Senior-Subordinated Financial Structures
Senior-subordinated structures are referred to as self-insuring structures because they rely on internally generated credit support to protect the investor from losses. Typically, senior-subordinated bonds employ a combination of excess spread, overcollateralization and subordination. Losses are absorbed in reverse priority through the capital structure, first by excess spread, then overcollateralization (OC) and finally via the principal writedown of the subordinated bonds.
As mentioned previously, collateral may be either all fixed or adjustable rate or consist of both fixed and adjustable rate. Credit enhancement structures may be designed to accommodate the different collateral groups. These structures are referred to as I-, H-, or Y-structures.
Type I credit enhancement structures accommodate a single collateral group of either fixed rate, adjustable rate, or mixed loan types.
Both the H and Y credit enhancement structures may be used with multiple collateral groups. The H-structure allows two collateral groups and two distinct subordinated bond groups.
The H-structure can be thought of as two distinct transactions, except that excess interest may be shared between collateral groups to maintain target OC levels and cross coverage of subordinate bonds for triple-A support. Because excess interest is shared between groups, the Hstructure is said to be cross collateralized.
For example, if Group 2’s excess interest is insufficient to cover losses and maintain target OC levels and Group 1 has sufficient excess interest to cover its losses and maintain excess interest, then Group 1’s excess interest may be used to bring Group 2’s OC to the target level.
The Y-structure also allows two distinct collateral groups. However, unlike the H-structure, the Y-structure employs a single subordination group to support both the Group 1 and the Group 2 senior tranches.