i. Hitherto our consideration of credit derivatives has concerned single-named assets. We considered a single-name CDS and a single-name TRS, both of which were synthetic assets replicating a single-name referent (a corporate bond) from a single-name reference entity (a corporation). However, the deep historical-materialist significance of synthetic finance concerns the differentiation of multi-name credit derivatives (sometimes also called ‘portfolio swaps’, or ‘portfolio credit derivatives’) from out of their single-name incarnation –and in particular their usage, when combined with the technology of securitization, to engineer structured synthetic financial assets. For this reason, we will expand our understanding of the peculiar but profound materiality of synthetic finance by now turning our discussion to securitization, or structured finance.
We will inaugurate this discussion by examining tranches.
While single-name credit derivatives make reference to a single obligation (e.g. a bond) of a single entity (e.g. Marx Corp. or Black Corp), multi-name credit derivatives reference a pool of obligations from a pool of names.
From one perspective, multi-name credit derivatives are simply the composition of a series of single-name credit derivatives into one portfolio. However, this only tells half of the story. The radical transformational essence of structured finance is its capacity –as a technology, a process, an object, and method of synthetic exchange– to aggregate a multi-named set of heterogeneous risks into one homogenous pool with a single risk, and then re-segregate this risk into different classes, whereby the risks and cash flows ontologically change in kind in the course of being structured as such. These new classes are called ‘tranches’, which may be arranged in a variety of ways, to obtain a variety of specified risks and their associated cash flows.
Therefore, ‘structured finance’ is the term we use to define a process for the de-differentiation and subsequent re-differentiation of the economic property of risk by method of tranching: it is a process for the pooling and redistribution of risk, through which any risks and cash flows (as well as other economic properties) become not only fungible, plastic, mobile, and substitutable, but now also capable of dynamically changing in kind.
ii. Let us construct and consider a most elementary example of a multi-name credit derivative.
First, we will collect 100 corporate reference debt obligations from a 100 corporate entities, which are representative of a wide variety of industries (e.g. agriculture, manufacturing, real estate, etc.). Each name, or referent, has a notional value of $10 million: each referent is a generic financial asset; they collectively constitute 100 generic financial assets; they have a notional value of $10 million each. We pool these names together, which creates a portfolio whose total notional value is $1 billion.
Secondly, we then construct five sequential tranches of notional value, ascending in seniority, as follows:Tran. Not. Value Attach Detach Lev. A $840m 16% 100% 1. 00 B $40m 12% 16% 6.25 C $40m 8% 12% 8.33 D $40m 4% 8% 12.50 E $40m 0% 4% 25.00 Total $1 billion
Our reader is encouraged to remain mindful that here we concern ourselves only with synthetic replicas of 100 corporate reference obligations of $10 million each; our portfolio has neither purchased nor invested in, and otherwise can claim no physical ownership of these 100 corporate bonds of $10 million each. If we did generically invest in and/or physically own such assets, and then proceeded to pool and tranche them, i.e. according to the methods of structured finance, we would now be elaborating for our reader the process of ‘cash securitization’, or ‘structured generic finance’ –which is the process of securitizing generic financial assets. Here we are specifically concerned with ‘synthetic securitization’, or ‘structured synthetic finance’, which is a process for securitizing synthetic financial assets; and so all of our previous observations on single-name credit derivatives (in Notes 1-3) may be comported into our compounded understanding of structured synthetic finance herein.
From the example provided above, we see a concrete illustration of our earlier assertion –namely, that the process of pooling de-differentiates 100 increments of $10 million each worth of risks and cash flows into one portfolio of $1 billion worth of risk and cash flow; and then the subsequent process of tranching re-differentiates the now $1 billion worth of risk and its cash flow into 5 new classes of risks and cash flows –albeit the quantity and quality of these risks and their cash flows have materially metamorphosed, i.e. they have ontologically changed in kind. For this reason our reader will see why we say that structured finance is a technology for the fungible distribution of risk and cash flow. Moreover, we also see that we are synthetically ‘repeating’ the generic asset, but in process of this repetition we produce a difference, we produce a new change in kind.
iii. Closer consideration of the nature of tranches will better illustrate this truth.
To observe that (a) the result of pooling 100 corporate names into a single portfolio is to homogenize their risks and cash flows into one asset with a single risk and single cash flow; and that (b) once we pool these names together, we can then re-differentiate this one risk and its cash flow differently and flexibly as we so choose –this is intriguing enough in itself.
However, our reader may have noticed an additional interesting material result of the process of structuring financial assets: by pooling 100 credit derivatives into a single synthetic financial asset, and then ontologically re-differentiating the risk and cash flow of this new asset through method of tranching, a synthetically-structured financial exchange involves the birth to actuality of several new economic properties which are specific to it, i.e. which were not originally “in” or “of” the generic financial asset acting as its referent. Anytime we use tranches to re-differentiate risk, there are ‘levels of subordination’ to the tranches, which have a series of ‘attachment points’ and ‘detachment points’; this structuring process actualizes several new economic properties –for example, the properties of ‘credit enhancement’ and ‘leverage’ (among several others that we will not discuss herein). This is as unexpected as it is insightful, since it means that the synthetic asset begins by announcing itself as a mere replica of its generic referent, just as the synthetic exchange begins by appearing as an avatar of a generic financial exchange; but there is a new difference produced by its repetition, for there are new and novel economic properties brought into being which are not of the generic asset, and not present in the generic financial exchange whose asset acts as the referent to the synthetic exchange.
Let us briefly define and consider these properties.
Levels of subordination are defined as the order of seniority of risks and cash flows among the different tranches. An attachment point is the point at which losses attach to a particular tranche. And a detachment point is the point at which losses detach from a particular tranche, in order to attach to a different tranche with a higher level of subordination. The effect of tranching is the organic creation of such points. And the effect of these points is the organic creation of credit enhancements, which are various amounts of credit support provided to the different levels of subordination. This, in turn, amounts to the embedding of leverage into the exchange: it infuses the property of natural leverage into these levels (leverage here being defined as the deployment of debt to augment the volume and speed of gains and losses).
For instance, in the example provided above we have arranged Tranche E as the most junior level of subordination, with an attachment point of 0%, and a detachment point of 4%. Tranche E is therefore exposed to the risk of the total portfolio, insofar as the first dollar of any loss in notional value to the synthetic portfolio is absorbed by Tranche E, but materially affects none of the other Tranches. Correlatively, the first dollar of appreciation in notional value beyond the $1 billion valuation in the portfolio –which is to say any increase in profits beyond the amount agreed to at the commencement of the synthetic exchange– is enjoyed by Tranche E, but materially affects none of the other Tranches. For this reason we say that Tranche E is the ‘equity tranche’ in the synthetic portfolio, but that all of the other Tranches are ‘debt tranches’. And of course all of the levels will have various amounts of expected yield, agreed to at the commencement of the transaction. So for example, Tranche E will obviously have the highest expected yield, given that E assumes the greatest amount of risk.
Because we know that Tranche E has a notional value worth $40 million in a portfolio whose total value is $1 billion, we see that the Tranches have been arranged such that Tranche E will continue to absorb all losses to the portfolio until such time that $40 million (or 4%) of the total notional value of the portfolio has been depleted –at which point the risk to the portfolio will detach from Tranche E, and then attach to Tranche D. Therefore, we can see that Tranche E provides a 4% level of credit enhancement to the other Tranches. But as we just noted, there also is no ceiling on the increased profits enjoyed by Tranche E, if and as the notional value of the total portfolio appreciates beyond $1 billion. This means that Tranche E, whose value is only $40 million, is exposed to the total returns and losses on a $1 billion portfolio –in other words, Tranche E is leveraged 25 times (i.e. $1 billion ÷ $40 million = 25). This is the meaning of our statement that Tranche E is the most junior level of subordination, with an attachment point of 0%, and a detachment point of 4%, provides 4% credit enhancement to the other Tranches, and has a leverage ratio of 25.
At the top end of the example provided above, we have arranged Tranche A as the most senior level of subordination, with an attachment point of 16%, and a detachment point of 100%. Tranche A is therefore not exposed to any risk of the $1 billion portfolio until the total notional values of Tranches E through B have been completely wiped out. For instance, once the first $40 million from Tranche E is wiped out, which is 4% of the total notional value of the portfolio, Tranche D begins absorbing subsequent losses in the portfolio up to 8%; at which point the losses to Tranche D detach, and Tranche C begins absorbing all subsequent losses up to 12%; at which point Tranche B now attaches, and begins to absorb all subsequent losses up to 16% of the total notional value of the portfolio of names.
Because we know that Tranche A has a notional value of $840 million of a portfolio whose total notional value is (or was, to begin with) $1 billion, up until the time that $160 million (or 16%) of the total notional value of the portfolio has been depleted, Tranche A remains materially unaffected by the losses to the other Tranches. Consequently, Tranche A is exposed to comparatively less risk than the 4 Tranches with lower levels of subordination, and has comparatively little, and in fact almost no leverage whatsoever. Tranche A also provides no credit enhancement to the other levels. As a result of all of these factors, the expected yield of Tranche A will be comparatively less than the other Tranches.