tranched or that a synthetic deal holds cash collateral. For the exam, classify a product by its collateral and by whether risk is moved through assets or derivatives.
A practice question
A bank bundles a portfolio of leveraged corporate loans into a special purpose vehicle, which issues notes of different seniority against the loans. This structure is best described as:
- a collateralized loan obligation (CLO) - correct
- a residential mortgage pass-through securityWhy not: A pass-through shares cash flow pro rata and has no seniority ranking; the collateral here is corporate loans, not home mortgages.
- a synthetic CDO referencing a credit default swap indexWhy not: A synthetic CDO takes exposure through credit default swaps; here the SPV owns the loans themselves.
- a covered bondWhy not: A covered bond stays on the issuer's balance sheet with recourse to the issuer and is not tranched by seniority.
A pool of loans owned by an SPV that issues tranched notes is a CLO when the loans are corporate (typically leveraged) loans. The cash flows are tranched by seniority and the assets are owned, so it is a cash structure, not a synthetic one.
A harder one
A bank wants to cut its credit exposure to a portfolio of corporate loans but does not want to sell the loans or inform the borrowers. Which structure fits best?
- A true-sale cash CLO in which the loans are transferred to the SPV.Why not: A true sale transfers the loans to the SPV, so the loans do leave the bank's books and borrowers are normally notified.
- A pass-through MBS issued by the bank, sharing the loans' cash flow pro rata.Why not: A pass-through is for mortgage pools, transfers the cash flows and does not by itself move credit risk through tranches.
- A synthetic securitization with protection bought through swaps. - correct
- A CDO-squared built from tranches of other deals.Why not: A CDO-squared is built from other tranches, not from the bank's own loans, and so does not hedge them.
Only the synthetic route moves risk without moving the assets: the bank buys protection via CDS on tranche exposures while the loans stay on its books and the client relationship is undisturbed.
The hardest tier
Compared with a pass-through mortgage security, a collateralized mortgage obligation (CMO) issued from the same pool of agency mortgages primarily:
- redistributes principal timing across classes rather than paying pro rata. - correct
- removes the interest rate risk of the pool by hedging it with swaps.Why not: The classes still carry interest rate and prepayment risk; the CMO changes how it is shared, not whether it exists.
- converts the pool's prepayment risk into credit risk by taking the agency guarantee away.Why not: The agency guarantee is unchanged; a CMO is a way of splitting cash flow timing, not of removing a guarantee.
- raises the expected total cash flow of the pool by shifting losses to the servicer.Why not: Tranching never increases the pool's total cash flow; it only splits it among holders.
A pass-through pays every holder a pro rata share of interest and principal. A CMO sequences or otherwise structures principal across classes, so early classes have short, stable lives and later ones absorb extension or contraction.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Structured Credit Risk
- Outline how tranching works and how credit losses are spread across tranches in a securitization.
- Describe how a securitization's waterfall is organised.
- Name the chief parties taking part in securitizing assets, and spell out where their interests may clash.
- Work through and evaluate the first iteration or two of interim cashflows for a securitization split into three tiers.
- Spell out how excess spread is dealt with in a securitization structure, and work out the overcollateralization account's value as each year ends.
- Account for the tests a custodian runs on excess spread at each year end to decide what cash flows to the overcollateralization account and to equity noteholders.
- Spell out a simulation-based way of arriving at credit losses for each tranche of a securitization.
- Show why a securitization's credit risk depends on the default probabilities and default correlations of its collateral.
- Account for how tranche default sensitivities are gauged.
- Spell out the factors of risk to which structured products are subject.
- Show what is meant by implied correlation and the way it can be gauged.
- Name the motives behind the use of structured credit products.