ABS Structures to Address Credit Risk

ABS inherently carries a high credit risk primarily due to the possibility of underlying borrowers defaulting on their obligations. This can significantly affect the returns for ABS holders. Therefore, structures within ABS are designed to address and mitigate these risks. In a basic securitization procedure, a sole ABS class may be sold. In such cases, certificate holders are allotted a specific share of the returns from the combined assets after deducting any relevant fees. Investors can be vulnerable to the innate risks of the asset pool, like default risk. Many Special Purpose Entities (SPEs) implement various credit enhancement techniques to address these vulnerabilities and protect investor returns, developing complex securitization structures with multiple ABS debt classes.

Mechanisms of Internal Credit Enhancement

1. Overcollateralization: This method ensures that the total value of the assets backing the bond exceeds the bond’s issuance value. So, even when some assets default, the extra value from the surplus ensures continued payments to bondholders. For instance, if a bond worth €1,000 million is backed by assets valued at €1,200 million, an extra €200 million acts as a buffer against potential defaults.
2. Excess spread: This is the gap between the interest generated by the collateral and the interest paid out to bondholders. If a loan yields a 9% return, but securities derived from the pool return just 6%, the resulting 3% yield differential can offset potential collateral shortfalls or be set aside for future contingencies.
3. Subordination or Credit Tranching: Subordination or “credit tranching” serves as a protective measure for more senior bond classes. Essentially, the subordinated bond classes bear the losses before the senior bond classes do. This protective mechanism is known as a “waterfall” structure, highlighting the step-by-step flow of payments between bond classes during default scenarios.

Other external credit enhancement methods are third-party guarantees (from entities like banks or insurers), credit letters, and designated cash collateral reserves.

Securitization Process

In a securitization setup, an entity might acquire a pool of assets (e.g., car loans). This entity could then issue multiple bond classes, each with different par values and risk profiles. In such a structure, payments prioritize the most senior tranche, which has the lowest risk and return. The hierarchy then descends to mezzanine tranches and junior or equity tranches with the highest risk and potential return.

Distribution of Risk

If a total loss on the collateral is less than a specified amount, the most junior tranche absorbs this loss first. The next tranche would then bear any remaining balance, and so on. If the loss doesn’t exceed a certain threshold, the senior tranches might remain unaffected, receiving their due payments. This setup allows investors to select their preferred risk level and get returns accordingly. Additionally, altering tranche features allows investors to pick an ideal mix of maturity, risk, and return characteristics.

Risk Ratings & Bond Classes

Every bond class in a securitization gets a risk rating. This rating depends on both the collateral quality and the class’s seniority. These ratings help investors gauge the credit risk of the bond class in conjunction with the collateral pool’s credit risk. In many cases, certain bond classes might have better credit ratings due to collateralization or credit enhancement than those seeking to raise funds through securitization.

Question

Which of the following statements about the senior/subordinated structure in securitizations is most accurate?

1. The junior tranche, having the highest priority in payments, carries the least risk among all tranches.
2. The senior tranche always receives interest payments after all other tranches have been paid.
3. The mezzanine tranche carries a slightly higher risk than the senior tranche and typically offers better returns.

The correct answer is C.

The mezzanine tranche assumes a slightly higher risk than the senior tranche but offers higher returns.

A is incorrect: The junior tranche is the first to absorb losses and, as a result, carries the highest risk among all tranches. The statement misrepresents the risk profile of a junior tranche in securitization.

B is incorrect: The senior tranche, due to its priority in the hierarchy, receives payments before the other tranches and thus bears the least risk.