Background
Leveraged super senior transactions provide protection on a super senior tranche. The structures are often characterized by attachment points that significantly exceed the level of losses consistent with an AAA rating. The risk that portfolio credit losses will exceed the attachment points is therefore remote for a super senior tranche. Owing to their low credit risk, super senior tranches offer potential protection sellers a low risk premium when considered on an unleveraged basis. Furthermore, super senior notional--as a percentage of collateralized debt obligation liabilities--is quite large. Hence only investors such as monolines with big balance sheets could afford to provide super senior protection. This method worked very well for corporate CDOs, collateralized loan obligations and individual structured finance securities; however, it did not work that well for asset-backed security CDOs, as monolines already had exposure to individual ABS.
This forced dealers to look for new market participants to lay off the super senior risk. For other participants, the main hurdles in the traditional way of providing super senior protection were the low returns of the tranches and large balance sheet requirements. Adding leverage to the product made it possible to achieve a higher return on the cash invested, as well as limit the risk to only the cash invested, thus avoiding the need for a large balance sheet. This encouraged other participants like conduits and hedge funds to provide protection to the dealers in the form of leveraged super senior notes.
Dealer Motivation
The dealer's correlation desk is seeking to buy protection on a hypothetical super senior portion of a reference portfolio. The investors, such as hedge funds or conduits, are willing to sell protection but they have limited capital and are seeking higher returns than those provided by the plain vanilla super senior tranche. Hence, these investors sell protection on a leveraged basis in the form of leveraged super senior notes. The return on the notes is slightly less than the leverage multiplied by the spread on the super senior tranche, the difference being the dealer's profit.
Corporate Vs. ABS Leveraged Super Senior
ABS are very different from corporate assets. First, ABS notional values can amortize, whereas corporate assets typically have bullet maturities. Secondly, ABS have a legal finite maturity. Corporate assets also have finite maturity, but corporations themselves do not, as these are operating entities. The rating of a corporate asset is tied to the rating of the corporate entity and does not take into account the maturity of the corporate asset. Lastly, ABS are much more likely to suffer writedowns rather than simply default, whereas a corporate credit event is more explicit.
These differences in collateral characteristics introduce unique risks for ABS LSS.
1) Extension Risk
This risk arises in ABS as their notional values can amortize. Early prepayments are beneficial, but late prepayments can have an adverse effect. For example, consider residential mortgage backed securities, where junior tranches are more susceptible to extension risk than the senior tranches. In a portfolio of mortgage loans, generally better credits pay off, and only weaker loans extend. Hence, last dollar outstanding in a junior RMBS has more than the average risk. This risk can be mitigated by structural features, such as market value overcollateralization triggers, which give credit for deleveraging in the later part of the transaction.
2) Marginal Ratings Migration
The ratings migration profile of ABS is very different from that of corporate assets because ABS have a limited life. Due to this time decay, ratings of performing ABS are likely to be upgraded as they get closer to maturity. Conversely, ratings of poorly performing ABS are likely to be downgraded at an accelerated pace, closer to maturity. This can also be explained in terms of marginal ratings migration. The marginal ratings migration is much quicker in the last year than in the first year; hence, ratings may diverge as the ABS get closer to maturity.
3) Writedown
ABS suffer writedowns at various times before actually defaulting. This is quite different from corporate assets that just default at a given point in time when the corporate entity defaults. Hence, severity or loss given default may be more difficult to measure for ABS than for the corporate assets. So far, this has not been a big issue, as most of the risk in currently rated leveraged super senior transactions is spread risk rather than loss risk.
4) Ratings Migration Dependent on ABS Type
For corporate leveraged super senior, Derivative Fitch has one migration table for all corporate sectors. It can be argued that, in terms of migration, ABS types are more diverse than corporate sectors. Within ABS, certain sectors may suffer more credit downgrades than other ABS. Hence investors should be aware of the migration profile of their portfolios.
Modeling
Modeling the risk in leveraged super senior essentially involves modeling the probability that triggers will be hit. Since most of the ABS leveraged super senior transactions use spread-loss triggers, this section describes modeling issues related to using such triggers. The risks in ABS leveraged super senior transactions arise from spread widening, ratings downgrades, and writedown.
Spread Widening
The spread risk can be divided into the following components:
1) Market movements within a rating category.
2) Spread increase due to ratings downgrades.
3) Correlation with other ABS assets.
Ratings Downgrades
The risk of ratings downgrades is captured using the ratings migration table.
Writedown
As in modeling traditional ABS CDOs, leveraged super senior modeling assumes that these ABS simply default, and writedown is derived from the recovery assumptions used in the agency's model for collateralized debt obligations. In a transaction this risk can be mitigated, from the investor's perspective, by forcibly defaulting an asset whose spread has increased beyond a certain threshold level. This is done only for the purpose of the trigger calculation and the effect is to delay hitting the trigger. If and when the trigger is hit, the mark-to-market of the super senior tranche properly takes into account whether the asset had actually defaulted or not.
Triggers
Triggers assure the protection buyer that the funded amount, or the leveraged super senior notional, will be sufficient to cover the fall in value of the protected amount, i.e. the super senior mark-to-market value.
There are several types of unwind triggers. These can be based either on the reference portfolio or on the super senior tranche itself. So far, the market has seen the following triggers based on the reference portfolio:
1) Pure loss trigger;
2) Weighted average rating factor, or WARF, trigger;
3) Spread-loss trigger; and
4) Market value overcollateralization trigger.
Pure Loss Trigger
The pure loss trigger is the simplest trigger type, and it is based on the losses in the portfolio. From the perspective of the protection buyer, this trigger provides the least amount of protection, as it looks only at past losses but does not take into account any possible increase in future losses implied from ratings deterioration or spread widening.
Weighted Average Rating Factor Trigger
This trigger incorporates credit migration. It provides better protection than a pure loss trigger as it takes into account a possible increase in future losses implied by the ratings migration.
Spread-Loss Trigger
The spread loss trigger is based on both spread widening and losses in the portfolio. The spread widening is measured by the change in weighted-average spread of the portfolio. This trigger provides a reasonable level of protection, as it incorporates both the portfolio losses and any possible increase in future losses by the weighted-average spread widening.
Market Value Overcollateralization Trigger
This trigger is based on the mark-to-market of the reference portfolio. Market value overcollateralization is defined as the reference portfolio market value divided by the super senior notional. This trigger is very similar to the spread loss trigger but provides better protection since market risk is measured more precisely. It also takes into account amortization of the portfolio and subsequent deleveraging.
Super Senior Mark-To-Market Trigger
This trigger is based on the mark-to-market of the super senior tranche itself. Since the super senior market is not transparent (until recently, only monolines were providing super senior protection), the mark-to-market on the super senior tranche is not readily available. Hence, triggers are defined using mark-to-model. This trigger, as compared to other available triggers, provides the maximum protection to the protection buyer. Using a model would be fine if there were a standard model, but each arranger has its own model and may not be willing to give details on the model. Investors--protection sellers--may not be very comfortable with this because the lack of transparency makes it very difficult to determine when the trigger will be hit.
Besides triggers, the investor's option to deleverage is extremely important in leveraged super senior. The investor may not suffer a loss even if a trigger is hit. This is because investors can avoid triggering an unwind event by increasing the funded amount, and hence, deleveraging the transaction. The investor thus avoids realizing a mark-to-market loss, which may, for example, be attractive in situations of temporary high spread volatility. Deleveraging, however, also reduces the future returns on leveraged super senior.
This week's Learning Curve was written by Raman Kalraand Richard Hrvatin, structured credit analysts at Derivative Fitch in New York.
