In the structuring illustrations in the next two chapters, we use residential mortgage loans as a representative asset. It is helpful to classify securitizations in terms of the borrower’s credit. The market can be broadly divided into prime borrowers and subprime borrowers. Prime borrowers are viewed as having high credit quality because they have strong employment and credit histories, income sufficient to pay the loans without compromising their creditworthiness, and substantial equity in the underlying property. The loans made to such individuals are broadly classified as prime loans, and have historically experienced low incidences of delinquency and default. In contrast, loans to borrowers of lower credit quality that are more likely to experience significantly higher levels of default are classified as subprime loans and the borrowers are referred to as subprime borrowers. Subprime loan underwriting typically relies on nontraditional measures to assess the borrower’s credit risk, as these borrowers often have lower income levels, fewer assets, and blemished credit histories. After issuance, these loans must also be serviced by special units designed to closely monitor the payments of subprime borrowers. In the event that subprime borrowers become delinquent, the servicers move immediately to either assist the borrowers in becoming current or mitigate the potential for losses resulting from loan defaults.

The reason why this distinction between deals backed by prime and subprime borrowers is important is because of the credit enhancement that is required. The high credit quality of the loans in the prime sector makes the credit enhancement fairly straightforward. For example, residential mortgage loans that satisfy the underwriting standards of Ginnie Mae, Fannie Mae, and Freddie Mac are viewed as prime loans and the resulting securitizations are referred to as agency deals.⁹ Credit enhancement in agency deals is obtained through the mechanism of the guaranty provided by the agency issuing the deal. This guaranty is paid for by the sponsor of the deal in the form of a guaranty fee. In the case of the securitization of the rest of the prime loan universe, the credit enhancement mechanism employed is the subordinated structure wherein there are bond classes that have different degrees of priority with respect to both cash inflows and loss write-offs. While structurers have some flexibility with respect to creating the most efficient credit enhancement in prime deals, determination of the amount of credit enhancement is often dictated by the rating agencies, and the subordination structures are fairly straightforward. What has the greatest impact on the execution of the deal is how the senior bonds are structured. Because of pooling of a large number of diversified loans, the size of the nonsenior bond classes is small in terms of par value relative to the senior bond classes. (They are zero in the case of agency deals.) The rules for the allocation of losses are fairly straightforward. (In agency deals there are no loss allocation rules.) Often, the securitizer seeks a triple-A rating for the most senior bond class in the structure.

Now let us look at the securitization of subprime loans. As with prime loans that have been securitized that are not agency deals, these securitizations will have bond classes with a range of cash flow priorities and ratings. However, compared to the securitization of prime loans, the securitization of subprime loans requires a larger amount of credit enhancement in order to create senior bond classes. This fact affects what drives the cost efficiency of prime versus subprime deals. While the driving force in prime deals in order to create efficient structures is the carving up of the senior bonds, in subprime deals it is structuring the transaction so as to produce efficient credit enhancement with the overriding goal of protecting the senior bonds in the deal.¹⁰

For this reason, while the structuring approach is similar in terms of creating bond classes with different priorities and ratings, the credit enhancement techniques utilized for securitizing prime loans would be inefficient if applied to subprime loans, particularly if subordination is used as the only form of credit support. There are least two reasons for this. First, the subordinate bond classes would be larger relative to those in the case of prime securitizations. In addition, the incremental interest paid by the borrowers whose loans are being securitized (which typically carry high rates due to their greater credit risk) may be optimally utilized toward providing credit support for the senior bond classes. It is for this reason that in securitizing subprime loans, structurers utilize a combination of the credit enhancement mechanisms that will be described in Chapter 5. The second reason is that in establishing the rules for the allocation of cash flows in the securitization of subprime loans, they must be such that there are more tests designed to safeguard the senior bond classes compared to the securitization of prime loans. We discuss this further when we review the different types of credit enhancement mechanisms in Chapter 5.

Either acting as agents for an originator or as principals, investment bankers will structure a transaction. While it is not unusual in some securitizations to find a transaction with 70 bond classes, the maximization of the number of bond classes is not the objective in structuring. Rather, the sole economic goal of the structurer is to maximize the total proceeds received from the sale of all the bond classes that are backed by the asset pool. (In market parlance, the goal is to obtain best execution.) Or alternatively, for a given funding size, the goal is to attain the lowest weighted average cost. In seeking to obtain the highest prices or the lowest cost, the structurer must take into account market conditions, demand for various structured products, and all the costs of creating such bond classes. For example, in a steep yield curve environment, a structurer will seek to create as much par value of short-term bond classes because the yield that must be offered to sell those bond classes to the market will be less than that for intermediate-term and long-term bond classes.

Maximizing proceeds in an asset securitization can be accomplished by structuring the cash flows in two ways. First, and the purpose of the discussion in the next chapter, carving up a collateral’s cash flows and tranching them so as to create bond classes that better match the specific interest rate risk (i.e., effective duration, effective convexity, and key rate durations) and return profiles or views of different investor clienteles. This type of structuring typically takes place in both agency deals and for the senior bond classes in deals with prime loans. The techniques discussed in the next chapter are employed to alter the return and risk profiles of the senior bond classes in a structure by altering how principal and/or interest are allocated to the bond classes in question. The structurer seeks to produce a combination of bond classes that maximize the proceeds received once all the bond classes are sold.¹¹

The second way to maximize proceeds in an asset securitization is for the investment banker to create more cost-efficient structures, particularly for nonagency deals where the cost of credit enhancement is embedded in the transaction through the mechanism of subordination. Generally, the securitizer in such cases will realize better execution by creating the largest possible amount of senior bonds while simultaneously obtaining the greatest possible proceeds for the resulting nonsenior bond classes (i.e., subordinated bond classes and interests). As it will be explained, the nonsenior bond classes can often be complex, particularly for asset-backed securities deals that utilize the credit enhancement mechanisms of subordination and overcollateralization that will be discussed in Chapter 5.