Question

You hold a portfolio of mortgages $100. 115% of these morgages default, you will lose exactly $ . If 12% of these morgages default, you will lose exactly $ A bank has used $100 million morgages to create the following tranches: 15%/ AAA 25% AA 18% Residua/Equit Imagine that you invest your $100 in the BBB tranch. 115% of the underlying morgages default, you will lose exactly $ 12% of the underlying morgages default, you will lose exactly $ If Hint: Think of the water cascade! Sit back and compare these two investment choices (directly into morgages, versus indirectly via tranches). See how the risk profile is very different? This is what surprised many investors just before the GFC. The stuned faces in the "Big Short" as well as "Margin Call" reflect the sudden realization of this underlying risk.

Answer 1

No Tranching:

Total Investment = $ 100, Loss in Case of 5 % Default = 0.05 x 100 = $ 5 and Loss in Case of 12 % Default = 0.12 x 100 = $ 12

Tranching:

Total Tranche Investment = $ 100 million with various % in each tranche, In this investment structure, the lower tranches bear losses in case of default upto the extent of their full principal. Hence, lower rates tranches are more vulnerable to default losses as compared to higher rated tranches.

5% default of underlying mortgage implies a default loss of 0.05 x 100 = $ 5 million which can be easily absorbed by the residual/equity tranche (as it gets 5 % of the total tranche investment of $ 100 million). Hence, the investor with a $ 100 investment in the BBB tranche is absolutely safe and faces no loss.

12 % default of underlying mortgage implies a default loss of 0.12 x 100 = $ 12 million which would need the entire principal value of the residual and BBB tranches to be absorbed.Hence, the $ 12 million loss is compensated by the BBB tranche principal of $ 7 million and residual tranche principal of $ 5 million. The investor with a $100 investment in the BBB tranches will lose his/her entire investment in thie scenario.