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

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

Losses are absorbed from the bottom of the capital structure upward: the equity tranche takes them first, then the mezzanine tranche, and the senior tranche only after all subordination is exhausted. This subordination is what gives senior tranches their higher credit quality.

  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, and only then by the senior trancheCorrect
  3. CLosses are absorbed first by the senior tranche because it has the largest notional
  4. DLosses are absorbed first by the mezzanine tranche because it has the highest credit spread

Explanation

Structured credit uses a sequential loss waterfall. The equity (first-loss) tranche absorbs losses first, then mezzanine, and the senior tranche is hit only after subordination below it is exhausted. Pro rata sharing does not occur in a tranched structure.

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