The following article is reprinted from the September/October, 2000 issue
of On the Edge, the Interactive Data Fixed Income Analytics bimonthly newsletter.

HEL Credit Enhancement Techniques

Dan Foley
Executive Vice President

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The Interactive Data Fixed Income Analytics Structured Finance Department adds nearly 1,000 CMO/ABS/CMBS deals to the BondEdge database each year. This involves gathering several categories of data relating to each deal, and translating into our rules-modeling language the prospectus text which describes the deal’s cashflow distribution rules. Especially with ABS deals, these activities often require us to ferret out hard-to-find data, and to cope with dauntingly abstruse prospectus language that may or may not describe truly complicated payment concepts. One good case in point is credit enhancement techniques for HEL deals, where the complexity of data gathering and rules interpretation is substantial. Fortunately, the basic concepts at work are relatively straightforward, and an understanding of their operation should contribute to effective use of these securities in an investment portfolio.

Prepayment Risk vs. Credit Risk
It’s worthwhile to compare HEL structuring to agency CMO structuring. In the latter case, the basic objective is to create tranches with differentiated average lives, corresponding to the investment preferences of targeted investors. Within a particular average life clientele, the significant structuring consideration is the allocation of collateral prepayment uncertainty across investors more or less capable or willing to bear that uncertainty. Although the prepayment uncertainty cannot be reduced in the aggregate, it can be unequally allocated across tranches having nominally similar average lives under a base case prepayment scenario. VADM and PAC bond principal cashflows are relatively unaffected by changes in prepayment speeds, whereas the average lives of support bonds are correspondingly unstable. Artfully structuring a deal results in the market value of the tranches maximally exceeding the cost of the collateral, thereby optimizing the “manufacturing arbitrage” to the issuer from repackaging the collateral cashflows.

Credit risk is not a concern when structuring an agency CMO, because the deal is collateralized by agency passthroughs that are guaranteed as to the payment of interest and principal. So the investor in an agency CMO tranche can count on receiving the full face amount of principal over time, although collateral prepayment uncertainty does introduce uncertainty as to the timing of those payments. This highlights a fundamental difference between prepayment risk and credit risk: prepayment risk is realized as an opportunity cost, in that the investor will be disadvantaged in having too many funds to reinvest in low interest rate environments and a scarcity of reinvestment funds in high interest rate environments. While potentially significant, this is nevertheless different in kind from the credit risk present in HEL deals, which could result in a permanent reduction of as much as 100 percent of invested capital.

Types of Credit Enhancement
When the collateral underlying a deal is itself not free of default risk, e.g. home equity loans, some type of credit enhancement is necessary to obtain investment grade ratings for some or all of the tranches in the deal. External and internal credit enhancement techniques are available, and are often employed in combination. In any case, the basic idea is to provide loss-absorbing mechanisms which stand between collateral losses and certain of the tranches. The credit enhancement intercepts and absorbs losses which otherwise would be assigned to the protected tranches.

External credit enhancement contractually obligates a third party guarantor to bear a designated amount of prospective losses. This may be accomplished via an insurance policy, letter of credit, or the like. In any event, it is a form of protection against losses which must be purchased explicitly, thereby reducing the deal’s net proceeds to the issuer. The involvement of the third party guarantor also complicates the credit analysis of the deal, in that event, risk associated with a possible quality rating downgrade of the guarantor must be considered. The counterpoint to these disadvantages is the fact that a larger fraction of the deal’s tranches can achieve an investment grade rating, compared to deals with internal credit enhancement mechanisms as discussed below.

Excess Interest and Overcollateralization
When the collateral balance exceeds the sum of the tranche balances, the collateral pool can suffer some looses without affecting the tranches. Although an ABS deal may be structured with a starting collateral balance which exceeds the aggregate of the tranche balances, home equity deals are more likely to achieve such an over-collateralized state over time, due to excess interest. When the net WAC of the collateral generates interest in excess of that required to pay tranche coupons, the excess amount is generally used to pay current losses, then to pay down tranches for some period of time or until some “clean-up” target is reached, whereupon any remaining funds are returned to the issuer or to a residual tranche. By virtue of using collateral interest to pay tranche principal, the aggregate tranche balance is reduced below the remaining collateral balance. Realized losses incurred when the deal is in an overcollateralized state can be absorbed to the extent of excess collateral, before impacting the next layer of credit protection (insurance or subordinate tranches).

Internal Credit Enhancement
Internal credit enhancement, or credit tranching, is analogous to structuring techniques which are employed to allocate prepayment risk disproportionately to support tranches in favor of scheduled tranches. Instead of off-loading the risk of credit losses, the risk is retained in the deal, but allocated differentially between subordinated and senior tranches and thereby among investors more and less willing or able to bear the risk. Because no payment is made to a third party guarantor, an internally-credit-enhanced deal is “self-funding.” This may generate larger net proceeds to the issuer, depending upon the market’s appetite for these types of deals. In any event, it avoids introducing the additional complexity of analyzing the credit worthiness of a third-party guarantor.

A natural measure of the amount of credit-loss protection available to a senior tranche is the “subordination level” expressed as the non-senior-tranche fraction of the outstanding collateral balance. The larger this amount, the more insulated the senior tranche is from credit losses. If the collateral balance of a deal is the sum of the senior and sub tranches A and B and any over-collateralization amount OC, we have

A + B + OC = C or A + B = C - OC

and the subordination levels which apply to the senior and sub tranches, expressed as fractions of the collateral balance, are

A_subord = (C – A)/C and B_subord = (C – A – B)/C

The protection available to the subordinated tranche evaluates to zero in the absence of overcollateralization, meaning that the sub tranche is fully exposed to (uninsured) losses in that situation.

Shifting Interest
Two basic ways to shield senior tranches from losses are to pay them off as quickly as possible (so they are out of the picture before losses are experienced), and to pay them down relatively more than the subordinated tranches (to maximize the remaining fraction of the deal which is composed of non-senior tranches and can thereby act as a loss shield for the senior tranches). Both objectives are served by directing principal payments from certain sources disproportionately to the senior tranches for some period of time. This disproportionate allocation of payments is referred to as “shifting interest,” although “shifting participation” would perhaps be a less-confusing term. The degree of inequality in these payments typically starts out at a maximum imbalance in favor of the senior tranches (e.g., 100% for the first 5 years), and then “steps down” as time passes, approaching pro-rata sharing. A shifting interest step-down schedule specifies the percentage of the subordinated tranches’ share that the senior tranches are to receive in addition to their own proportional share. A typical schedule is:

 

In this example, if the senior tranches represent 80% of the deal and the subordinated tranches represent 20% of the deal, instead of allocating principal prepayments in a 80/20 split between the senior and subordinate tranches, 100% of prepayments would be directed to the senior tranche(s) during years 1-5, 70% in year 6 and so on.

Prepayments tend to degrade the average creditworthiness of HEL collateral, as the stronger credits exit loan pool and those less able to refinance are left behind. Consequently, principal prepayments (and excess interest and any default recoveries) are usually paid entirely to the senior tranches for the first few years of the deal’s life, to maximize loss protection during the span of time when defaults are empirically most likely to occur.

Adherence to the shifting interest step-down schedule is subject to achieving and maintaining various targets expressed as balances and/or ratios among the senior and sub tranches and collateral of the deal, as well as requirements that the collateral be performing satisfactorily with respect to loss and delinquency experience to date.

Scheduled amortization of collateral principal, on the other hand, is generally distributed to all tranches (senior and subordinated), in proportion to their remaining balances. Unlike prepayments, a reduction in collateral balance due to scheduled amortization does not diminish the senior tranches’ remaining credit protection. In fact, the opposite applies, since cumulative amortization builds homeowners’ equity, which serves as an increasing incentive to avoid foreclosure.

Summary
Asset-backed deals, in particular HEL deals, are structured to provide forms of credit enhancement that are not required for agency-backed CMO deals. These structural nuances, which are often buried in the prospectus or supporting documents, are critical to reverse-engineering the deals correctly, and are equally important to the investor in understanding the true nature of the credit protection in a deal.