Is credit tranching different than prepayment tranchning. Are there any other traches that are designed to absorb credit losses or most subordinated tranche absorb losses for both credit and prepayment?
Yes credit tranching is different than prepayment tranching simply in a way that it redistributes credit risk rather than prepayment risk. These are senior and subordinate tranches and are available in ABS securities.
Wouldnt there be an inverse relatinship between creit and prepayment tranches…
I mean credit tranching would allocate more contraction rist to senior tranches and prepayment tranching would alocate less prepayment risk to senior tranches…
Is that right?
@Waldziuchna Thanks for the response. However, my question was does the support which is to absorb prepayment risk can also accept credit risk or do I have to have separate traches for credit than prepayment?
@adq123 There are diffreent types of credit risks. Which one are you referring to? I am not even sure which ones are part of ABS tranching. I don’t know if the other statement makes sense to me or not. I thought contraction and extention risk were primarily because of the prepayment because they either get paid fast or slow. But in case if prepayment, they may not get paid at all.
This post does give you some indication of how it’s done.
http://www.analystforum.com/forums/cfa-forums/cfa-level-ii-forum/91120208
credit tranching is about who suffers the losses (ie people defaulting on their mortgages)
prepayment tranching is about who suffers due to extra prepayments/slower prepayments.
Right so the question is by design, do they design to have both of these losses shared by just one tranche or there are different dedicated tranches for both of these losses.
Acc to me there is only one support tranche which is designed either to absorb credit risk or prepayment risk coz u cant have a win-win situation if u want to protect yourself from contraction risk u have to take up credit risk.
But why can’t two suppport tranches have win-win situation in which one would absorb the credit losses and other one absorb prepayment loss. What is wrong with this?
You could, but my thoughts are that the effects would cancel each other out. You’re basically saying half the borrowers are going to pay early, and half are starting to pay late - I dont think the structure works on a borrower-by-borrower basis. How would the servicer be able to say “this is a prepayment, so send it to the Prepayment support trance, but these guys defaulted on their mortgage, so trance Y shouldn’t get anything”? Everything is aggregated and then distributed. Either way, the support tranches take the hit first.
With a deal like that, the interest is paid out accordingly. ALL of the principal is aggregrated, and if the prepayments are within the collar, each tranche gets paid out accordingly. So Senior 1 gets all of his principal, Senior 2, … on down the line. Any excess goes to the support.
If prepayments are too high, meaning too much principal is paid in, then all of the balance goes to the support tranche. Likewise, if principal payments arent coming in as planned, then the lower tranches don’t get their principal. If there’s no principal to pay out, theres no principal to pay out.