Structured Products
The logic of securitization
Structured products pool cash flows - mortgages, auto loans, credit cards, corporate loans - and issue claims with different seniority. Tranching reallocates credit risk: senior tranches absorb losses last, mezzanine next, equity first. Credit enhancement comes from subordination, overcollateralization, excess spread, and third-party insurance. Learn the waterfall and how losses flow upward from the equity tranche.
Prepayment and extension
Mortgage-backed securities add prepayment risk. Falling rates encourage refinancing, shortening the security's life and capping upside - negative convexity. Rising rates slow prepayments, extending duration - extension risk. PAC tranches offer prepayment protection funded by a companion tranche.
Non-mortgage ABS and CDOs
Know collateral types and the difference between cash and synthetic structures. In CDOs, default correlation drives tranche risk: low correlation favors the equity tranche, while high correlation threatens the senior tranche.
Traps
- Calling senior tranches safe. They are lower-risk, not risk-free; correlation shocks can reach them.
- Mixing up prepayment (rates fall) and extension (rates rise).
- Forgetting that subordination protects only up to its stated size.
- Ignoring servicer quality and the credit profile of the collateral pool.
Worked rule of thumb
A $100m pool has 20% subordination. The senior tranche takes no loss until cumulative pool losses exceed $20m. If expected losses are 8% ($8m), the senior tranche retains a 12-point cushion. Always express protection as a percentage of the pool, not of the tranche.