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

In a typical non-agency residential MBS structured as a senior-subordinate deal, losses on the underlying mortgage pool are first absorbed by which tranche?

The most junior, or equity, tranche absorbs losses first. Subordination allocates pool losses from the bottom of the capital structure upward, so mezzanine tranches are hit next and the senior tranche is affected only after the lower tranches are exhausted.

  1. AThe senior tranche, because it has the largest balance
  2. BThe most junior (equity or first-loss) trancheCorrect
  3. CAll tranches pro rata to their principal balances
  4. DThe mezzanine tranche only, before the equity tranche

Explanation

Credit enhancement through subordination means losses are allocated from the bottom of the capital structure upward. The equity (first-loss) tranche absorbs losses first, then mezzanine, and only then the senior tranche. Pro rata sharing would remove the benefit of subordination.

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