LO 34.5: Explain the credit risk securitization process and describe the structure

LO 34.5: Explain the credit risk securitization process and describe the structure o f typical collateralized loan obligations (CLO s) or collateralized debt obligations (C D O s).
The credit risk securitization process is a technique that uses financial engineering to combine a segregated pool of assets into one tradable security with various inherent risk levels. The company that starts this process is called the originator. The originator will purchase a series of different assets, like corporate bonds, leveraged loans, mortgages, auto loans, or perhaps credit card loans. These assets are held on the originators balance sheet until they have a sufficient quantity of assets to repackage this pool into a security.
The actual repackaging process occurs in an off-balance-sheet entity, like a special purpose vehicle (SPV). Once assets are transferred to the SPV, securities must be issued, based on this reference pool of assets, to fund the purchase of the assets. The securitized asset is structured in such a way that the originator has no recourse for losses sustained after an investor purchases a securitized asset.
Part of the securitization process also involves establishing various risk layers within the new investment product. These layers are called tranches. The senior tranches have the lowest risk of loss. There are several mezzanine tranches as well. The idea is that in the event of default by the underlying assets, the most junior tranches will realize the loss first. In fact, the senior tranches will not experience any loss unless the more junior tranches all experience 100% losses. This cash loss process is sometimes called the waterfall structure of securitized products and it provides an apparent safety margin for the senior tranches.
There is a very broad category of securitized products known as collateralized debt obligations (CDOs). In general, a CDO is an asset-backed security that can branch into corporate bonds, emerging market bonds, residential mortgage-backed securities (RMBS),
2018 Kaplan, Inc.
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commercial mortgage-backed securities (CMBS), real estate investment trust (REIT) debts, bank loans, other forms of asset-backed securities backed by auto and credit card loans, and even other CDOs.
Figure 3: A CDO With TV Underlying Securities
Senior Tranche
Cash
w W
Return
SPY
Cash
w Return
i
Mezzanine Tranches
Security 1
Security 2
Security N
Junior Tranche
Perhaps the most well-known form of a CDO is called a collateralized loan obligation (CLO). CLOs focus on repackaging high-yield bank loans. With a CLO, below-investment- grade bonds are restructured into tranches, which include investment-grade senior tranches, a junior equity tranche, and possibly intermediate-quality tranches between the senior and junior tranches (i.e., mezzanine tranches). The senior tranches achieve investment-grade ratings by effectively outsourcing the default risk to the equity tranche. This allows the originator of the high-yield loans to sell the senior tranches to insurance companies and pension funds, which are required to own investment-grade debt instruments. It is also important to note that bank loans are amortizing, which means they have a shorter duration than corporate bonds with similar maturities.
Consider an example of the CLO repackaging process. A bank compiles $1 billion in high-yield loans that are below investment-grade. This group of loans will meet certain parameters, such as the number of industries represented in the loan pool, the maximum percentage in any given industry, and the maximum percentage in any given issuer. This data will communicate risk to potential investors. The bank will securitize this CLO into perhaps three tranches. A senior secured tranche class A, a senior secured tranche class B, and a residual or equity tranche that is subordinate. The weighted average life of the loans in the CLO is six years with an average coupon of LIBOR plus 230 basis points. The senior class A notes will have a face value of $830 million, a 12-year maturity, a coupon of LIBOR plus 40 basis points, and a robust investment-grade rating. The senior class B notes will have a face value of $60 million, a 12-year maturity, a coupon of LIBOR plus 150 basis points, and a low-end investment-grade rating. The subordinated equity tranche will have a face value of $90 million, a 12-year maturity, a residual claim on any CLO assets, and a non-investment-grade rating.
During the first six years of this example CLO, loans begin to mature. However, the tranches all have a 12-year maturity. The CLO originator will reinvest the maturing proceeds in additional six-year loans adhering to the initial industry and concentration risk
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stipulations. After this initial rebalancing, the CLO investors will begin to receive principal repayments as the loans mature. The first in line will be the senior class A notes. Since the underlying high-yield loans are paying such a high spread over what the senior tranches will receive, the equity tranche has the potential to earn a very substantial return if defaults do not materialize. Typically, the originating bank will retain the equity tranche to keep a small amount of skin in the game.
S y n t h e t i c C D O s a n d S i n g l e -Tr a n c h e C D O s

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