Structured Credit Risk

This chapter we will emphasize two main classes of credit risky securities that are securitizations and structured credit products. They are important in contemporary finance and they have been in existence for a while. The development of the market based or shadow banking system has relied on them.

The ultimate objective is to get to know the challenges they present to risk management by traders and investors, and their effects on the financial system before and during the crisis period. There are also a number of variations with the same trend. An understanding of structured credit products will help one understand the growth of leverage in the financial system and its role in the subprime crisis.

Structured credit basics

Portfolio credit products

Portfolio credit products are tools that create bonds or credit derivatives backed by a number of loans (sometimes other claims). We can group structured credit products into the context of other securities based on pooled loans. The complexity of structure and the hierarchy corresponds roughly to the historical development of structured products.

Covered bonds

Covered bonds are mainly given by European banks (majorly, Germany and Denmark). Mortgage loans are aggregated into a cover pool in this type of structure, by which a bond issue is secured. The covered bond owners are covered first by the cover pool before they could be applied to repay general bank creditors. These bonds are not considered full-fledged securitizations since the underlying assets always remain on the one who issues balance sheet. The general cash flows of the issuer are used to pay the principal and interest on the secured bond, rather than out of the cash flows generated by the cover pool. Lastly, apart from the security of the cover pool, the covered bonds are backed by the issuer’s obligation to pay.

Mortgages pass

Since the cash flows paid out by the bonds and the credit risk to which they are exposed, they are more completely dependent on the cash flows and credit risks generated by the pool of underlying loans. They are backed by a pool of mortgage loans, removed from the mortgage originators’ balance sheets, and administered by a servicer, who collects principal and interest from the underlying loans and distributes them to the bondholders. There is little default risk with most pass through since they are agency MBS and are issued under a U.S. federal guarantee of the performance of the underlying loans. But the principal and interest on the bonds are “passed through” from the loans, so the cash flows depend not only on amortization but also voluntary prepayments by the mortgagor. The bonds are repaid slowly over time, but at an uncertain pace, in contrast to bullet bonds, which receive full repayment of principal on one date. Bondholders are therefore exposed to prepayment risk.

Collateralized mortgage obligations

As a result of prepayment risk, CMOs were developed to help in copying up with risk, but also as a way to create both longer- and shorter-term bonds out of a pool of mortgage loans. Such loans amortize over time, creating cash flow streams that diminish over time. CMOs are tranched into bonds or tranches that are paid depending on a specified schedule. Structured credit products do bring up one more innovation, referred to as the sequential distribution of credit losses on the banks’ balance sheet, rather than being sold off-balance-sheet. However, they are segregated from other assets of the bank in the event the bank defaults.

Securitization is one approach to financing pools of loans and other receivables that have developed over the past two decades. They are, depending on the type of underlying assets, often generically called asset- or mortgage-backed securities (ABS or MBS), or collateralized loan obligations (CLOs). Securitizations that repackage other securitizations are called collateralized debt obligations (CDOs, issuing bonds against a collateral pool consisting of ABS, MBS, or CLOs), collateralized mortgage obligations (CMOs), or collateralized bond obligations (CBOs).

Underlying asset classes’ collaterals are usually composed of residential or commercial real estate loans, consumer debt such as credit card balances and auto or student loans, and corporate bonds.

Structured products are tools for redirecting the cash flows and credit losses generated by the underlying debt instruments. Rather than being made directly into debt holders, they are split up and channeled into structured products in various ways, one of them being tranching, the number and size of the bonds carved out of the liability side of the securitization. The other one is the number of levels of securitization involved, that is, whether the collateral pool consists entirely of loans or liabilities of other securitizations. Risk management challenges differ from pool to pool.

Static pools

Static pools are amortizing pools that involve a set of loans that is placed in the trust. As the loans amortize, are repaid, or default, the deal, and the bonds it issues, gradually wind down. They are mostly found for such asset types as auto loans and residential mortgages, which do have a fixed (and relatively long) term at origination but pay down over time. Revolving pools specify an overall level of assets that is to be maintained during a revolving period. The size of the pool is maintained as the underlying loans are being repaid by introducing additional loans from the balance sheet of the originator. Revolving pools are common for bonds backed by credit card debt that is not issued in a fixed amount but can within limits be drawn upon and repaid by the borrowers at their own discretion and without notification. When the revolving period comes to an end, the loan pool becomes fixed, and the deal winds down gradually as debts are repaid or become delinquent and are charged off.

Managed Pools

In this type of pools, the manager of the structured product has the ability to remove individual loans from the pool, sell them, and replace them with others. They are common in CLOs. Managers of CLOs are hired in part for skill in identifying loans with higher spreads than warranted by their credit quality. They can identify credit problems arising at an early stage, and trade out of loans they believe are more likely to default.

Asset type and on the size of the securitization determine the number of debt instruments in pools.

Synthetic securitizations are assets of some structured products that are not cash-backed instruments but rather credit derivatives.

Capital Structure and Credit Losses in a Securitization

Tranching refers to how the liabilities of the securitization SPV are split into a capital structure. The general principle of tranching is that more senior tranches have priority to payments of principal and interest, while more junior tranches must be written down first when credit losses occur in the collateral pool. Tranches are categorized into:

  1. Equity: In this tranche, there is no fixed coupon payment received. It is fully exposed to defaults in the collateral pool.
  2. Junior debt: It earns a relatively high fixed coupon or spread, and it is next in line to suffer default losses in case the equity tranche is exhausted by default in the collateral pool. Junior bonds are also called mezzanine tranches and are typically also thin.
  3. Senior debt: They do earn a relatively low fixed coupon or spread, but are protected by both the equity and mezzanine tranches from default losses. Senior bonds are usually the bulk of the liabilities in a securitization.

Capital stuck refers to a capital structure with senior bonds at the top of the stack.Most securitizations also feature securities with different maturities but the same seniority, a technique similar to sequential-pay CMOs for coping with variation in the term to maturity and prepayment behavior of the underlying.

Two tranches do have a boundary which, when expressed as a percentage of the total of the liabilities, is called the attachment point of the more senior tranche and detachment point of the more junior tranche. The equity tranche only has a detachment point, and the most senior only has an attachment point. A securitization can be thought of as a mechanism for securing long-term financing for the collateral pool.

Overcollateralization refers to selling an amount of bonds that is smaller than the set amount of underlying collateral. It provides credit enhancement for all of the bond tranches of a securitization.

There are a few holes inside the capital structure that must be filled and kept at specific levels before junior and value notes can get cash. These stores can be filled from two sources: slowly, from the abundance spread, or rapidly by means of over-collateralization. These two methodologies are regularly utilized as a part of the blend. The last is at times called hard credit upgrade, as opposed to the delicate credit improvement of abundance spread, which gathers bit by bit after some time and is absent at the start of the securitization. Managers rotating pools have an early amortization trigger that ends the renewal of the pool with crisp obligation if a default trigger is ruptured.

By and large, the security pool contains resources with various maturities(that amortize over time). When it comes to loan developments, it is unverifiable in light of the fact that the advances can be paid ahead of time preceding development, potentially after an underlying lockout period has passed. Hence, risk examination, for the most part, centers on the weighted average life (WAL) of a securitization. A WAL is related with a specific prepayment presumption, and standard suppositions are set for some advantage classes by tradition.

The tranche structure of a securitization leads to a somewhat different definition of a default event from that pertaining to individual, corporate, and sovereign debt. Losses to the bonds in securitizations are determined by losses in the collateral pool together with the waterfall. Losses may be severe enough to cause some credit loss to a bond, but only a small one.

For corporate or sovereign bonds, default is a binary event; if interest and principal cannot be paid, then bankruptcy or restructuring ensues. Corporate debt typically has a “hard” maturity date, while securitizations have a distant maturity date that is rarely the occasion for a default. For these reasons, default events in securitizations are often referred to as material impairment to distinguish them from defaults.


Waterfall refers to the rules about how the cash flows from the collateral are distributed to the various securities in the capital structure. A typical structured credit product begins life with a certain amount of hard over-collateralization, since part of the capital structure is an equity note, and the debt tranches are less than 100 percent of the deal. Soft over-collateralization mechanisms may begin to pay down the senior debt over time with part of the collateral pool interest or divert part of it into a reserve that provides additional credit enhancement for the senior tranches.

The assumption that all the loans and bonds have precisely the same maturity date is a great simplification in several respects. Although one of the major motivations of securitization is to obtain term financing of a pool of underlying loans, such perfect maturity matching is unusual in constructing a securitization. The problem of maturity transformation in financial markets is important.

Regardless of whether the default rate is constant, default losses accumulate, so for any default rate, the cash flows from any collateral pool will be larger the early in the life of a structured credit product.

Issuance Process

The process of creating a securitized credit product is best explained and described by describing some of the players in the cast of characters that bring it to market. There are also some of the conflicts of interest that pose risk management problems to investors.

Loan Originator

The loan originator is the original lender who creates the debt obligations in the collateral pool. This is often a bank, for example, when the underlying collateral consists of bank loans or credit card receivables. But it can also be a specialty finance company or mortgage lender. If most of the loans have been originated by a single intermediary, the originator may be called the sponsor or seller.


The underwriter is at times called the arranger, and is often, but not always, a large financial intermediary. Typically, the underwriter aggregates the underlying loans, designs the securitization structure, and markets the liabilities. In this capacity, the underwriter is also the issuer of the securities. A somewhat technical legal term, depositor, is also used to describe the issuer. The underwriter bears the warehousing risk, the risk that the deal will not be completed and the value of the accumulated collateral still on its balance sheet falls.

Rating Agencies

Rating agencies are locked in to survey the credit nature of the liabilities. An essential piece of this procedure is deciding connection focuses and credit subordination. As opposed to corporate securities, in which rating organizations opine on financial soundness(however have little impact over it), evaluations of securitizations include the offices in choices about structure. The rating office may tell the backer how much improvement is required, given the arrangement of the pool and different highlights of the arrangement, to pick up a speculation review rating for the highest point of the capital stack. These most senior bonds have brought down spreads and a more extensive financial specialist crowd, and are accordingly exceptionally critical in the financial matters of securitizations. Rating offices are commonly repaid by guarantors, making rise to a conflict of interest.

Servicers and Managers

The servicer collects principal and interest from the loans in the collateral pool and disburses principal and interest to the liability holders, as well as fees to the underwriter and itself. The servicer may be called upon to make advances to the securitization liabilities if loans in the trust are in arrears. Servicers may also be tasked with managing underlying loans in distress, determining, for example, whether they should be resolved by extending or refinancing the loan, or by foreclosing. Managers of actively managed loan pools may also be involved in conflicts of interest. As is the case with bankers, investors delegate the task of monitoring the credit quality of pools to the managers and require mechanisms to align incentives. Trustee and custodian are tasked with keeping records, verifying documentation and moving cash flows among deal accounts and paying noteholders.

Credit Scenario Analysis of a Securitization

Credit scenario analysis is done in two parts:

  1. analyzing the cash flows prior to maturity; and
  2. analyzing the cash flows in the final year of the securitization’s life.

Let’s take as a base assumption an annual expected default rate of 2 percent. As we will see, the securitization is “designed” for that default rate, in the sense that if defaults prove to be much higher, the bond tranches may experience credit losses. If the default rate proves much lower, the equity tranche will be extremely valuable, and probably more valuable than the market requires to coax investors to hold the position at par.

Because the recovery amounts are held back rather than used to partially redeem the bonds prior to maturity, and because, in addition, even in a very high default scenario, there are enough funds available to pay the coupons on the bond tranches, the bonds cannot “break” before maturity. In real-world securitizations, trust agreements are written so that in an extreme scenario, the securitization can be unwound early, thus protecting the bond tranches from further loss.

Measuring structured credit risk via simulation

In chapter – Portfolio Credit Risk, there were two ways to taking account of default correlation in a credit portfolio, one that was linked to the single-factor model and the other one was the simulation via a copula model. Now in this chapter, the underlying collateral is a product of several loans. By taking into account the default correlation, this simulation-based analysis unlocks the entire distribution of outcomes, not just particular outcomes.

The Simulation Procedure and the Role of Correlation

    1. Estimate parameters

First, we need to determine the parameters for the valuation, in particular, the default probabilities or default distribution of each individual security in the collateral pool, and the correlation used to tie the individual default distributions together.

    1. Generate default time simulations

Using the estimated parameters and the copula approach, we simulate the default times of each security (here, the underlying loans) in the collateral pool. With the default times in hand, we can then identify, for each simulation thread and each security, whether it defaults within the life of the securitization, and if so, in what period.

    1. Compute the credit losses

The default times can be utilized to create a succession of money streams from the security pool in every period for every reenactment string. This piece of the method is the same as the income examination of the past segment. The distinction is just that in the reproduction approach, the quantity of defaults in every period is directed by the aftereffects of the recreation. The securitization capital structure and waterfall allocates the money streams after some time, for every reenactment string, to the securitization tranches. For every reproduction string, the credit misfortune, assuming any, to every obligation and the lingering income, assuming any, to the value tranche would then be able to be registered. This gives us the whole circulation of misfortunes for the bonds and of IRRs for the value. The dispersions can be utilized to register to acknowledge insights, for example, Credit \(VaR\) for every tranche.

Granularity can essentially decrease securitization dangers. In Chapter – Portfolio Credit Risk, we saw that “knotty” pools of security have a more serious danger of outrageous exceptions than granular ones. A decent case of securitizations that are not regularly granular are the numerous CMBS bargains in which the pool comprises of a relatively small number of home loan advances on expensive properties or purported combination bargains in which a genuinely granular pool of littler credits is joined with a couple of huge advances. At the point when the advantage pool isn’t granular, as well as connection is high, the securitization is said to have high focus chance.

Standard Tranches and Implied Credit Correlation

Structured credit products are claims on cash flows of credit portfolios. Their prices, therefore, contain information about how the market values certain characteristics of those portfolios, among them default correlation. The correlation obtained in this way is called an implied credit or implied default correlation. It is a risk-neutral parameter that we can estimate whenever we observe prices of portfolio credit products.

Credit Index Default Swaps and Standard Tranches Credit index default swaps or CDS indexes are a variant of CDS in which the underlying security is a portfolio of CDS on individual companies, rather than a single company’s debt obligations.

The two groups of CDS indexes that are particularly frequently traded are CDX or CDX.NA(CDS on North American companies) and iTraxx(CDS on European and Asian companies). Both groups are managed by Markit, a company specializing in credit-derivatives pricing and administration. There are, in addition, customized credit index default swaps on sets of companies chosen by a client or financial intermediary.

Implied Correlation

The values, sensitivities, and other risk characteristics of a standard tranche can be computed using the copula techniques described in Chapter – Spread Risk and Default Intensity Models, but with one important difference. In the previous section, the key inputs to the valuation were estimates of default probabilities and default correlations. But the constituents of the collateral pools of the standard tranches are the 125 single-name CDS in the IG index, relatively liquid products whose spreads can be observed daily, or even at a higher frequency. Implied credit correlation is as much a market-risk as a credit-risk concept. The value of each tranche has a distinct risk-neutral partial spread 0l, rather than a default 01, that is, sensitivities to each of the constituents of the IG 125.

Default Correlation Concepts summarized

  1. Default correlation is the correlation concept most directly related to portfolio credit risk. We formally defined the default correlation of two firms over a given future time period as the correlation coefficient of the two random variables describing the firms’ default behavior over a given time period.
  2. Asset return correlation is the correlation of logarithmic changes in two firms’ asset values. In practice, portfolio credit risk measurement of corporate obligations often relies on asset return correlations. Although this is in a sense the “wrong” correlation concept, since it isn’t default correlation, it can be appropriate in the right type of model. For example, in a Merton-type credit risk model, the occurrence of default is a function of the firm’s asset value. The asset return correlation in a factor model is driven by each firm’s factor loading.
  3. Equity return correlation is the correlation of logarithmic changes in the market value of two firms’ equity prices. The asset correlation is not directly unobservable, so in practice, asset correlations are often proxied by equity correlations.
  4. Copula correlations are the values entered into the off-diagonal cells of the correlation matrix of the distribution used in the copula approach to measuring credit portfolio risk. Unlike the other correlation concepts, the copula correlations have no direct economic interpretation. They depend on which family of statistical distributions is used in the copula-based risk estimate. However, the correlation of a Gaussian copula is identical to the correlation of a Gaussian single-factor model. The normal copula has become something of a standard in credit risk. The values of certain types of securities, such as the standard CDS index equity tranches, as we just noted, depend as heavily on default correlation as on the levels of the spreads in. The values of these securities can, therefore, be expressed in terms of the implied correlation.
  5. Spread correlation is the correlation of changes, generally in basis points, in the spreads on two firms’ comparable debt obligations. It is a mark-to-market rather than credit risk concept.
  6. Implied credit correlation is a gauge of the copula connection got from advertises costs. It’s anything but an unmistakable “hypothetical” idea from the copula relationship, however, is touched base at in an unexpected way. As opposed to evaluating or speculating on it, we induce it from showcase costs. Like spread relationship, it is a market, as opposed to credit risk.

Issuer and Investor Motivations For Structured Credit

To identify why securitizations are created, incentives of the loan originators need to be identified.

    1. Incentives of the issues

The securitization “exit” is attractive for lenders only if the cost of funding via securitization is lower than the next-best alternative. If the loans are retained, the loan originator may be able to fund the loans via unsecured borrowing. But doing so is more costly than secured borrowing via securitization.

Securitizations attempted principally to catch the spread between the hidden credit intrigue and the coupon rates of the liabilities are at times called arbitrage CDOs, while securitizations persuaded to a great extent for asset report alleviation are named accounting report CDOs. In any case, while the inspirations are adroitly unmistakable, it is difficult to recognize securitizations along these lines. Among the variables that tend to bring down the spreads on securitization liabilities are credit pool broadening and an originator’s notoriety for high endorsing measures. The financing costs on the fundamental advances, the default rate, the potential credit subordination level, and the spreads on the securities cooperate to decide whether securitization is monetarily better than the options. On the off chance that, as is regularly the case, the backer holds the overhauling rights for the advances, and appreciates noteworthy economies of scale in adjusting, securitization licenses him to build overhauling benefits, raising the edge loan fees on the liabilities at which securitization ends up alluring.

    1. Incentives of Investors

Securitization empowers capital markets financial specialists to take an interest in differentiated products such as contracts, credit cards, and auto loans. Tranching innovation gives extra methods for profit and risk sharing. Bankers’ needs are met by pooling and securitization—they don’t require tranching. More slender subordinate tranches draw financial specialists craving returns, while thicker senior tranches draw speculators looking for lower risk securities.

However, these features are useful to investors only if they carry out the due diligence needed to understand the return distribution accurately. Some institutional investors, particularly pension funds, have a high demand for high-quality fixed-income securities that pay even a modest premium over risk-free or high-grade corporate bonds. This phenomenon, often called “searching” or “reaching for yield,” arises because institutional investors deploy large sums of capital while being required to reach particular return targets.

Practice Questions

1) Which among the following is not a pattern in respect to the interaction between correlation and default probability?

  1. Convexity
  2. Increased bond losses
  3. Increased IRR of equity tranches
  4. Distribution of losses

The correct answer is D.

Convexity, increased bond losses and increased IRR of equity tranches are all important patterns with respect to the interaction between correlation and default probability. The distribution of losses is not one of these patterns.

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