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

PRIVATE LABEL CREDIT ENHANCEMENT

The first step in structuring the credit enhancement for a private label deal is to split the face value of the loans into senior and subordinated interests. The senior bonds have higher priority with respect to both the receipt of interest and principal and the allocation of realized losses, and are generally created with enough subordination to be rated AAA by the credit rating agencies. In most cases, the subordinate interests are subdivided (or tranched) into a series of bonds that decline sequentially in priority. The subordinate classes normally range from AA in rating to an unrated first-loss piece. These securities are often referenced as the six-pack , since there are six broad rating grades generally issued by the rating agencies. In the investment-grade category, bonds range from AA to BBB; noninvestment grade ratings decline from BB to the unrated first-loss piece. The structure (or “splits”) of a hypothetical deal is shown in panels A and B of Exhibit 8.1, while a schematic detailing how and losses are allocated within the structure is contained in Exhibit 8.2.

Internal credit enhancement requires two complimentary mechanisms. The cash flows for deals are allocated through the mechanism of a waterfall, which dictates the allocation of principal and interest payments to tranches with different degrees of seniority. At the same time, the allocation of realized losses is also governed by a separate prioritization schedule, with the ...