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FRM Part I · FRM Exam Part I · Banks

A bank securitizes a pool of mortgages into three tranches: a senior tranche, a mezzanine tranche, and an equity tranche. Pool losses first reduce the equity tranche, then the mezzanine, then the senior. Which statement about this structure is correct?

The equity tranche bears first losses and therefore earns the highest expected return as compensation. Subordination protects the mezzanine and senior tranches, which are paid ahead of it. Losses are not shared pro rata, since tranching creates a priority ordering of loss absorption.

  1. AThe senior tranche absorbs losses first because it has the largest principal
  2. BThe equity tranche has the highest expected return and bears first lossesCorrect
  3. CThe mezzanine tranche is paid after the equity tranche in the waterfall
  4. DAll tranches share losses pro rata to their principal amounts

Explanation

In a sequential-loss structure, subordination means the equity tranche absorbs losses first and is compensated with the highest promised return. The senior tranche is protected by the tranches below it. Pro rata sharing is not how tranching works.

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