Name the motives behind the use of structured credit products.
The idea
Structured credit products are created for several reasons. Originators use balance-sheet securitization to move loans off the balance sheet, free regulatory capital, transfer credit risk and raise cheaper funding than their own unsecured borrowing would give. Arbitrage structures buy a pool of higher-yielding assets and fund it with tranches whose combined cost is lower. The equity holder keeps the spread. Tranching tailors risk and return to investor demand. A pool of lower-rated loans can support a senior tranche rated AAA, which satisfies investors with rating or capital constraints. The junior tranches serve those who want leveraged credit exposure. Securitization also creates liquidity from illiquid assets. The usual mistake is to treat the extra yield on senior tranches as free. It compensates for correlation, model and liquidity risk. Exam point: separate balance-sheet motives from arbitrage motives.
Formulas
Equity cash return in an arbitrage CDO
equity return = (collateral yield × pool − Σ note coupon × note balance) ÷ equity
- collateral yield
- the yield on the collateral
- pool
- the collateral balance
- note coupon
- each note's coupon rate
- note balance
- each note's balance
- equity
- the equity investment
Before fees and losses. Divide by the equity invested, not the pool; the leverage makes the return large and risky.
A practice question
A bank securitizes a loan portfolio mainly to transfer credit risk, release regulatory capital and obtain funding. This is best described as which type of motive?
- A balance-sheet motive. - correct
- An arbitrage motive.Why not: An arbitrage CDO exploits the spread between collateral yield and tranche costs, and the sponsor does not mainly relieve its balance sheet.
- A trading-book hedging motive for the equity tranche.Why not: The case is about the loans' balance sheet impact, not hedging a trading position.
- An accounting motive to postpone loan losses.Why not: Securitization does not postpone recognising losses on the sold assets.
Balance-sheet securitizations remove assets and risk from the originator, reduce capital needs and offer funding independent of the originator's credit rating.
A harder one
A pension fund can only hold securities rated AAA. How does tranching help it, when the underlying loans are rated BBB?
- By averaging the ratings of the loans into a single AAA rating.Why not: Ratings of the pool are not averaged to AAA; the senior tranche rating depends on the credit enhancement it receives.
- By guaranteeing each loan against default with a government guarantee.Why not: Tranching does not add a government guarantee.
- By subordination: junior tranches absorb first losses so the senior tranche can be rated higher than the pool. - correct
- By removing the default correlation among the loans.Why not: Tranching leaves correlation unchanged; it redistributes losses.
Subordination and excess spread give the senior tranche enough protection to be very unlikely to lose money, so it can carry a higher rating than the pool. Tailoring risk to such constraints is a main motive for structured credit.
The hardest tier
An arbitrage CDO buys a USD 1,000 million pool yielding 7.0 percent. It issues USD 800 million of senior notes at 4.2 percent, USD 150 million of mezzanine at 6.5 percent and USD 50 million of equity. Ignoring fees and losses, closest to the equity holder's annual cash return on its investment?
- 53.3 percent - correct
- 7.0 percentWhy not: Reports the pool yield as if the equity earned only the collateral yield.
- 72.8 percentWhy not: Deducts only the senior interest and leaves out the mezzanine coupon.
- 2.7 percentWhy not: Expresses the USD 26.65 million of residual cash as a percentage of the total pool rather than of the equity invested.
Income = 7.0% x 1,000 = 70.0. Interest = 4.2% x 800 + 6.5% x 150 = 33.6 + 9.75 = 43.35. Residual = 26.65 on equity of 50, a return of 53.3 percent before losses; the leverage is what makes the arbitrage attractive and risky.
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.
- 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.