Who bears the risk of bad debts in securitization?

By Jared Coulson AAA
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. Who regulates a credit rating agency?

    Find out how American and international regulators interact with Credit Rating Agencies, and learn about the rules adopted ...
  2. What is the difference between a hedge fund and a private equity fund?

    Learn the primary differences between hedge funds and private equity funds, both of which are utilized by high net worth ...
  3. Where does a hedge fund get its money?

    Learn how a hedge fund is structured and how the managing partner of the fund goes about the process of finding and soliciting ...
  4. How do I use Commodity Channel Index (CCI) when creating a forex trading strategy?

    Learn that forex traders can use the Commodity Channel Index to create a forex trading strategy or as an additional indicator ...
RELATED TERMS
  1. Collateralized Loan Obligation - CLO

    A security backed by a pool of debt, often low-rated corporate ...
  2. ISDA Master Agreement

    A standard agreement used in over-the-counter derivatives transactions.
  3. Residential Mortgage-Backed Security (RMBS)

    A type of security whose cash flows come from residential debt ...
  4. Collateralized Mortgage Obligation - CMO

    A type of mortgage-backed security in which principal repayments ...
  5. Hybrid Security

    A security that combines two or more different financial instruments. ...
  6. Collateralized Debt Obligation - CDO

    An investment-grade security backed by a pool of bonds, loans ...

You May Also Like

Related Articles
  1. Investing Basics

    The Most Popular Bitcoin Mining Software

  2. With stocks surging, financial advisers and their wealthy clients are asking why they should continue to bother with poorly performing alternatives.
    Professionals

    Are Advisors Off Alternatives?

  3. Investing Basics

    Putting Your Retirement Eggs in Several ...

  4. bitcoin
    Investing Basics

    Medici, The Blockchain Stock Exchange

  5. Investing Basics

    The 5 Most Important Virtual Currencies ...

Trading Center