Senior Tranches Research Articles

A Benchmark for Collateralized Loan Obligations

We build a benchmark for AAA-rated tranches of collateralized loan obligations (CLOs) using business development companies (BDCs), which hold a diversified portfolio of loans as CLOs do. BDCs are publicly listed, and their share price, equity volatility, and borrowing cost can be easily obtained. Applying a structural model to BDCs, we extract market-implied correlation in their loan portfolio, compare spreads on CLO tranches and BDC-implied benchmark, and find that observed large credit spreads on CLO senior tranches after the financial crisis are a fair reflection of the systematic risk of correlated loan defaults. This paper was accepted by Lukas Schmid, finance. Supplemental Material: The online appendix and data files are available at https://doi.org/10.1287/mnsc.2022.00097 .

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

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

A Benchmark for Collateralized Loan Obligations

We build a benchmark for AAA-rated tranches of Collateralized Loan Obligations (CLOs) using Business Development Companies (BDCs), which hold a diversified portfolio of loans as CLOs do. However, BDCs are publicly listed, and their share price, equity volatility and borrowing cost are observable. Furthermore, BDCs' debt is not rated as AAA. Applying a structural model to BDCs, we extract market-implied correlation in their loan portfolio, compare spreads on CLO tranches and BDC-implied benchmark, and find that observed large credit spreads on CLO senior tranches after the financial crisis are a fair reflection of the systematic risk of correlated loan defaults.

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.

Structured climate financing: valuation of CDO on inhomogeneous asset pools

Recently, a number of structured funds have emerged as public-private partnerships with the intent of promoting investment in renewable energy in emerging markets. These funds seek to attract institutional investors by tranching the asset pool and issuing senior notes with a high credit quality. Financing of renewable energy (RE) projects is achieved via two channels: small RE projects are financed indirectly through local banks that draw loans from the fund’s assets, whereas large RE projects are directly financed from the fund. In a bottom-up Gaussian copula framework, we examine the diversification properties and RE exposure of the senior tranche. To this end, we introduce the LH++ model, which combines a homogeneous infinitely granular loan portfolio with a finite number of large loans. Using expected tranche percentage notional (which takes a similar role as the default probability of a loan), tranche prices and tranche sensitivities in RE loans, we analyse the risk profile of the senior tranche. We show how the mix of indirect and direct RE investments in the asset pool affects the sensitivity of the senior tranche to RE investments and how to balance a desired sensitivity with a target credit quality and target tranche size.

Portfolio Liquidity and Security Design with Private Information

Abstract A privately informed seller seeks to liquidate a portfolio to raise cash. Each asset’s liquidity thus depends on the impact of its sale on the value of the entire portfolio. We demonstrate the importance of cross-signaling and derive sufficient conditions for a liquidity “pecking order” that determines the order of sale. For assets backed by a common pool, liquidity naturally aligns with seniority. Finally, we extend the portfolio liquidation game to consider security design and demonstrate the optimality of pooling securities and selling senior tranches or debt secured by the pool, with retention increasing in asset quality or informational asymmetry.

How safe are european safe bonds? An analysis from the perspective of modern credit risk models

Several proposals for the reform of the euro area advocate the creation of a market in synthetic securities backed by portfolios of sovereign bonds. Most debated are the so-called European Safe Bonds or ESBies proposed by Brunnermeier et al. (2017). The potential benefits of ESBies and other bond-backed securities hinge on the assertion that these products are really safe. In this paper we provide a comprehensive quantitative study of the risks associated with ESBies and related products, using an affine credit risk model with regime switching as vehicle for our analysis. We discuss a recent proposal of Standard and Poors for the rating of ESBies, we analyse the impact of model parameters and attachment points on the size and the volatility of the credit spread of ESBies and we consider several approaches to assess the market risk of ESBies. Moreover, we compare ESBies to synthetic securities created by pooling the senior tranche of national bonds as suggested by Leandro and Zettelmeyer (2019). The paper concludes with a brief discussion of the policy implications from our analysis.

Structured Climate Financing: Valuation of CDOs on Inhomogeneous Asset Pools

Recently, a number of structured funds have emerged as public-private partnerships with the intent of promoting investment in renewable energy in emerging markets. These funds seek to attract institutional investors by tranching the asset pool and issuing senior notes with a high credit quality. Financing of renewable energy (RE) projects is achieved via two channels: small RE projects are financed indirectly through local banks that draw loans from the fund's assets, whereas large RE projects are directly financed from the fund. In a bottom-up Gaussian copula framework, we examine the diversification properties and RE exposure of the senior tranche. To this end, we introduce the LH++ model, which combines a homogeneous infinitely granular loan portfolio with a finite number of large loans. Using expected tranche percentage notional (which takes a similar role as the default probability of a loan), tranche prices and tranche sensitivities in RE loans, we analyse the risk profile of the senior tranche. We show how the mix of indirect and direct RE investments in the asset pool affects the sensitivity of the senior tranche to RE investments and how to balance a desired sensitivity with a target credit quality and target tranche size.

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.

Asset Protection-State Guarantee Schemes in Systemic European Non-Performing Loans Securitisations: Contractual Structure, State Aid and Bank Corporate Law Issues

In the prolonged battle against european non-performing loans (NPLs) and systemic risk, Authorities have ultimately devised and made available to the affected credit institutions an additional resolution tool. Securitisation schemes, backed by a limited State guarantee, only for the senior tranche part under detailed conditions, have been legislated almost identically in Italy and Greece. Those “Asset Protection Schemes” are viewed as laboratory cases for a model co-investment (private-public) strategy, with the ambition to transform the EU banking environment and correct national NPL markets failures. The Article, originating from the distinctive implications of impaired loan portfolios’ securitisations, focuses on the contractual architecture of the Schemes and the roles of major contracting parties (originating credit institution, Issuer, Noteholders, Servicer, State, Rating Agency etc.). Funding of the portfolio acquisition is discussed from both legal and financial perspectives, revealing the important differences of securities tranches (senior, mezzanine, junior notes), their economic function and appeal to investors. Designated State involvement is depicted with emphasis on the legal nature and conditions of the offered “first-demand” guarantee, including its relevant remuneration. From the EU state-aid perspective, Schemes are assessed as aid-free measures, consistent with potential private operators’ commercial activity under normal market conditions. Such a conclusion is drawn after appraisal of model securitisation’s voluntary nature, risk allocation structure, a model-based approach for the calculation of State guarantee fee (factoring appropriate risk premia with adjusted benchmarking), and additional mechanisms to control and mitigate State’s risk. Implementation of Schemes is advocated, on the condition that bank executives and board members comply with detailed organizational and procedural requirements of EU banking regulation, to ensure prudent risk management and financial stability. Competence of the Board and pursuit of corporate best interests are being challenged in cases of largest NPL securitisations, involving substantial bank assets which may provoke ample one-off accounting losses or even risk-weighted capital depletion. Sound business judgment is associated with an objective evaluation of existing NPL resolution alternative options, careful measurement of medium-to-long-term benefits of the cornerstone securitisation transaction along with its imminent consequences, risks, and inherently limited accessibility of the State guarantee regime. Due fulfillment of bank directors and executives’ obligations extends to the application of a coherent methodology in the preparation, structuring and execution of securitisations. They should apply a transparent and efficient investor-selection procedure, and employ internal resources and specialist financial and legal advisors to obtain expert advice on best calibration of securitisation particulars, fair and reasonable terms of the transaction, and to maximize total divestment proceeds. Legal agreements and related capital implications should be carefully and timely consulted with the Authorities, to ensure securitisation significant risk transfer recognition and avoid its potential adverse unwinding. Overall, transaction losses must prove proportionate to the deleverage benefits for the credit institution itself and the enhancement of financial stability. In those respects, the Article contributes to the evaluation of such newly established EU public policy measure for NPL resolution, particularly from the involved bank corporate and market participants’ perspective, along with its technical roadmap for due implementation.

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.

How effective are sovereign bond-backed securities as a spillover prevention device?

Brunnermeier et al. (2017) propose the introduction of sovereign bond-backed securities (SBBS) in the euro area. It and other papers address how the securitisation would insulate senior security holders from actual default-related losses. This article generalises the assessment by using the VAR-based Diebold & Yilmaz (2012) spillover index methodology to assess potential attenuation of the spillover of shocks in holding-period returns across asset markets from the introduction of SBBS. This is made possible by employing SBBS yields estimated from historical euro area member state sovereign bond yields using Monte Carlo methods, as described in Schönbucher (2003). The econometric results show that (i) SBBS tranching protects senior SBBS holders by reducing the spillover of shocks from the higher-risk peripheral member states to it; (ii) spillovers from high risk sovereigns to a weighted portfolio are much higher than those to the senior SBBS; (iii) a smaller junior SBBS tranche reduces spillover from it to the senior SBBS; and (iv) rolling window analysis indicates that the spillover of shocks from the junior tranche to the senior tranche declines during a period of financial stress.

Does skin-in-the-game affect security performance?

This paper documents that complex financial innovations like collateralized debt obligations (CDOs) enabled informed parties in the commercial mortgage-backed securitization pipeline to reduce their skin-in-the-game in a way not observable to other market participants. This reduction in first-loss security retention significantly impacted the probability that more senior tranches ultimately defaulted. We show that this performance is entirely driven by the amount of first-loss sold to (affiliated) CDOs within 12 months of the commercial mortgage-backed securities (CMBS) deal. Our result is robust to using the differential access of first-loss investors to CDO funding as an instrument to identify exogenous variations in the retention of first-loss securities.

Creating a Euro Area Safe Asset without Mutualizing Risk (Much)

This paper explains and evaluates three proposals to create for the euro area based on bonds, in which risk is limited through diversification and some form of seniority. These assets would be held by banks and other financial institutions, replacing concentrated exposures to their own sovereigns. The paper focuses on three ideas: (1) to create multitranche sovereign bond-backed securities (SBBS), of which the senior tranche would constitute a safe asset; (2) to create a senior, publicly owned financial intermediary that would issue a bond backed by a diversified portfolio of loans (E-bonds); and (3) to issue bonds in several tranches and induce banks to hold a diversified pool of senior bonds (multitranche national bond issuance). Public attention (including public criticism) has so far focused on the first idea; the other two have not yet been seriously debated. We find that none of the competing proposals entirely dominates the others. SBBS do not deserve most of the criticism to which they have been subjected. At the same time, E-bonds and multitranche national bond issuance have several interesting features -- including inducing fiscal discipline -- and warrant further exploration.

Do Rare Events Explain CDX Tranche Spreads?

ABSTRACTWe investigate whether a model with time‐varying probability of economic disaster can explain prices of collateralized debt obligations. We focus on senior tranches of the CDX, an index of credit default swaps on investment grade firms. These assets do not incur losses until a large fraction of previously stable firms default, and thus are deep out‐of‐the money put options on the overall economy. When calibrated to consumption data and to the equity premium, the model explains the spreads on CDX tranches prior to and during the 2008 to 2009 crisis.

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.

UK regulation of term securitization following a hard Brexit

The myriad asset classes and structures comprising the modern term securitization market (as opposed to bank-sponsored asset-backed commercial paper conduits) are all more or less complex variations on one theme: overcollateralized bonds. The bonds are typically issued on the credit of a segregated pool of financial collateral, not the credit of an operating company. Even though securitization documentation is more complex than that found in a typical corporate bond issue, securitization transactions are simpler and, arguably, more ‘scientific’ credits. That is because the underlying credit analysis is based on the aggregation of many small, broadly homogeneous credits or pools of credits that lend themselves to a quantitative credit analysis. The bonds usually are issued in tranches of different priorities, with the most senior tranche typically assigned a top, or AAA/Aaa, credit rating. Thus, a top-rated residential mortgage-backed security, or RMBS, with a face value of, say, 80 might be collateralized by residential mortgages with a principal value of 100. The structuring exercise makes possible funding at rates and maturities not otherwise obtainable in the fixed income market. For convenience, the rubric ABS, or asset-backed securities will also be taken to include RMBS and commercial mortgage backed securities, or CMBS.1

No Economic Catastrophe Bonds

The Financial Crisis of 2008 did much to discredit the idea of securitization. A recent argument has arisen concerning the idea that a senior tranche of a CDO should be treated as a security whose only risk exposure is to a true economic catastrophe, since anything less would be absorbed by the lower seniority tranches. This means that loss given default would be very large and also very systematic, so the highest rated tranches should be priced to pay larger risk premia than comparably rated single name bonds. Blochlinger argues that this line of reasoning is wrong in theory, and empirically, observed yield spreads in the market do not support it either. Not only do the AAA tranches default only under the same extreme conditions as government bonds do, but they also benefit from the diversification within the CDO pool. The article demonstrates that this should make the most senior CDO tranches safer than (less diversified) single name bonds of the same rating. A key point in the proof is to recognize that, within the most senior tranche, the effect of diversification in the CDO pool is different for the average dollar of principal value than for the marginal dollar in that tranche (i.e., at the attachment point). Diversification in the pool increases the average value of the senior-most tranche, even though it lowers the value of the marginal dollar.

Second Mortgages: Valuation and Implications for the Performance of Structured Financial Products

AbstractWe provide an analytic valuation framework to value second lien mortgages and first lien mortgages when homeowners can take out a second lien. We use the framework to value mortgage‐backed securities (MBS) and, in particular, quantify the greater risk associated with MBS backed by first liens that have “silent seconds.” Rating MBS without accounting for homeowners' equity extraction option results in much higher ratings than warranted by expected loss. While in our benchmark calibration, the senior tranche rating should be A1 rather than , the big losers from the equity extraction option are the mezzanine tranches that are nearly wiped out.