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FRM Part I · FRM Exam Part I · Anatomy of the Great Financial Crisis of 2007-2009

A mortgage pool of USD 500 million is securitized into three tranches: equity USD 25 million, mezzanine USD 75 million, and senior USD 400 million. Losses on the pool are allocated from the bottom up. If the pool suffers a loss of USD 60 million, what is the loss on the mezzanine tranche as a percentage of its principal?

Equity absorbs the first USD 25 million of the USD 60 million loss, leaving USD 35 million for the mezzanine tranche. Divided by its USD 75 million principal, that is a 46.7% loss. The senior tranche is untouched because losses are allocated from the bottom up.

  1. A20.0%
  2. B46.7%Correct
  3. C60.0%
  4. D80.0%

Explanation

The equity tranche absorbs the first USD 25 million. The remaining USD 35 million falls on the mezzanine tranche. 35/75 = 46.7%. Using 20/25-style or whole-loss allocations ignores the equity tranche absorbing the first loss; 60/75 = 80% ignores equity absorption altogether.

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