Question

Suppose that ABSs are created from portfolios of subprime mortgages with the following allocation of the principal to tranches: senior 85%, mezzanine 10%, and equity 5%. (The portfolios of subprime mortgages have the same default rates.) An ABS CDO is then created from the mezzanine tranches with the same allocation of principal. How high can losses on the mortgages be before the mezzanine tranche of the ABD CDO bears losses?

Answer 1

ABSs are created from portfolios of subprime mortgages with the following allocation of the principal to tranches: senior 85%, mezzanine 10%, and equity 5%.

Now assume a principal amount = $100; then allocation will be in following manner –

• Senior tranche= $85
• Mezzanine tranche = $10
• Equity = $5

If the losses incurred then first equity principal will wiped out, then mezzanine and after that senior tranche

As the equity principal has 5% share, therefore 5% losses on the mortgages can be before the mezzanine tranche of the ABD CDO bears losses.