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FRM Part I · FRM Exam Part I · Mortgages and Mortgage-Backed Securities

A CMO is backed by a $300 million pool. It issues Tranche A of $150 million, Tranche B of $100 million and Tranche C (the residual/equity-like piece) of $50 million, with losses allocated first to C, then B, then A. The pool suffers credit losses of $70 million. What is the loss borne by Tranche B?

Tranche B bears a $20 million loss. The first $50 million of the $70 million pool loss is absorbed entirely by the junior Tranche C, leaving $20 million to hit Tranche B. Subordination, not pro rata sharing, determines the allocation.

  1. A$20 millionCorrect
  2. B$23.33 million
  3. C$70 million
  4. D$0

Explanation

Losses hit Tranche C first, wiping out its $50 million. The remaining $20 million of loss then falls on Tranche B. Tranche A is untouched. The $23.33 million figure comes from allocating losses pro rata (70 x 100/300), which ignores the subordination.

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