Securitisation

A bank makes thousands of car loans. Each one is small and the bank has to keep money aside against all of them. It would rather have the cash back to lend again.

So it sells them. Not to another bank, but to a company created for this one purpose, which does nothing else and owns nothing else. That company pays for the loans by issuing bonds to investors, and the loan repayments coming in from thousands of drivers pay the bonds.

The bonds are not all the same. They are cut into layers. The top layer is paid first out of whatever arrives; the bottom layer is paid last and absorbs the first losses. Because the bottom layer takes the damage, the top layer is very safe — safer than the bank that made the loans.

That arrangement — who is paid, in what order, out of what arrives — is written into a contract called the waterfall. The waterfall is the actual product. The loans are just what flows through it.

Why the separate company matters

The whole structure exists so that the assets survive the failure of whoever created them. Three things have to be true:

• True sale. The transfer must be a real sale, not a disguised loan — otherwise the assets go back into the originator's insolvency.
• Bankruptcy remoteness. The vehicle must have no other business and restricted powers, so it cannot fail for its own reasons.
• Servicing continuity. Somebody must keep collecting, even if the originator is gone.

Legal opinions are obtained on the first two in every jurisdiction the assets sit in, and a deal that cannot get them does not happen.

The layers of protection, in order

1. Excess spread — the loans pay more interest than the notes do, and the difference absorbs losses first. It disappears quietly, which is why the monthly report matters.
2. Over-collateralisation — more loans than notes.
3. Subordination — the junior notes take losses before the senior ones.
4. Reserve funds — cash set aside at the start.

Retention

Regulation in most jurisdictions requires the originator to keep a slice of the risk, so that whoever made the loans still cares how they perform. It is the direct response to a specific failure, and it is the most consequential rule on this desk.

The instrument this creates

See the asset-backed security and the mechanism on the markets side. This page is the transaction that manufactures one.

How the protection is sized

Agencies model the pool statistically: historical default rates, timing, recoveries, and how those behave under stress. The amount of subordination a tranche needs is an output of that model. Which explains two things at once — why deals within an asset class look almost identical, and why an asset class with no performance history is expensive to fund.

Correlation is what the model cannot survive

Subordination sized on the assumption that borrowers default independently is sized wrongly when they default together. That is the central lesson of the crisis in these instruments, and it is not an argument against the structure — it is an argument about one assumption inside it.

A pool of ten thousand car loans across a country is genuinely diversified against individual misfortune and not at all against a recession. The senior tranche is protected against the first; the second is what the whole capital structure has to absorb.

The triggers, and what they do

Structures contain tests that redirect cash automatically when performance deteriorates: arrears above a level, losses above a level, excess spread below one. A breached trigger stops paying the junior notes and repays the senior ones faster.

Nobody decides this. It happens because a contract says so, which is the deepest difference between this and corporate credit — there is no management to negotiate with and no board to appeal to.

What to read

• The investor report. Published monthly or quarterly for the life of the deal — the most transparent corner of credit and the least read.
• The post-enforcement waterfall, which differs from the normal one and is what the notes are actually worth.
• The servicer, and whether a replacement is identified and able to take over.
• Excess spread, which erodes before anything else shows up.

The formulas above are standard textbook formulations, simplified for teaching. They explain the mechanism — they are not a valuation tool, and they will not reproduce a dealer’s price.