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FRM Part II · FRM Exam Part II · An Introduction to Securitisation

A pool of USD 1,000 million of loans backs three tranches: equity USD 50 million, mezzanine USD 150 million and senior USD 800 million. Cumulative pool losses over the life of the deal reach USD 120 million and there is no excess spread or recovery beyond this net loss figure. Which outcome is correct?

Equity absorbs the first USD 50 million and is wiped out. The remaining USD 70 million of loss falls on the mezzanine, which is 46.7% of its USD 150 million principal. The senior tranche is untouched because losses stay below the USD 200 million subordination beneath it.

  1. AEquity is wiped out and the mezzanine loses USD 70 million, about 46.7% of its principalCorrect
  2. BEquity is wiped out and the mezzanine loses USD 120 million
  3. CEquity loses USD 120 million and the other tranches are unaffected
  4. DEquity is wiped out and the mezzanine loses USD 70 million, about 7% of its principal

Explanation

Losses are allocated bottom-up. Equity absorbs the first USD 50 million, leaving USD 70 million for the mezzanine. Loss on the mezzanine is 70/150 = 46.7%, and the senior is untouched because losses are below USD 200 million. The 7% option divides by the pool size, using the wrong base.

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