Overview
Structured finance is the financial engineering process of transforming illiquid, heterogeneous cash flows into tradable securities through tranching, credit enhancement, and stochastic modeling.
Securitization Fundamentals
- Special Purpose Vehicle (SPV): Ensures bankruptcy remoteness and true sale, isolating collateral from originator credit risk.
- Tranching & Waterfall: Cash flows are distributed sequentially (Senior to Subordinated). Senior tranches receive lower yield but highest priority. Equity/Residual absorbs first losses.
- Credit Enhancement:
- Subordination: Junior tranches absorb losses before senior tranches are impaired.
- Overcollateralization: Asset pool par value exceeds securities par value.
- Excess Spread: Difference between collateral WAC and securities WAC, trapped in reserves.
RMBS (Residential Mortgage-Backed Securities)
- Agency RMBS: Guaranteed by GSEs (Fannie, Freddie, Ginnie). Zero credit risk but high prepayment risk.
- Non-Agency RMBS: Private-label securities requiring credit enhancement.
- Prepayment Modeling:
- PSA Curve: Benchmark for measuring prepayment speeds (CPR/SMM).
- Refinancing S-Curve: Prepayments accelerate rapidly when rates fall 50-100 bps below WAC, but flatten out due to burnout effect.
CMBS (Commercial Mortgage-Backed Securities)
- Underwriting: Non-recourse loans underwritten based on property cash flow (DSCR) and equity cushion (LTV).
- Prepayment Protection: Unlike RMBS, CMBS have structural barriers to refinancing:
- Lockout Period: Absolute prohibition on prepayment.
- Yield Maintenance: PV penalty for lost interest.
- Defeasance: Substituting collateral with Treasury securities.
- CMBS behave more like corporate bonds due to stable duration and lack of negative convexity.
ABS (Asset-Backed Securities)
- Auto Loans: Short duration (3-5 years), predictable cash flows, minimal prepayments.
- Credit Cards: Master trust structure with a revolving period where new receivables replace paid-off balances.
- Student Loans: Long duration (10-20 years), high prepayment variability.
Monte Carlo Valuation Framework
Structured finance securities with embedded options require path-dependent pricing:
- Interest Rate Simulation: Generates paths using short-rate models (Vasicek/CIR/Hull-White).
- Prepayment & Default Model: Estimates prepayments and defaults dynamically for each path.
- Cash Flow Engine: Routes payments through the deal-specific structural waterfall.
- Option-Adjusted Spread (OAS): The pure credit and liquidity premium after removing interest rate risk and embedded options. RMBS exhibit negative convexity (prices rise less when rates fall than they fall when rates rise).