$5,875,000 in interest every year to the owner of the promissory notes for five years.After five years, the interest rate is re-set according to an agreed to formula. TheHouseholds plan their “loans” with the organization they consider “their bank.”
ii) Step 2:
Whoever originated the loans sells the package of 100 promissory notes to a SpecialPurpose Vehicle in exchange for $100,000,000
The Special PurposeVehicle knows it will get “more” because it knows that investors will pay extra fordifferent rights that exist in the package. These rights can involve many things but thesimplest rights are those that involve different priorities to the cashflow collected by theSpecial Purpose Vehicle.For example, three investors will negotiate for three sets of privileges:Tranche A: Invests $70,000,000 at what seems to be 4.00%, and agrees for one set of rightsTranche B: Invests $20,000,000 at what seems to be 7.50%, and agrees to another set of rightsTranche C: Invests $14,000,000 at what seems to be 10.00%, and agrees to still another set of rights.The purchased rights most often involve priority to monthly collected cashflow.To continue with the simplified example, to make the above numbers work, we assumethat the total amount of cash collected from the Tranche investors is $104,000,000. Theinvestment bankers and organizing originators are paid $4,000,000 in fees by the Trancheinvestors who are introduced to the investment opportunity. In this simple example, theServicer receives $175,000 annually to collect and monitor the payments of 200individual monthly events. This fee is a large amount of money to pay for the salary of one individual to monitor compliance, most of which is paid electronically. Serviceremployee teams generally handle many more than 200–loans-per-individual teams. Tothe casual observer, from the outside, the securitization is refinancing itself at what seemsto be a cost of 5.649% per year, a savings of 0.226%.Said another way, the combined amount of money the Tranche investors pay for theprivilege of receiving the $5,875,000 annually is $104,000,000 (i.e. $4,000,000 morethan the principal amount actually owed by Households). Each Tranche investor, via aninvestment agreement, negotiates for different rights. These rights most often involve thepriority associated with the redistribution of the cashflow collected for the SpecialPurpose Vehicle via the Servicer.
iii) Elaboration in slightly greater detail…
By negotiating to prioritize the receipt and redistribution of the cash-flow into differenttranches, the investor groups give themselves the impression of assuring themselvesgreater certainty about the flow of cash they receive at specific points in time.In the example, Tranche A, who puts up 70% of the cash required by the securitization, ishappy to receive an effective cash yield of 4% in exchange for being paid the first 70% of all cash received by the Servicer. The Tranche A investor has bought more “timingcertainty,” something that is very important to some investors. These Tranche Ainvestors also get comfort from the fact that if an underlying portfolio does not perform
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