STRUCTURING AND THE WATERFALL MECHANISM
Differentiating the seniority levels of notes issued means that investors have different priority claims on the cash flows of the SPE, some being "senior" and others being "subordinated" claims. This differentiates the risks across notes issued by the SPE while simultaneously ensuring a protection for the more senior notes. The protection against credit risk of senior investors results from the fact that equity, the most subordinated note issued, and subordinated notes provide a loss protection for more senior notes.
The simplest way to provide a safety cushion for investors that are not willing to suffer from the first losses of the portfolio is to use an oversized pool of assets. The collateralized assets have a higher volume than claims acquired by senior investors. Since only a fraction of the pool suffices to compensate these investors, the over-collateralization of senior notes provides a safety cushion against adverse deviations of the flows generated by the pool. For instance, a pool of assets can generate 100, and only 60 are necessary to compensate senior investors if the subordinated notes compensation is 40% of the total pool cash flow. The risk of loss for these investors materializes only when the actual cash flow goes under 60. The structure pays the flows promised to investors as long as the flows generated by the assets do not decrease by more than 40%. However, in this description, we ignore the loss of value by investors due to changes of market parameters or to a downgrade of notes issued by rating agencies.
Structuring of Notes
The structuring of the transaction consists of defining the amounts of the various notes issued and their risk-return profile. Structuring defines the seniority level and the thickness of each note issued. All subordinated notes to a given senior note absorb losses first. They serves as a safety cushion protecting the senior notes. When cash flows do not suffice to pay the all obligations to all note holders, the deficiencies first hit the subordinated notes. At the lower end of subordination, the risk is highest, since the most subordinated notes concentrate all the risk of the pool of assets. At the upper range of senior notes, the risk is near zero because it is nearly impossible for losses to reach a level such they would hit this upper class notes (Figure 58.3).
The subordination level of a note is defined by two parameters: the thickness of the notes (the size in percentage of total assets funded), and the attachment point. The attachment point defines the size of the subordinated notes ranking below the note. The higher this "safety cushion," the lower the risk of the notes protected by the more subordinated notes.
Agencies rate notes according to their risks. Senior notes can be investment grade because the likelihood that the pool of assets losses exceed the safety cushion provided by the subordinated notes is near zero for the highest grades. When moving down the scale of seniority, the loss franchise provided by the subordinated notes shrinks. The last subordinated note, which is like equity, gets all first losses and has no rating. Either the seller of assets or a third party acting as a "credit enhancer," holds the last tranche. Since the equity tranche bears all the risk of the assets, the spread compensating credit enhancers is high. Since this note is likely to disappear once the losses exceed the amount of the note, this tranche is sometimes called the "zero-equity tranche." Its return depends on how long the equity tranche survives, hence on the timing of defaults of the pool of assets.
FIGURE 58.3 Structuring of notes
FIGURE 58.4 Waterfall of cash flows and of losses
The Waterfalls of Cash Flows and Losses
The structure routes the flows generated by the pool of assets to investors using priority rules based on the seniority level, first to senior notes and last to the "equity" tranche. This is the "waterfall of cash flows." The "waterfall of losses" follows symmetrical paths. They hit the equity tranche first, then the subordinated notes, and finally the senior notes. The first cash flows go to the senior notes. The first losses go to the subordinated notes. Figure 58.4 shows the waterfall of cash flows and losses, with the thickness of arrows measuring the priority level ruling the routing of cash flows or losses to destination.
Structuring through differentiated seniority levels allows issuing several types of securities differing in terms of their risk-return profiles and their maturities. Issuing several classes of structured notes of different seniority levels makes the securities attractive to various populations of investors, over the entire spectrum of risk. High-risk notes are of interest to investors looking for a higher than expected spread in compensation for the added risk. Investors in senior notes benefit from a good rating.
The amortization of notes can be parallel or sequential. Maturities vary across notes, under the sequential amortization scheme, because the payments flow first to senior notes, thereby amortizing them quicker. The concurrent amortization scheme amortizes notes in parallel, but any deficiency of cash flows still hits the subordinated notes first. In all cases, the equity tranche gets fully amortized first.