SPV / CDO Tranches - factors that are taken into consideration for risk rating?

CFA General
#1

Hi all

I wonder if there are any SPV/CDO experts out there who wouldn’t mind shedding some light on the below :slight_smile:

Are the tranches in a CDO (Senior, Mezzanine, and Equity) built from the same underlying pool of asset-backed securities (i.e. RMBS)?

I am asking this question because I am trying to understand what differentiates the senior tranche from the equity tranche for example.

  1. Is it the underlying assets, i.e. senior tranche is based on highly rated RMBS and Equity tranche is based on low rated RMBS? And, or
  2. Is it based on only the priority of cash flows, i.e. the senior tranche is paid first and therefore will get a higher rating

Ultimately, what does Moody’s take into account when rating a selection of CDO Notes?

#2

You can have the same underlying asset on each pool. You are correct that priority of cash flow and which tranches take the hit (in cash of default) can be one of the factor determines the seniority of the tranches. Other factors can be quality of the underlying assets, level of collateral protections, side-letters

#3

Thanks ws

So the underlying assets can differ per tranche?

#4

Yes, each tranche can have different asset (different risk rating), or same asset but different cash flow treatment.

#5

Structured finance analyst here…

The pool is a homogenous cashflow asset. It’s unlikely for individual loans / assets split up and allocated to different tranches. I’ve not heard of it before.

The rating of each tranche is based on the credit enhancement; i.e., what level of subordination sit below you in the cap stack. The AAA may account for 70% of the stack, meaning you have 30% CE, the equity has 0 CE and is therefore first loss.

The cap stack tranching i.e. how much is AAA, AA, A, BBB, BB, NR is based on assumed default rate, loss severity (recovery), scheduled and unscheduled repayments.

#6

Thank you!! Very helpful! :slight_smile: