Overview
Most structured securities follow a common set of steps when originated.
- Porfolio Selection : When a bank structures a security, it usually has a target for the credit rating that it wishes the security to have. In fact, it will work with the credit rating agencies to achieve the desired rating. The primary way to achieve a target credit rating is by altering the mix and credit worthiness of the assets placed in the structure.
-
Security Structure
In addition to choosing the assets to back a given security, the issuer must determine the security structure. That is,
the cash flows generated by the underlying pool of assets are routed to different investing groups, called tranches,
through a pre-defined algorithm. For instance, one structure could route all princial payments to one tranche first, and then
principal is paid to a second tranche after the first tranche has been paid off.
In this way, each tranche of a structured security can have different credit profiles, as well as maturities and other characteristics. The tranches can be structured in any way.
From a legal perspective, each tranche is just like a bond issued by a company (although with a more complicated payment structure) - Credit Enhancement If the estimated credit rating of a given structure is not as high as the issuer desires, they can add a credit enhancement to the structure. A credit enhancement is some sort of guarantee to cover a certain amount of losses in the structure. This can be a guarantee from the issuer of the security, or from some other third party who is paid for the guarantee. Additionally, the issuer can overcollaterize the security, in which case, excess cash flows revert back to the issuer.