Case 013Structured finance and securitisationCore
A vehicle loan pool is securitised into a senior tranche, a subordinated tranche and cash collateral. How would you evaluate the senior tranche's credit risk?
1The situation
Ekanvi Motor Finance sells a Rs 500 crore pool of commercial vehicle loans to a trust. The trust issues a senior tranche of 85% of the pool and a subordinated tranche of 10%, and Ekanvi provides cash collateral of 5% that absorbs losses first. Principal collected is paid to the senior tranche first.
Ekanvi's historical data suggests an expected lifetime loss on the pool of 3%. The rating team's severe stress, drawn from the worst vintage in a freight downturn and then increased, is a lifetime loss of 12%. Ignore excess interest for the first pass.
2Your task
What credit enhancement does the senior tranche have, how many times does it cover expected and stressed losses, and what else would you examine?
Quick check
In the 12% stress, who absorbs the Rs 60 crore of losses?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
The senior tranche has 15% credit enhancement, Rs 75 crore beneath it, covering the 3% expected loss 5 times and the 12% stress 1.25 times. In the stress, the cash collateral is used up and the subordinated tranche loses 70%, but the senior tranche is untouched. That is strong on paper; the rest of the evaluation is the servicer, the legal sale and how losses arrive over time.
Step 1How does tranching protect the senior investor?
Picture a building where rain leaks in through the roof and water fills the basement first. The top floor stays dry until the basement and the ground floor are full. Pool losses fill the capital structure from the bottom, so the senior tranche is hit only after every layer beneath it is used up. The size of those layers, as a share of the pool, is the senior tranche's credit enhancementThe loss a pool can suffer before a tranche loses its first rupee: the tranches and cash reserves ranking beneath it.: here 10% subordination plus 5% cash collateral, 15% or Rs 75 crore.
Step 2How many times does the cushion cover the losses?
Divide enhancement by loss. 15% over 3% expected loss is 5.0 times; 15% over the 12% stress is 1.25 times. Rating agencies think in these multiples: the higher the rating, the more times enhancement must cover expected loss, and the stress case is built to be the loss the tranche must survive at its rating. In the stress, Rs 60 crore of loss takes all Rs 25 crore of cash collateral and Rs 35 crore of the subordinated tranche, leaving Rs 15 crore of cushion unused.
| Layer | Size, Rs crore | Loss at 3% | Loss at 12% |
|---|---|---|---|
| Cash collateral | 25 | 15 | 25 |
| Subordinated tranche | 50 | 0 | 35 |
| Senior tranche | 425 | 0 | 0 |
| Pool | 500 | 15 | 60 |
Step 3What else would you examine beyond the loss multiples?
Four things, because the multiples rest on them. The pool's loss estimate is only as good as the data and the servicer collecting it. Check the stress against Ekanvi's worst vintages, not its average one, and the pool's concentration by region, vehicle type and borrower. Second, the servicer: if Ekanvi itself gets into trouble, who collects the instalments, and how quickly can a backup take over? Third, the legal side: a true sale of the loans to the trust, and cash collections kept separate from Ekanvi's own accounts so they are not trapped in its insolvency.
Fourth, timing. Senior principal is paid first, so as the pool amortises, the senior tranche shrinks while the layers beneath it stay, and enhancement as a percentage rises. That helps, unless losses come early, before much principal has been repaid. Close with the view: the senior tranche looks well protected on these numbers, and the rating would depend on the servicer and legal checks as much as on the 5 times multiple.
Where candidates lose it
Candidates spread the losses across the tranches in proportion to their size, which gives the senior tranche 85% of every loss. Securitisation exists to do the opposite: losses are taken in order from the bottom.
The second miss is stopping at the multiples. An interviewer at a rating agency wants the servicer, the legal structure and loss timing, because that is where structured deals have actually failed.
What the interviewer asks next
- Excess interest of 4% a year is available to absorb losses first. How does that change your view?
- What stress loss would the senior tranche just survive?
- Why might a subordinated tranche holder want a turbo feature that speeds up senior repayment?
Asked at Moody's, Credit Risk, New York, 2024 (Wall Street Oasis): What is Strucutred finance, how would you evaluate..., credit risks
Company names and figures are illustrative.