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

An investor compares two ABS deals backed by similar consumer loans. Deal A uses a sequential-pay structure, while Deal B uses a pro-rata structure in which principal is shared across the senior and mezzanine tranches. Which statement best describes the difference when pool performance deteriorates and a trigger is breached in Deal B?

When a trigger is breached, a pro-rata structure typically switches to sequential payment. Principal then goes first to the senior tranche, increasing its subordination and protection, while mezzanine and junior investors receive principal later and face greater extension and loss exposure.

  1. ASwitching Deal B to sequential payment redirects principal to the senior tranche first, which protects the senior tranche but delays repayments to the mezzanineCorrect
  2. BSwitching Deal B to sequential payment lowers credit enhancement for the senior tranche
  3. CPro-rata payment always provides senior investors more protection than sequential payment
  4. DA trigger breach has no effect on the order of principal payments

Explanation

Performance triggers typically convert a pro-rata structure to sequential, so senior notes are repaid first and their credit enhancement builds up faster. Mezzanine investors wait longer for principal. Therefore the senior is protected and the statement about lowering enhancement is wrong.

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