Spell out the factors of risk to which structured products are subject.
The idea
Structured products carry the credit risk of the collateral (default probability, recovery and, above all, default correlation), but also other risk factors. Market risk includes interest rates and credit spreads, which move tranche prices even without defaults. Prepayment risk matters for mortgage and consumer pools. Liquidity risk shows up as wide bid-ask spreads in stress. Counterparty risk arises in synthetic structures through the protection seller or swap provider. Model risk comes from unobservable inputs such as correlation. Structural risk comes from the waterfall, triggers and servicer behaviour. Tranching also adds leverage: a thin tranche's loss rate can be many times that of the pool. Senior tranches in particular have systemic risk, paying in full except in extreme states of the world. Exam point: link each factor to its source, and do not treat a rating as a measure of all of them.
A practice question
Prepayment risk in a pool of mortgage or consumer loans refers to the risk that:
- the servicer pays itself its own fees ahead of schedule from the collateral.Why not: Prepayment risk is about borrowers' repayments, not servicer fees.
- the rating agency withdraws the rating of the notes before maturity.Why not: A rating withdrawal is not prepayment of the collateral.
- the equity tranche is repaid before the senior tranche.Why not: Principal allocation follows the waterfall; it is not what prepayment risk means.
- borrowers repay principal ahead of schedule, changing the timing of cash flows and excess spread. - correct
Prepayments shorten the life of the assets and tranches and can reduce the interest margin when high-coupon loans are the ones that prepay. They are a market and behavioural risk rather than a default risk.
A harder one
Compared with a cash CDO that owns its collateral, a synthetic CDO built from credit default swaps carries an additional risk of:
- counterparty risk to the protection seller or swap provider. - correct
- prepayment risk of the collateral loans.Why not: Synthetic structures reference corporate credits through CDS; prepayment is not their distinct issue.
- interest rate risk that cash CDOs do not have.Why not: Both structures carry interest rate risk; counterparty risk is the distinct addition.
- loss of subordination protection.Why not: The tranching and its subordination are the same in both forms.
In a synthetic structure the payments depend on counterparties' ability to deliver on contractual swap payments. A default of a major protection seller can hit the structure even if the reference names perform.
The hardest tier
The collateral pool of a CDO suffers a loss of 8 percent of its notional. A mezzanine tranche attaching at 6 percent and detaching at 10 percent is outstanding. How much of the tranche's notional is lost, and what does it show?
- 8 percent of its notional, the same as the pool, because tranching only reallocates losses.Why not: Tranching reallocates, but a thin tranche loses a much larger share of its own notional than the pool does.
- 2 percent of its notional, because the pool loss exceeds the attachment by two points.Why not: Two points is the loss as a percentage of the pool; dividing by the 4 percent thickness gives the loss on the tranche.
- 50 percent of its notional, about six times the pool loss rate, which shows the leverage embedded in tranching. - correct
- 100 percent of its notional, because the pool loss has passed the attachment point.Why not: Exceeding the attachment point only starts the losses; the tranche is wiped out at the detachment point.
Tranche loss = (8% - 6%) / 4% = 50 percent of its notional, 6.25 times the pool loss. Leverage of this kind means that thin tranches are far riskier than the average pool asset.
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 the usual kinds of structured products.
- 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.
- Show what is meant by implied correlation and the way it can be gauged.
- Name the motives behind the use of structured credit products.