Tranche

A securitisation structure separates the pool's cash flows from the claims against them. Interest and principal collected from the underlying loans enter a payment waterfall: servicing fees and expenses come first, then interest to each class in order of seniority, then principal according to the structure's rules. Losses run up the same ladder from the bottom.

Each class can be described by an attachment point and a detachment point, expressed as percentages of the original pool balance. A tranche attaching at 5 percent and detaching at 12 percent absorbs nothing until cumulative pool losses exceed 5 percent, is written down proportionally between 5 and 12 percent, and is wiped out entirely above 12 percent. The distance between the attachment point and zero is the credit enhancement supporting that class: subordination from the tranches beneath it, supplemented by overcollateralisation, excess spread and reserve accounts.

Two distinct problems are solved by slicing a pool. Credit tranching redistributes default risk, converting a pool of uniformly risky loans into classes that range from investment grade to first-loss. Time tranching redistributes timing risk, which matters most where borrowers can prepay without penalty.

In a sequential-pay collateralised mortgage obligation, all principal is directed to the first class until it retires, then to the second, and so on. The short classes absorb early prepayments and have predictable average lives; later classes are shielded from contraction but bear extension risk if prepayments slow. Planned amortisation class structures go further, guaranteeing a fixed principal schedule across a band of prepayment speeds while support tranches absorb the variation. The two techniques are independent and are routinely combined in a single deal.

Residential mortgage-backed securities, commercial mortgage-backed securities, collateralised loan obligations, auto loan ABS and credit card master trusts all use tranching, though the risks differ. CMBS pools contain few, large, non-prepayable loans, so credit tranching dominates and call protection is contractual rather than structural. Agency CMOs carry government-related credit backing, so time tranching does the work. CLOs layer both: senior notes for insurers and banks, mezzanine notes for credit funds, and an equity tranche that receives the residual after all debt service.

Structures are policed by coverage tests. If overcollateralisation or interest coverage ratios breach their triggers, cash that would flow to junior classes is diverted to repay senior notes early, deleveraging the deal at the expense of the equity holder.

Expect to be given a pool balance, a set of classes with sizes and seniority, and a loss or prepayment scenario. Work from the bottom: apply cumulative losses to the equity tranche until it is exhausted, then to each successive class, and report the remaining principal or the percentage write-down for the class in question. For time tranching, identify which class currently receives principal and whether the scenario shortens or lengthens its expected average life.

Understand why senior ratings depend on assumptions about default correlation rather than on subordination alone. When defaults cluster, losses breach thick subordination layers that looked ample under an assumption of independence, and the senior tranche's apparent safety proves to be a statement about the model, not the collateral.