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.

Securitization is the process of financially structuring a non-liquid asset or group of similar non-liquid assets into a security that can then be sold to investors. The mortgage-backed security was first created by trader Lew Ranieri in the early 1980s. It became an extremely popular investment in the 1990s and early 2000s. The idea was that the new security could be sold on the secondary mortgage market, offering investors significant liquidity on an asset that would otherwise be quite illiquid. 

Pools and Tranches

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. (See also: 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. (See also: Subrpime Mortgages Feature.)