Chapter 20

Structured Credit

If something happens once, it will never happen again. But if something happens twice, it will surely happen a third time.

—Paulo Coelho, The Alchemist

The objective of securitization is to pool securities (debt instruments) to distribute risk and then issue new securities backed by the cash flows from the pool. In principle, all assets can be securitized as long as they have a cash flow; hence, the general reference for securities issued with these pools’ backing as asset-backed securities (ABS). Collateralized debt obligations (CDOs), collateralized mortgage obligations (CMOs), and collateralized loan obligations (CLOs) are all products of securitization that differ mainly by the types of securities forming the pools (credit card debt, car loans, bank debt, mortgages, and so forth) and the manner in which they structure prioritized claims on the pool (called tranches).

Mortgage securitization, for example, involves taking an illiquid asset, mortgages, pooling them and issuing a security backed by the cash flows received on the pool. What distinguishes these from other securities is their inherent prepayment option. Thus, because a mortgage can be paid off at any time, all the cash flows may be received at once. This makes the duration of this asset (and, therefore, its cash flows) a function of factors that influence prepayment behavior. For example, when interest rates fall, prepayments rise as homeowners refinance their mortgages. Therefore, prepayment behavior will influence the duration of bonds issued against the pool and therefore their risk.

Figure 20.1 illustrates the basic elements of structured credit. When banks originate loans, they create new assets on their balance sheets. With these assets comes credit risk and banks shed that risk by removing these assets from their balance sheets by selling pooled loans to special purpose vehicles. The SPV is a trust that is separate from the bank's balance sheet. It creates new securities (bonds), whose risks are prioritized in tranches and which are backed by the cash flows of the pool. Thus, the SPV effectively isolates the credit risk from the balance sheet of the originator of the CDO, shifting that risk to investors in these tranches. An investment in these tranches is the same as buying a bond with a prioritized claim to the pool's cash flows. The bank creates the SPV, which, in turn, designs the structured credit product (CDO, CMO, ABS, and so forth), which shifts the credit risk to investors while the bank continues to collect service fees and commissions.

Figure 20.1 Structured Market Credit