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 of the arguments in favor of debt securitization?

    Find out how debt securitization creates benefits for loan originators, borrowers, investors and capital markets by diversifying ... Read Answer >>
Related Articles
  1. Investing

    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

    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. Investing

    Investing In Securitized Products

    Securitized assets are customizable and have a wide range of yields, making them an attractive asset class.
  5. Personal Finance

    CDOs and the Mortgage Market

    These structured products contribute to keeping borrowing rates low.
  6. Investing

    What Are Tranches?

    “Tranche” is a French word that refers to a slice.
  7. Investing

    3 Bonds You May Have Never Heard Of

    These lesser-known bonds may give your portfolio a boost when other investments products fall short.
  8. Personal Finance

    Profit From Mortgage Debt With MBS

    Mortgage-backed securities can offer monthly income, a fixed interest rate and even government backing.
  9. Investing

    The Return of CDOs After the 2008 Financial Crisis

    Learn how the market for CDOs is coming back after the 2008 financial crisis, and understand how the market for these products has changed.
RELATED TERMS
  1. Tranches

    A piece, portion or slice of a deal or structured financing. ...
  2. Sequential Pay CMO

    A type of collateralized mortgage obligation (CMO) in which there ...
  3. Asset-Backed Security - ABS

    A financial security backed by a loan, lease or receivables against ...
  4. Collateralized Loan Obligation - CLO

    A security backed by a pool of debt, often low-rated corporate ...
  5. Active Tranche

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

    A portion of a syndicated loan that is made up of a revolving ...
Hot Definitions
  1. IRS Publication 970

    A document published by the Internal Revenue Service (IRS) that provides information on tax benefits available to students ...
  2. Federal Direct Loan Program

    A program that provides low-interest loans to postsecondary students and their parents. The William D. Ford Federal Direct ...
  3. Cash Flow

    The net amount of cash and cash-equivalents moving into and out of a business. Positive cash flow indicates that a company's ...
  4. PLUS Loan

    A low-cost student loan offered to parents of students currently enrolled in post-secondary education. With a PLUS Loan, ...
  5. Graduate Record Examination - GRE

    A standardized exam used to measure one's aptitude for abstract thinking in the areas of analytical writing, mathematics ...
  6. Graduate Management Admission Test - GMAT

    A standardized test intended to measure a test taker's aptitude in mathematics and the English language. The GMAT is most ...
Trading Center