Credit Risk: From Transaction to Portfolio Management

Targeted amortization

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.

Support class

Designed to alleviate pre-payment on other categories. Investors agree

to subordinate their principal repayments to other holders in

exchange for a higher return.

Floating-rate tranches

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

European marketplace.

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

Securitization 187

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

Figure 4.7.

188 Credit risk: from transaction to portfolio management

SPV

Parent

Owner’s trust

‘Captive’ issuer

Investors

Figure 4.6 Auto-backed securitization.

Example of distribution

1. Fees

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.