The TAC gives investors protection against early pre-payment. This is
done by ascribing a constant rate of principal payment to the class. If
pre-payments occur more rapidly than expected the excess is diverted
to the other tranches.
Designed to alleviate pre-payment on other categories. Investors agree
to subordinate their principal repayments to other holders in
exchange for a higher return.
These pay ﬂoating rates of interest usually expressed as a spread to a
common interest rate.
The call class
Investors in this category receive no interest or principal until the
other classes have been paid. They potentially have the longest life of
all the tranches. Scheduled interest payments that are missed are
added to the principal amount until cash becomes available following
the retirement of other classes. This is a beneﬁt because when inter-
est payments begin they will be based upon a larger principal.
IO and PO mortgage-backed securities
Subsequent securities can be stripped into their component interest
and principal payments. The US expression of stripping refers to the
fact they trade independently and in the manner of a zero coupon
bond which has appeal to certain types of investors.
Figure 4.4 shows the relative importance of mortgage activity within
the US and Figure 4.8 displays the relative importance within the
4.3 Auto- and loan-backed securities
These constitute an important section of the market and you will be
pleased to learn one of the simpler. The subsequent securities can be
structured into both single asset and multi-class structures.
Auto-backed securities are set against underlying loans which are
provided to purchasers of vehicles. These assets behave in a fairly uni-
form manner. This is because pre-payments are much less sensitive to
changes in interest rates than in the mortgage world. The loans are
amortized according to a schedule and repaid, usually over a 6 year
period. They are collateralized against the vehicle purchased and so
consequently offer strong backing.
Figure 4.6 illustrates the common arrangement within the vehicle
financing operation. The parent company usually sets up two independ-
ent trusts. It physically transfers the receivables into the ﬁrst trusts
(or SPV). The SPV preferentially transfers some of these receivables into
the ‘owners’ trust. Which issues securities with a correspondingly lower
yield because of the priority accorded to payments. The SPV is ﬁnanced
usually by a subsidiary of the parent company who issue investor
securities for the net end investor (the so-called ‘captive’ issuer).
The resulting securities have payments prioritized according to
188 Credit risk: from transaction to portfolio management
Figure 4.6 Auto-backed securitization.
Example of distribution
2. Hedging transaction
3. Senior ‘owners’ notes principal
4. Senior ‘owners’ notes interest
5. Subordinated ‘owners notes’ principal
6. Subordinated ‘owners notes’ interest
7. Liquidity deposit
8. Regular ‘end investor’ principal allocation
9. Any surplus retained by the seller
Figure 4.7 The priority of payment within an auto-backed arrangement.