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

A CLO pool of USD 1,000 million has an equity tranche of 0 to 5%, a mezzanine tranche of 5 to 15% and a senior tranche above 15%. The pool suffers a USD 90 million loss. Which statement about the tranche losses is correct?

Equity absorbs its full USD 50 million, the remaining USD 40 million hits the mezzanine tranche, and the senior tranche is untouched. Losses are allocated sequentially from the most junior tranche upward, and the senior tranche attaches only above USD 150 million of pool losses.

  1. AEquity loses USD 50 million and mezzanine loses USD 40 million, and senior is unaffectedCorrect
  2. BEquity loses USD 50 million and senior loses USD 40 million
  3. CEquity and mezzanine each lose USD 45 million
  4. DMezzanine loses USD 90 million and equity is unaffected

Explanation

Losses are allocated bottom-up. Equity absorbs the first 5% = USD 50 million. The remaining USD 40 million falls in the mezzanine band (USD 50 to 150 million), so it is absorbed there. The senior tranche attaches at USD 150 million and takes no loss. Pro rata allocation is wrong because it ignores seniority.

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