Pay-through Structures: Prepayment Tranching vs. Credit Tranching

Asset-backed securities can be issued as pass-through or pay-through securities.

ABS Pass-through Structure: In a pass-through structure, the cash flows generated by the asset pool are passed through to investors, less a servicing fee, on a pro-rata basis (this is the same general structure as that of the mortgage pass through securities previously discussed).

ABS Pay-through Structure: This is similar to a collateralized mortgage obligation, where tranches with different characteristics are paid out differently based on their risk-return profile.

The tranching within a pay-through structure can be of two types: credit tranching and prepayment tranching. Tranching is a type of internal credit enhancement.

Two Types of Pay-through Structures

  • Credit Tranching: This is the most common form of tranching and creates a senior/subordinate structure. A typical senior/subordinate structure consists of several tranches varing in their seniority. Cash flows are divided among senior and subordinated tranches. The senior tranches are the first ones to be paid the principal from the available cash flow. Subordinate tranches are the first to absorb default losses, so the subordinate tranches provide protection to the senior tranches. This protection structure is also called waterfall structure. The structure redistributes credit risk and is considered a credit enhancement.
  • Prepayment Tranching: Cash flows are divided among tranches that have different principal payment parameters.  These tranches can be sequential pay or planned amortization class, for example.  This structure redistributes prepayment risk. The senior tranche is divided into tranches with different exposure to prepayment risk. In this way, senior tranches can be transferred among the senior tranches.

You may find these interesting

Inflation vs Deflation?
Recently there has been a lot of talk about whether US economy is headed towards deflationary enviro...
Overview of Credit Risk
Over the past few years, financial institutions have faced severe difficulties due to various reason...
Equity Vs. Debt Financing
Choosing between equity and debt is one of the most common decision made by business managers while ...
Finance Train Premium
Accelerate your finance career with cutting-edge data skills.
Join Finance Train Premium for unlimited access to a growing library of ebooks, projects and code examples covering financial modeling, data analysis, data science, machine learning, algorithmic trading strategies, and more applied to real-world finance scenarios.
I WANT TO JOIN
JOIN 30,000 DATA PROFESSIONALS

Free Guides - Getting Started with R and Python

Enter your name and email address below and we will email you the guides for R programming and Python.

Saylient AI Logo

Accelerate your finance career with cutting-edge data skills.

Join Finance Train Premium for unlimited access to a growing library of ebooks, projects and code examples covering financial modeling, data analysis, data science, machine learning, algorithmic trading strategies, and more applied to real-world finance scenarios.