Junior Tranche Research Articles

The Credit Suisse CoCo wipeout: Facts, misperceptions, and lessons for financial regulation

The Credit Suisse CoCo wipeout: Facts, misperceptions, and lessons for financial regulation

The Design of a Central Counterparty

AbstractThis article analyzes the optimal allocation of losses via a Central Clearing Counterparty (CCP) in the presence of counterparty risk. A CCP can hedge this risk by mutualizing losses among its members. This protection, however, weakens members’ incentives to manage counterparty risk. Delegating members’ risk monitoring to the CCP alleviates this tension in large markets. To discipline the CCP at minimum cost, members offer the CCP a junior tranche and demand capital contribution. Our results endogenize key layers of the default waterfall and deliver novel predictions on its composition, collateral requirements, and CCP ownership structure.

Are CLO Collateral and Tranche Ratings Disconnected?

Abstract Between March and August 2020, S&P and Moody’s downgraded approximately 25$\%$ of collateral feeding into CLOs and only 2$\%$ of tranche values, with rating actions concentrating in junior tranches. Both S&P and Moody’s modeling indicate that the impacts should have been considerably larger, especially for higher-rated tranches. Neither changes in correlation nor the accumulation of pre-COVID-19 protective cushions can explain the downgrade asymmetry on upper tranches. Instead, CLO managers repositioned their collateral pools to dampen the negative credit shock and rating agencies incorporated qualitative adjustments in their CLO ratings. Important potential policy and market implications from these findings are discussed. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

On the design of sovereign bond-backed securities

In this paper, we analyze Sovereign Bond-Backed Securities in the Euro area, concentrating our attention on the return of the different tranches and on their riskiness. We show that as the correlation level among States increases, the yield rate of senior tranches increases while the yield rate of junior tranches decreases. A similar effect is observed when introducing a block dependence structure with high correlation among States belonging to the same block. Introducing a nonzero recovery rate, as opposed to a null recovery rate, decreases the yield rate of senior tranches and increases the yield rate of junior tranches. We compute the loss distribution and the Value at Risk (VaR) associated with the market risk of retaining the different tranches of the bond. We also analyze the possibility of reaching a safe asset through pooling tranches of government bonds of different States. In summary, we show that the issue in reaching a comprehensive and safe offering through the securitization of government bonds is not the safety of senior tranches but the risk of the junior ones.

Market Discipline and Bank Diversification

Can banks be induced to adopt an efficient risk-taking via market discipline? We seek an answer to this question within the context of banks diversifying into the other bank’s asset, which may potentially intensify a systemic risk. The central results of the paper are as follows. When creditors punish the bank’s excessive risk exposure by demanding higher risk premium, the bank owners’ optimal diversification will coincide with the diversification that maximizes the combined value of debt and equity. However, market discipline is effective in aligning the bank shareholders’ interest to that of the creditors only when the bank leverage ratios are at some modest levels. In addition, the effectiveness improves when diversification through securitization is allowed since tranching bank debt into a senior and a junior tranches enables avoiding the dark side of diversification and hence ensures both the individual and social optimality. While supporting capital adequacy and disclosure requirements of Basel III, our analysis warns the consequence of public backstops, that feeds the notion of ‘too-big-to-fail’, in undermining creditors’ incentive to monitor the banks and hence encouraging the latter to adopt excessive and socially sub-optimal risk-taking.

Security Design in Non-Exclusive Markets with Asymmetric Information

We revisit the classic problem of a seller (e.g. firm) who is privately informed about her asset and needs to raise funds from uninformed buyers (e.g. investors) by issuing securities backed by her asset cash flows. In our setting, buyers post menus of contracts to screen the seller, but the seller cannot commit to accept contracts from only one buyer, i.e., markets are non-exclusive. We show that an equilibrium of this screening game always exists, it is unique and features semi-pooling allocations for a wide range of parameters. In equilibrium, the seller tranches her asset cash flows into a debt security (senior tranche) and a levered-equity security (junior tranche). Whereas the seller of a high quality asset only issues her senior tranche, the seller of a low quality asset issues both tranches but to distinct buyers. Consistent with this, whereas the senior tranche is priced at pooling valuation, the junior tranche is priced at low valuation. Our theory's positive predictions are consistent with recent empirical evidence on issuance and pricing of mortgage-backed securities, and we analyze its normative implications within the context of recent reforms aimed at enhancing transparency of financial markets.

Are CLO Collateral and Tranche Ratings Disconnected?

Between March and August 2020, S&P and Moody's downgraded approximately 25% of collateral feeding into CLOs and only 2% of tranche values, with rating actions concentrating in junior tranches. This paper examines explanations for this potential rating disconnect. We find no evidence that: rating agency model-implied risk disproportionately affect junior tranches, collateral downgrades were too severe, CLOs accumulated pre-COVID protective cushions, or value-creation through active management. Instead, we find evidence consistent with both non-model considerations by rating agencies and strategic CLO manager trading. The end result is that CLOs are considerably riskier than their current ratings suggest.

Pricing and integration of credit default swap index tranches

AbstractThis paper first designs an efficient procedure to value Credit Default Swap Index tranches using an intensity‐based model. The tranche spreads are effectively explained by a three‐factor version of this model, both before and during the financial crisis of 2008. We then construct tradable tranche portfolios to track the intensity factors and compare the pricing of the tranches with equities and their derivatives. Our results show that the senior tranche spreads do not offer returns in excess of the common risk compensations in the equity and derivatives markets, while the junior tranche is not spanned by these standard factors.

On the Design of Sovereign Bond-Backed Securities

We analyze Sovereign Bond-Backed Securities, concentrating our attention on the return of the different tranches and on their risk. We show that as the correlation level among defaults increases, the yield rate of senior tranches increases while the yield rate of junior tranches decreases. A similar effect is observed when introducing a block dependence structure with high correlation among states belonging to the same block. Introducing a non-zero recovery rate, as opposed to a null recovery rate, decreases the yield rate of senior tranches and increases the yield rate of junior tranches. We compute the loss distribution and the Value at Risk (VaR) associated with the market risk of detaining the different tranches of the bond. We also analyze the possibility of reaching a safe asset through pooling tranches of government bonds of different States. In summary, we show that the issue in reaching a comprehensive and safe offering through the securitization of government bonds is not the safety of senior tranches but the risk of the junior ones.

Credit ratings and structured finance

Abstract The poor performance of credit ratings of structured finance products in the financial crisis has prompted investigation into the role of credit rating agencies (CRAs) in designing and marketing these products. We analyze a two-period reputation model in which a CRA both designs and rates securities that are sold both to investors who are constrained to purchase highly rated securities and investors who are unconstrained. Assets are pooled and senior and junior tranches are issued with a waterfall structure. When the rating constraint is lax, the CRA will include only risky assets in the securitization pool, serving both types of investors without any rating inflation. Rating inflation is decreasing in the tightness of the rating constraint locally. But rating inflation may be non-monotonic in the rating constraint globally, with no rating inflation when the constraint is lax or tight.

Risk Allocation Through Securitization – Evidence From Non-Performing Loans

Employing a unique and hand-collected sample of 648 true sale loan securitization transactions issued by 57 stock-listed banks across the EU-12 plus Switzerland over the period from 1997 to 2010, this paper empirically analyzes the relationship between true sale loan securitization and the issuing banks’ non-performing loans to total assets ratios (NPLRs). We provide evidence for an NPLR-reducing effect during the boom phase of securitizations in Europe suggesting that banks in our sample (partly) securitized NPLs as the most risky junior tranche and did not (fully) retain NPLs as a reputation and quality signal towards less informed investors in imperfect capital markets. In contrast, we find the reverse effect during the crises period in Europe indicating that issuing banks provided credit enhancement and demonstrated `skin in the game'. Our baseline result remains robust when controlling for endogeneity concerns and a potential persistence in the time series of the NPL data. Moreover, results from a variety of sensitivity analysis reveal that the NPLR-reducing effect is stronger for opaque securitization transactions, for issuing banks exhibiting higher average levels of NPLRs and for banks operating from non-PIIGS countries. In addition, a reduction of NPLRs through securitization is observed for issued collateralized debt obligations, residential mortgage-backed securities, consumer and other unspecified loans as well as for non-frequently issuing, systemically less important and worse-rated banks. Our analysis offers essential insights into the loan risk allocation process through securitization and provides important implications for the vital debate on reducing NPL exposures and the process of revitalizing and regulating the European securitization market.

Information Frictions in Securitization Markets: Unsophisticated Investors or Opaque Assets?

Security prices are informative about the probability of a subsequent downgrade, but this informativeness is affected by two frictions taking place between the issuer and the investor. I use a measure of documentation quality in private label mortgages to show that the predominant friction relates to incomplete documentation on the underlying loans. Prices of junior tranches appear no more informative than those of AAA tranches within low-doc deals, while the latter are no less informative within full-doc deals. The agency friction stemming from lack of investor sophistication is secondary. The results suggest that documentation transparency can be an effective complement to skin in the game requirements.

Investment Performance of Credit Risk Transfer Securities (CRTs): The Early Evidence

Credit risk transfer (CRT) securities were introduced by Fannie Mae and Freddie Mac in 2013. As of the end of 2017, in combination, the two government sponsored housing enterprises had issued a total of $53 billion in CRTs linked to residential mortgage loans with a total face value of $1.79 trillion. The goal is to shift mortgage risk from tax payers to the private sector. In return, investors expect to be compensated. The authors document the returns earned by investors in the various CRT tranches since their inception. The most senior tranches have provided an average representative return of 0.26% per month. The most junior tranches have provided an average representative return of 1.71% per month. These compare with average monthly returns of 0.03%, 0.15%, and 0.87% to T-bills, 15-year agency mortgage-backed securities, and 10-year high-yield corporate bonds, respectively, over the same time periods.

Reinforcing the Capital of a Bank with Two Tranches of Coco Bonds

Following the 2008 crisis, Basel III has imposed higher banking capital requirements. To comply with this, banks will have to issue new equity and/or sell some of their assets, which will put pressure on financial markets. To ease such pressure, banks and regulators are wondering whether capital might be raised in other forms such as Contingent Convertible (CoCo) bonds, which are basically bonds that can be converted into equity when triggered by a specified event. This article examines the capital structure of a bank financed by equity, traditional bonds, and two tranches of debt-to-equity CoCo bonds. The Junior Tranche aims to prevent risk when the bank is still in good health, while the Senior Tranche aims to rescue the bank when it is already in crisis. The choice of triggers is decisive to ensure that the two tranches of CoCo bonds fulfil their missions of prevention and rescue.

Investment Performance of Credit Risk Transfer Securities (CRTs): The Early Evidence

Credit Risk Transfer (CRT) securities were introduced by Fannie Mae and Freddie Mac in 2013. As of the end of 2017, in combination, the two Government Sponsored housing Enterprises (GSEs) had issued a total of $53 billion in CRTs linked to residential mortgage loans with a total face value of $1.79 trillion. The goal is to shift mortgage risk from tax payers to the private sector. In return, investors expect to be compensated. We document the returns earned by investors in the various CRT tranches since their inception. The most senior tranches have provided an average representative return of 0.26% per month. The most junior tranches have provided an average representative return of 1.71% per month. These compare with average monthly returns of 0.03%, 0.15%, and 0.87% to T-bills, 15-year agency MBS, and 10-year high-yield corporate bonds, respectively, over the same time periods.

Credit Ratings and Structured Finance

The poor performance of credit ratings of structured finance products in the financial crisis has prompted investigation into the role of credit rating agencies (CRAs) in designing and marketing these products. We analyze a two-period reputation model in which a CRA both designs and rates securities that are sold both to investors who are constrained to purchase highly rated securities and investors who are unconstrained. Assets are pooled and senior and junior tranches are issued with a waterfall structure. When the rating constraint is lax, the CRA will include only risky assets in the securitization pool, serving both types of investors without any rating inflation. Rating inflation is decreasing in the tightness of the rating constraint locally. But rating inflation may be non-monotonic in the rating constraint globally, with no rating inflation when the constraint is lax or tight.

PROBABILITY DENSITY OF RECOVERY RATE GIVEN DEFAULT OF A FIRM’S DEBT AND ITS CONSTITUENT TRANCHES

This paper derives the theoretical underpinnings behind the following observed empirical facts in credit risk modeling: The probability of default, the seniority, the thickness of the tranche, the debt cushion, and macroeconomic factors are the important determinants of the conditional probability density function of the recovery rate given default (RGD) of a firm’s debt and its tranches. In a portfolio of debt securities, the conditional probability density functions of the recovery rate given default of tranches have point probability masses near zero and one, and the expected value of the recovery rate given default increases as the seniority or debt cushion increases. The paper derives other results as well, such as the fact that the conditional probability distribution function associated with any senior tranche dominates that of any junior tranche by first-order. The standard deviation of the recovery rate given default of a senior security need not be greater than that of a junior security. It is proved that the expected value of the recovery rate given default need not increase as the proportional thickness of the tranche increases.

Addressing the Safety Trilemma: A Safe Sovereign Asset for the Eurozone

At the 25th anniversary of the Maastricht Treaty, this paper reviews the merits of introducing a safe sovereign asset for the eurozone. The triple euro area crisis showed the costly consequences of ignoring the ‘safety trilemma’. Keeping a national safe sovereign asset (the German bund) as the cornerstone of the financial system is incompatible with having free capital mobility and maintaining economic and financial stability in a monetary union. The euro area needs a single safe sovereign asset. However, eurobonds are only foreseen after full fiscal integration. To address the safety trilemma member countries must therefore act as the joint sovereign behind the euro and choose from two options. First, they could establish a credible multipolar system of safe national sovereign assets. For this purpose, they could all issue both senior and junior tranches of each national government bond in a proportion such that the expected safety of the senior tranche is the same across countries while the junior tranche would absorb any sovereign default risk. Additional issuance of national GDP-linked bonds could insure governments against a deep recession that might lead to a self-fulfilling default and thereby help to make the junior tranche less risky. The second option is that the member countries together produce a common safe sovereign asset for a truly integrated and stable monetary union by creating synthetic eurobonds comprising both a safe senior claim and a risky junior claim on a diversified portfolio of national government bonds. This appears a more effective solution to the safety trilemma – especially when euro area governments would also issue national GDP-linked bonds – but it requires flanking measures to control for moral hazard.

ESBies: Safety in the Tranches

The euro crisis was fueled by the diabolic loop between sovereign risk and bank risk, coupled with cross-border flight-to-safety capital flows. European Safe Bonds (ESBies), a union-wide safe asset without joint liability, would help to resolve these problems. We make three contributions. First, numerical simulations show that ESBies would be at least as safe as German bunds and approximately double the supply of euro safe assets when protected by a 30%-thick junior tranche. Second, a model shows how, when and why the two features of ESBies – diversification and seniority – can weaken the diabolic loop and its diffusion across countries. Third, we propose a step-by-step guide on how to create ESBies, starting with limited issuance by public or private-sector entities.

The Sovereign-Bank Diabolic Loop and ESBies

We propose a simple model of the sovereign-bank diabolic loop, and establish four results. First, the diabolic loop can be avoided by restricting banks' domestic sovereign exposures relative to their equity. Second, equity requirements can be lowered if banks only hold senior domestic sovereign debt. Third, such requirements shrink even further if banks only hold the senior tranche of an internationally diversified sovereign portfolio--known as ESBies in the euro-area context. Finally, ESBies generate more safe assets than domestic debt tranching alone; and, insofar as the diabolic loop is defused, the junior tranche generated by the securitization is itself risk-free.