Mortgage-Backed Securities: Products, Structuring, and Analytical Techniques

FUNDAMENTALS OF ABS STRUCTURES

ABS deals have various forms of credit enhancement, which is higher than that associated with residential deals. In the residential sector, credit enhancement levels (i.e., the credit support for the senior, AAARATED tranches) vary depending on the type of loan securitized, but typically do not exceed 10% for the most risky loan categories. In contrast, ABS deals generally have initial enhancement levels in excess of 20%. A challenge with ABS deals is also to efficiently utilize the incrementally higher note rate of the underlying loans in providing credit support, effectively converting interest cash flows into principal. Understanding this requires the introduction of two concepts. One is excess spread, which (as noted previously) is the difference between interest received from borrowers on the loans and paid to the securities. While all deals technically have excess spread, it is not large enough in residential deals to supplement credit enhancement. However, due to the high note rates associated with risky loans, the amount of excess spread in a typical ABS deal is relatively high. A diagram of a hypothetical deal’s cash flows and excess spread is shown in Exhibit 9.1. (Note that the exhibit was constructed for expository purposes; the rates chosen do not necessarily represent real-world examples.)

The other concept is overcollateralization, or OC, which refers to the fact that the face value of loans collateralizing the deal is greater ...