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. Investing

    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. Personal Finance

    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. Markets

    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. Investing

    Profit From Mortgage Debt With MBS

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

    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 ...
  10. Markets

    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. Quantitative Trading

    Trading strategies based on quantitative analysis which rely on mathematical computations and number crunching to identify ...
  2. Bond Ladder

    A portfolio of fixed-income securities in which each security has a significantly different maturity date. The purpose of ...
  3. Duration

    A measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. ...
  4. Dove

    An economic policy advisor who promotes monetary policies that involve the maintenance of low interest rates, believing that ...
  5. Cyclical Stock

    An equity security whose price is affected by ups and downs in the overall economy. Cyclical stocks typically relate to companies ...
  6. Front Running

    The unethical practice of a broker trading an equity based on information from the analyst department before his or her clients ...
Trading Center