Super-senior tranche

[ajsa]

Hi David,

Is the CDO's SPE the CDS protection seller of the unfunded portion of the reference portfolio corresponding to the Super-senior tranche? I am asking because accoring to your sceencast, it seems the protection seller is a different entity.. The Super-senior tranche is one of the CDO tranches, rather than within the reference portfolio, right? Also is it true that the holder (buyer) of the Super-senior tranche indirectly become the protection seller through SPE, because the holder does not pay for Super-senior tranche but receeives CDS payments? In that case, SPE has not risk..

For the regulatory capital calcalation, you said "if left unfunded on balance sheet, assets receive normal risk weight", I wonder what the alternative is? do you mean that if the assets are hedged via CDS, they are not on balance sheet?

Thanks.

 

[David Harper CFA FRM]

Hi asja,

No, not the SPE. Yes, a different entity. The investor in the super senior is/was typically a monoline insurer like AIG. This is exactly where AIG got into trouble: they wrote unfunded credit protection on the super senior tranche. (and they are different than the notes investors) everything I've learned about this, btw, is from Janet Tavokoli.

Funding, again, might be the key perspective. Snapshot below from the synthetic CDO which is partially funded; my graphic is a copy of Culp's, I am not original, except for adding color

See how the portfolio ($100) divides into Funded (left, $15) and Unfunded (super-senior, right, $85)?

The investors purchase the notes issued by the SPE...
(re: our other thread, these are essentially CLNs issued by the SPE)
...but only on $15 out of $100, not the full $100. That is the meaning of partially funded: the SPE only needs to sell (raise funds) from investors notes against the $15.

The $85 is unfunded because, unlike the $15, the investors are not funding credit linked notes on the "upper" $85. The originator may just retain this "safer" piece, or more likely, they went out and hedged it by purchasing protection from a (different) firm like AIG. But unlike the funded 15 (which has collateral because investors paid for their notes), the purchased credit protection on the super senior, being a pure CDS transaction, may not be collateralized (This AM I was reading the ECB on CDS, and they said re AIG "most of its many exposures to European banks were not initially collateralised. In other words, no initial or variation margins were posted for these bespoke CDSs." So, they are saying (something i thought, but had never actually read) that AIG (the super senior protection seller) was not often even holding margain against this protection...)

...so in a way, you can mentally remove the super senior transaction and think of the SPE as the conduit between the "lower" funded tranch ($15) and the investors buying CLN against only that funded tranche. To recast in CLN terms, if the credit risk of the entire $100 is transferred away from the originator, here $15 is purchased by CLN buyers and $85 is promised (exposed to) by CDS sellers who are different.

Also: if the SPE does write the credit protection on the $85, and that is funded by investors, then we are back to the fully-funded synthetic CDO. Super-senior implies partially funded because the SS was created to justify the existence of a funded AAA note (i.e., the top of the funded $15) ... if it were not "invented" the top of the $15 could not be called senior (i highly recommend Tavakoli for the gory details!)

...let me know if that addresses, as i am still learning much in this area myself...David

http://learn.bionicturtle.com/images/forum/0912_scdo.png

 

[ajsa]

Hi David,

Thank you! It makes a lot of sense.

I was puzzled because I read the following article (see page 6). It gave me the feeling that the super senior is one of the CDO tranches..
http://www.adelsonandjacob.com/pubs/CDOs_in_Plain_English.pdf
"The "super senior" tranche in the example above is unfunded. The holder of that tranche makes no
principal investment but receives payments for assuming the risk that losses on the underlying
portfolio exceed 15% ($150 million). If they do, the holder of the super senior tranche would be
required to pay the CDO issuer the amount of losses above that level. The holder of the super senior
tranche is in a position similar to an insurance company that writes an $850 million insurance policy
with a $150 million deductible. The holder of the super senior tranche should feel pretty safe
because the likelihood that losses will exceed $150 million is quite small. This is evident from the
triple-A ratings on the Class A tranche, which is subordinate to the super senior tranche.

Apart from the super senior tranche, the other tranches of the synthetic CDO are funded. That is, the
holders of those tranches invest the principal amount of their tranches. They receive interest
payments to compensate them both for the risk that they take and for the time value of their invested
principal."

Thanks.

 

[David Harper CFA FRM]

Hi asja,

Thanks, that looks like a helpful document! That seems to be in agreement-yes? Clearly the SS is a CDO tranche...but I don't think the SPE is needed for the SS ...I *think* the SPE exists largely to be the conduit for the funded portion (i.e., the investors buying CLNs and the SPE using those funds as collateral for the CDS it writes)...I thought you were asking if the SPE was the CDS counterparty (i.e., the protection seller) on the unfunded piece like it is on the funded piece, and I *think* the answer is 'no.' (i.e., that's a contract between the originator/sponsor and the swap counterpart who holds the risk)...David

 

[ajsa]

Hi David,

That article led me think that SPE and the underwriter of the CDO needed to set up SS, and be the conduit for SS... It seems that is wrong..

thanks.