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

In a typical non-agency residential mortgage-backed securitization, the cash flows from the mortgage pool are allocated across tranches. Which statement best describes how losses are allocated among the tranches?

Losses are absorbed first by the equity or most junior tranche, then by the mezzanine tranches, and only afterward by senior tranches. This subordination is the credit enhancement that allows senior tranches to receive high ratings despite risky underlying mortgage pools.

  1. ALosses are shared equally across all tranches in proportion to their face value
  2. BLosses are absorbed first by the equity (most junior) tranche, then by mezzanine tranches, and only then by the senior tranchesCorrect
  3. CLosses are absorbed first by the senior tranche because it has the largest balance
  4. DLosses are absorbed by the mezzanine tranche before the equity tranche because it has a higher rating

Explanation

Credit enhancement through subordination means the most junior tranche takes the first losses, followed by mezzanine, with senior tranches protected until the junior tranches are exhausted. Pro rata sharing applies to a pass-through structure, not to a tranched non-agency deal.

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