The structured finance market has grown rapidly during the past two decades. An attractive feature of structured finance to investors is the senior subordinated debt structure where cash flows from underlying loan pool are allocated to various tranches of securities (bonds) according to rules.
Typically, prepayments of principal are often distributed first to the senior tranches while losses due to default are allocated first to the subordinated tranches. Therefore, investors buying senior tranches expect to be well protected from credit risks while those holding subordinated tranches will get higher expected returns. This senior-subordinated structure allows the financial intermediary to create a low-risk security that can potentially overcome the asymmetric information problem between the issuer and the investor.
In this senior-subordinated structure, bond subordination levels are key variables because they determine how much credit support senior tranches have from the subordinated tranches. Subordination levels are determined, in part, by critical ex-ante measures of default. A stylized fact about subordination levels is that there exists a time series trend showing subordination levels declining systematically over time for one type of structured financing: commercial mortgage-backed securities (CMBS). While papers such as Duffie and DeMarzo (1999), DeMarzo (2005) and Riddiough (1997) discuss the advantages for the creation of a low-risk security in a senior-subordinated structure, they do not provide empirical support for the types and characteristics of assets (loans) that would help solve the asymmetric information problem.
In this paper, we provide empirical support for the types and characteristics of assets (loans) that allow the financial intermediary to create a low-risk security in a senior-subordinated structure. Using cross-sectional tests of subordination levels in commercial mortgage-backed securities (CMBS) deal, we examine how AAA (low-risk) and BBB (higher-risk) bond subordination levels can be explained by both credit and non-credit variables at deal level. We pay special attention to the roles of original LTV and original DSCR, while existing literature suggest neither will be a good credit risk predictor for commercial mortgages. Second, we examine whether subordination levels change over time and identify the fundamental drivers of the changes in subordination.
In section 2, we introduce structure finance and the pooling and tranching of assets. In section 3, we briefly summarize the mechanism of CMBS structure and subordination; section 4 explains our research questions and empirical approach; sections 4 and 5 describe the data and model results; concluding remarks are in the final section.
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