Explaining Complexity in Actual Securitization Structures: An Epistemic Pitfall in Corporate Finance

Securitization has been a subject of interest in the security design literature, and various models have been developed to explain the existence of senior securities and junior securities. However, securitization structures are far more complex than a simple tranching by seniority, and manipulate interest as well as principal. We first address the fundamental reasons why some investors require par-priced securities, before modeling the contractibility of both interest and principal, as well as the par-pricing constraint. We can derive optimal designs closely resembling actual securitization structures. We also analyze the interactions between collateral characteristics and pricing at equilibrium, and show how much more attractive an excess-spread structure is relative to a more standard structure as expected collateral losses increase, explaining the widespread use of these mechanisms on low-quality collateral. We ascribe the fact that financial economics have not sought to explain the peculiar nature of structural complexity to an epistemological framework that privileged consistency with corporate debt analysis. This article received the Peter L. Bernstein award of 2023: https://www.pm-research.com/PB-Award/2023Winner