Securitization is the process of pooling various types of assets, like mortgages, auto loans, or credit card debt, into a financial product called an asset-backed security (ABS) that can be sold to investors on the financial markets. Securitization transfers the credit risk of the loans from the originators to the ABS investors. This also allows the originators (platforms) to recycle capital and use it to issue new loans.
Investors receive scheduled interest payments on their investment based on the payments collected on the underlying loans in the pool. ABS issuances are structured with different credit tranches offering various levels of risk and return based on credit tranching.
What is Credit Tranching?
Credit tranching is a key credit enhancement feature of most ABS structures. Under credit tranching, the cash flows from the underlying collateral asset pool are divided into securities with different maturities and credit risk levels known as tranches. Senior tranches are structured to offer low risk/lower yield securities, while junior tranches assume a higher degree of default risk in exchange for higher interest payments.
Tranching Creates Sequential Payment Priorities
The collateral cash flows are allocated across the tranches in a predefined sequence that establishes a priority hierarchy for periodic principal and interest distributions. Each tranche’s place in that hierarchy determines the level of credit risk it assumes.
- The top tranche has the highest priority claim on cash flows for both principal and interest payments
- Lower priority tranches do not receive any payments until the higher priority tranches are paid first
- This sequential payment structure means the senior tranches have the least default risk
- If some loans in the pool default, those losses hit the lowest tranches first before impacting more senior tranches
Tranching splits the risk of collateral into a series of securities with descending risk levels and corresponding increasing yields. It attracts different investors with varying investment goals and risk tolerances looking for yield based on their own risk profile.
Key Credit Rating Metrics for Tranches
The major credit rating agencies assign ratings to different tranches that reflect their default risk probability based on historical data and complex financial models. Two metrics often used are:
1. Subordination Level
Measures how much “cushion” a given tranche has from lower priority losses based on the number and size of the junior tranches. For example, a senior AAA tranche might have 30% subordination meaning 70% of the capital structure sits below it to absorb first losses.
2. Overcollateralization
Indicates the amount of excess collateral assets relative to the tranche balances. Provides additional loss coverage beyond the regular payments collected from borrowers. Typically created upfront by issuing securities less than the collateral asset value.
Types of Investors in Each Tranching Tier
Each credit tranche attracts a different investor profile targeting yield based on risk preference.
1. Senior Tranches
The highest rated AAA and AA tranches offer low volatility and default probability. They appeal to conservative fixed income investors like pension funds, insurers, commercial banks and central banks seeking safe assets comparable to government bonds.
2. Mezzanine Tranches
Intermediate A and BBB rated tranches seek higher returns from increased default risk. Investors include fixed income-oriented mutual funds, dedicated ABS managers and hedge funds engaging in relative value arbitrage strategies across structured securities.
3. Equity Tranches
The below investment grade and unrated bottom equity tranche assumes the highest risk as the first loss piece. Hedge funds with specialist ABS trading expertise typically hold these balances, often requiring at least a 20% return reflecting the leveraged risk. Equity investors may also buy the residual cash flows after senior tranches are fully repaid.
Comparing Returns Across Tranches
The sequential payment priorities provide credit protection for senior tranches while creating much higher yields for the junior mezzanine and equity layers.
For example, historical data shows the following base case average annualized loss severity and return by tranche priority tier for a hypothetical $100 million auto ABS issuance:
| Tranches | Principal at Issuance | Average Annualized Return Target | Expected Loss Severity |
| A Senior (AAA) | $70M | 2.5% | 0.10% |
| B Mezzanine (AA) | $15M | 5% | 1.5% |
| C Junior (A) | $10M | 10% | 4.5% |
| D Equity (unrated) | $5M | 20%+ | 10%+ |
This tiered structure lets ABS issuances appeal to a spectrum of risk tolerances all backed by the same collateral asset pool.
Examples of Specific Types of Credit Tranches
While the basic logic of credit tranching remains similar across most ABS types, some issuances utilize specific tailored tranches:
1. Planned Amortization Classes (PACs)
Have a fixed repayment schedule more typical of corporate bonds regardless of prepayments in the underlying loans. This appeals to investors valuing predictable cash flow timing. PACs can be further segmented into different average lives targeting different maturities.
2. Companion Tranches
Offer credit support to the PAC classes above them to control prepayment risk. They receive principal payments first until PAC balances reach certain thresholds.
3. Z Tranches
Are the most junior equity tranche specifically structured to bear losses from early payment defaults before those hit other tranches. Provide added protection for other tranches against fraud risk in the first few months after issuance.
4. Net Interest Margin (NIM) Securities
Represent the small excess interest cash flows left over after all expenses and fees are paid. The residual tranche in many CLOs/CDOs earns the originators a small extra yield component for arranging the deal.
This showcases the flexibility of credit tranching in distributing cash flows to appeal to an array of investors within a single ABS transaction.
Structuring Process During Securitization
Packaging assets into tranched securities is an intricate process requiring specialized expertise and multiple participants:
1. Sponsors – A special purpose entity is created as an issuer of the ABS by one or more sponsors usually the owners of the assets.
2. Investment Banks – Large underwriters facilitate the actual ABS issuance, structuring details, and provide warehouses for accumulating collateral assets. They market the securities to find buyers.
3. Rating Agencies – Specialists at agencies like S&P, Moody’s, and Fitch analyze the deal structure and collateral attributes to assign credit ratings to each tranche. This is only applicable for mature issuers. First time issuance from startups is generally unrated.
4. Credit Enhancers – Third party guarantors like insurers may provide additional guarantees or financial backing for certain tranches to bolster their ratings if needed.
5. Accounting/Valuation Firms – Verify and confirm the collateral asset details and cash flow models.
6. Law Firms – Handle requisite legal filings and disclosures to facilitate issuance under securities regulations.
7. Trustees – Independent parties oversee administration of cash allocations to investors per the prescribed waterfall payment priorities.
Benefits of Credit Tranching
Adding tranching on top of pooling assets into ABS has major advantages:
- Lets ABS appeal to much wider capital market – broadens liquidity and distribution
- Lowers financing costs for lenders and borrowers
- Customization attracts investors with specific portfolio needs
- Mitigates risks versus directly owning the collateral assets – especially for senior tranches
- Creates highly rated paper even from risky underlying collateral
- Adds flexibility to carve up cash flows to different risk tolerances
In particular, tranching expands the total lending capacity for the originators by attracting funding from risk-averse senior tranche investors.
Conclusion
In summary, credit tranching serves as an instrumental credit enhancement technique for most ABS issuances. It provides a mechanism to carve up the risk-return spectrum into a series of rated securities mapped to the specific needs of diverse investors. This supports expanded capital formation for the underlying lending activities.