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 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 >>
  5. What's the difference between a collateralized mortgage obligation (CMO) and a mortgage-backed ...

    Find out more about collateralized mortgage obligations and mortgage-backed securities and the difference between the two ... 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. 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 ...
  3. Investing

    Investing In Securitized Products

    Securitized assets are customizable and have a wide range of yields, making them an attractive asset class.
  4. Investing

    What Are Tranches?

    “Tranche” is a French word that refers to a slice.
  5. 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.
  6. Personal Finance

    Profit From Mortgage Debt With MBS

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

    Financial Institutions: Stretched Too Thin?

    Find out how to evaluate a firm's loan portfolio to determine its financial health.
  8. Investing

    Did Derivatives Cause The Recession?

    We may never come to a consensus on what caused the financial collapse, but derivatives definitely share a large part of the blame.
  9. Investing

    Introduction To Asset-Backed And Mortgage-Backed Securities

    In this article, we will go through the structure, along with some examples of ABS and valuation.
  10. Investing

    What are Debt Instruments?

    A debt instrument is a documented financial obligation that enables the issuer to raise funds by borrowing money and repaying it in the future.
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. Straddle

    An options strategy in which the investor holds a position in both a call and put with the same strike price and expiration ...
  2. Trickle-Down Theory

    An economic idea which states that decreasing marginal and capital gains tax rates - especially for corporations, investors ...
  3. North American Free Trade Agreement - NAFTA

    A regulation implemented on Jan. 1, 1994, that eventually eliminated tariffs to encourage economic activity between the United ...
  4. Agency Theory

    A supposition that explains the relationship between principals and agents in business. Agency theory is concerned with resolving ...
  5. Treasury Bill - T-Bill

    A short-term debt obligation backed by the U.S. government with a maturity of less than one year. T-bills are sold in denominations ...
  6. Index

    A statistical measure of change in an economy or a securities market. In the case of financial markets, an index is a hypothetical ...
Trading Center