Mortgage-Backed Securities: Products, Structuring, and Analytical Techniques

TIME TRANCHING

The most fundamental form of structuring is time tranching, which creates a series of bonds with different average lives and durations from either a collateral group or a preexisting parent bond. Basically, principal cash flows are allocated sequentially to a series of tranches. All principal payments are directed to the shortest maturity bond until it is fully amortized. Principal is then directed to the second bond until it is fully amortized, and so on until the principal source is fully amortized. A simple representation of the concept is shown in panels A and B of Exhibit 6.1, where pass-throughs are structured into short, intermediate, and long classes. Note that the collateral does not have to be pass-throughs; as noted above, other tranche types can be created and subsequently time-tranched.

In structuring a set of sequentials, the first step involves the specification of the number of sequential tranches and the associated average lives. One bond (typically the long or “last cash flow” bond) acts as a “plug” that receives cash flows after the other bonds receive the principal allocation necessary to achieve their average life target. Using the prepayment pricing speed, the beginning and ending date are calculated such that the average life target of each tranche is met, with the remain-ing cash flows directed to the plug bond. In some cases, other parameters may also be targeted in the structuring exercise. For example, sequential tranches can be structured ...