Structured Credit Products

Abstract

S tructured products include notes linked to interest rates, equities, foreign exchange and commodity assets, as well as credit derivatives, such as assetbacked securities (ABS), collateralized debt obligations (CDOs), and commercial mortgage-backed securities (CMBS). This chapter focuses on the latter group, known as structured credit products. These securities are created by pooling various assets and allocating the cash flows from the pool of assets to various tranches, classes, notes, bonds, or other securities. The assets that are pooled can include virtually any traded or nontraded assets, including consumer loans (residential mortgages or credit card, auto, and student loans), corporate debt and equity securities (leveraged loans, commercial mortgages, corporate bonds, common and preferred equity), government debt (e.g., emerging market sovereign debt), commodities, or other structured products. One feature common to all structured credit products is the use of financial engineering techniques to create securities that provide a range of risk-return profiles for different investors. Credit enhancement in the form of subordination or overcollateralization can transform high-yield or unrated assets into a family of securities with varying credit risks, from triple-A-rated notes to unrated, highly levered, equity-like securities.1 Structured credit products differ from other structured securities that partition interest rate risks instead of credit risks. Included in this asset class are mortgagebacked securities (MBS) and collateralized mortgage obligations (CMOs), securities that reference residential mortgage loans, usually, prime, fixed rate conventional conforming loans or government-guaranteed loans.2 When these securities are issued by the federal housing agencies (Government National Mortgage Association, Federal National Mortgage Association, and Federal Home Loan Mortgage Corporation), they enjoy implicit government guarantees that render them virtually free of credit risk.3 When these securities are issued by private entities, such as commercial and investment banks, they usually incorporate some form of private insurance to eliminate credit risk. Currently, MBIA and Ambac are the largest underwriters of bond insurance. Exhibits 14.1 and 14.2 provide summary data on the amount of securities outstanding for various categories of structured products. Note that agency MBS and CMOs dominate the charts. Part of the reason for this is that MBS and CMOs were the original prototypes for structured products. These securities were created