A:

Bad debts arise when borrowers default on their loans. This is one of the primary risks associated with securitized assets, such as mortgage-backed securities (MBS), as bad debts can stop these instruments' cash flows. The risk of bad debt, however, can be split up in different proportions among the investors. Depending on how the securitized instruments are structured, the risk can be placed entirely on a single group of investors, or spread throughout the entire investing pool. Let's take a look at two styles of securitization, and discuss how they affect the level of risk faced by investors.

A simple securitization involves pooling assets (such as loans or mortgages), creating financial instruments and marketing them to investors. Incoming cash flows from the loans are passed onto the holders of the new instruments. Each instrument is of equal priority when receiving payments. Since all instruments are equal, they will all share in the risk associated with the assets. In this case, all investors bear an equal amount of bad-debt risk. (For more on mortgage-backed securities, read Profit From Mortgage Debt With MBS.)

In a more complex securitization process, tranches are created. Tranches represent different payment structures and various levels of priority for incoming cash flows. In a two-tranche system, tranche A will have priority over tranche B. Both tranches will attempt to follow a schedule of payments that reflects the cash flows of the underlying loans or mortgages. If bad debts arise, tranche B will absorb the loss, lowering its cash flow, while tranche A remains unaffected. Since tranche B is affected by bad debts, it carries the most risk. Investors will purchase tranche B instruments at a discount price to reflect the level of associated risk. If there are more than two tranches, the lowest priority tranche will absorb the losses from bad debts.

For a one-stop shop on subprime mortgages and the subprime meltdown, check out the Subrpime Mortgages Feature.

RELATED FAQS
  1. Why do banks securitize some debts, and how do they sell them to investors?

    Learn how and why banks securitize debt, how the securitized debt is sold to other investors, and how different the different ... Read Answer >>
  2. What is a tranche?

    "Tranche" is actually a French word meaning "slice" or "portion". In the world of investing, it is used to describe a security ... Read Answer >>
  3. What is securitization?

    Securitization is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming ... Read Answer >>
  4. What is a Z bond in a collateralized mortgage obligation (CMO)?

    Learn about Z-bonds, which are the riskiest level of tranches in collateralized mortgage obligations, and understand how ... Read Answer >>
  5. What's the difference between a collateralized debt obligation (CDO) and a collateralized ...

    Find out how a collateralized mortgage obligation (CMO) is similar to a collateralized debt obligation (CDO), as well as ... Read Answer >>
  6. What are some historical examples of debt securitization?

    Find out how debt securitization started, how it works and why the government facilitated the mortgage-backed security market ... Read Answer >>
Related Articles
  1. Investing Basics

    What are Tranches?

    Tranches often describe specific classes of bonds within a security that hold different degrees of risks and maturities.
  2. Personal Finance

    Why Are Mortgage Rates Increasing?

    Learn how the secondary mortgage market and investor demand affect the cost of home ownership.
  3. Investing Basics

    What is Securitization?

    Securitization is the process of converting an asset, or group of assets, into a marketable security. Often times, the securitized assets are divided into different layers, or tranches, tailored ...
  4. Professionals

    Other Types of Bonds

    Zero-Coupon Bonds: Zero-coupon bonds are debt securities issued at a deep discount from par, with the difference between the discount and the face value paying out at maturity. These bonds ...
  5. Insurance

    Investing In Securitized Products

    Securitized assets are customizable and have a wide range of yields, making them an attractive asset class.
  6. Bonds & Fixed Income

    3 Bonds You May Have Never Heard Of

    These lesser-known bonds may give your portfolio a boost when other investments products fall short.
  7. Professionals

    Mortgage-Backed Securities

    Mortgage-Backed Securities
  8. Professionals

    Federal Issues

    CFA Level 1 - Federal Issues. Learn about the various federally related insitutions and government sponsored enterprises. Reveals the products and services they provide.
  9. Professionals

    Collateralized Mortgage Obligations (CMOs)

    FINRA Series 7 Online Study Guide Section 4
  10. Home & Auto

    Exploring Real Estate Investments: Buying And Owning Real Estate

    By Ian Woychuk, CFA In Chapter 2, we presented the investment selection matrix, which outlines your alternatives when choosing the kind of real estate investment to make. You can choose to invest ...
RELATED TERMS
  1. Sequential Pay CMO

    A type of collateralized mortgage obligation (CMO) in which there ...
  2. Tranches

    A piece, portion or slice of a deal or structured financing. ...
  3. Active Tranche

    A tranche of a collateralized mortgage obligation (CMO) that ...
  4. Pro-Rata Tranche

    A portion of a syndicated loan that is made up of a revolving ...
  5. Companion Tranche

    A class of tranche found in planned amortization class (PAC) ...
  6. Credit Tranche

    A system used by the International Monetary Fund (IMF) to govern ...

You May Also Like

Hot Definitions
  1. Goodwill

    An account that can be found in the assets portion of a company's balance sheet. Goodwill can often arise when one company ...
  2. Return On Invested Capital - ROIC

    A calculation used to assess a company's efficiency at allocating the capital under its control to profitable investments. ...
  3. Law Of Demand

    A microeconomic law that states that, all other factors being equal, as the price of a good or service increases, consumer ...
  4. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  5. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  6. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
Trading Center