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FRM Part I · FRM Exam Part I · Credit Risk Transfer Mechanisms

A bank originates USD 500 million of loans and securitizes them. It retains the first-loss equity tranche of USD 25 million and sells all other tranches. Pool losses over the year total USD 18 million. Which statement is correct regarding the bank's position?

The bank bears the full USD 18 million loss. The equity tranche is first-loss and absorbs all pool losses up to its USD 25 million size, so the loss is entirely within it, leaving USD 7 million of remaining equity cushion, and other investors lose nothing.

  1. AThe bank bears the full USD 18 million loss, because the equity tranche absorbs losses firstCorrect
  2. BThe bank bears USD 7 million, since USD 25 million less USD 18 million remains
  3. CThe bank bears no loss because mezzanine investors absorb first losses
  4. DThe bank bears USD 18 million spread proportionally across all tranches

Explanation

Losses are allocated by seniority, starting with the equity tranche. Since USD 18 million is below the USD 25 million tranche size, the bank absorbs all of it, leaving USD 7 million of equity cushion. The USD 7 million option confuses remaining capacity with the loss incurred. Pro-rata allocation is not how tranching works.

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