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FRM Part II · FRM Exam Part II · Structured Credit Risk

A bank sponsors a cash CLO that buys a portfolio of leveraged loans and funds it with senior, mezzanine and equity tranches. Which statement best describes how credit losses on the underlying loan pool are allocated among the tranches?

Losses go first to the equity tranche, then to mezzanine tranches, and only after those are exhausted to the senior tranches. This subordination structure provides credit enhancement to senior investors, which is why senior tranches can earn high ratings despite a risky collateral pool.

  1. ALosses are shared pro rata across all tranches according to their notional amounts
  2. BLosses are absorbed first by the equity tranche, then by mezzanine tranches, and only afterwards by the senior tranchesCorrect
  3. CLosses are absorbed first by the senior tranche because it has the first claim on collateral
  4. DLosses are allocated to the tranche with the lowest credit rating regardless of subordination

Explanation

Structured credit uses a waterfall for losses: the most subordinated (equity) tranche takes losses first, then mezzanine, then senior. Pro rata sharing would remove the credit enhancement that subordination provides.

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