Tranching, in structured finance, is the division of the cash flows and risks of a pool of financial assets into separate classes of securities, called tranches, that rank in a fixed order of priority. The word comes from the French for "slice". Each tranche has its own claim on the income from the pool and its own exposure to losses, so that a single pool of loans can back securities ranging from very safe to highly speculative.
Tranching is the defining feature of securitization. It is used in an asset-backed security, a mortgage-backed security and a collateralised loan obligation, and it lets issuers match securities to investors with different appetites for risk. The term is also used more loosely in finance for any funding divided into parts, such as the separate facilities of a syndicated loan or the staged instalments of an investment, but those are parts of a financing and not rankings of risk.
How credit tranching works
The assets are transferred to a special purpose entity, which issues several classes of notes to pay for them. Collections from the assets are distributed according to a securitisation waterfall: interest and principal go first to the most senior class, then to the next, and so on. Losses run in the opposite direction, reducing the most junior class first. Three layers are usually distinguished:
- The senior tranche. It is paid first and absorbs losses last. It is the largest part of the structure, carries the highest rating and pays the lowest return.
- The mezzanine tranche. One or more middle classes take losses once the junior layer is exhausted, in exchange for a higher coupon.
- The equity tranche. Also called the first-loss or residual piece, it receives whatever is left after the other classes are paid and is the first to lose money.
The share of the structure ranking below a tranche is its subordination, the main form of credit enhancement. A tranche is often described by its attachment point, the level of pool losses at which it begins to lose principal, and its detachment point, the level at which it is wiped out.
Worked example
Suppose a pool of loans of 100 million is funded by a senior tranche of 80 million, a mezzanine tranche of 15 million and an equity tranche of 5 million. If borrowers default and the pool loses 4 million, the equity tranche falls to 1 million and the other classes are untouched. If losses reach 12 million, the equity is eliminated and the mezzanine tranche loses 7 million. The senior tranche loses nothing until pool losses pass 20 million. The mezzanine tranche therefore attaches at 5% and detaches at 20%.
This is how a pool of loans with a moderate average credit rating can produce a large senior class rated well above the average. The risk has not been reduced; it has been concentrated in the junior classes.
Other forms of tranching
Tranches can also be distinguished by timing instead of by credit risk. In time tranching, classes rank equally for losses but receive principal in sequence, so that one class is repaid over the first few years and the next only afterwards. Mortgage securities use this to distribute prepayment risk, giving investors a choice of shorter or longer expected lives. Classes may further differ by interest type, with fixed-rate and floating-rate notes, or interest-only and principal-only strips, issued from the same pool. In a synthetic securitisation, tranches of credit risk are transferred through derivatives or guarantees without selling the underlying assets.
Role in the 2008 financial crisis
Tranching was central to the growth of mortgage securitisation before the 2008 financial crisis. Mezzanine tranches of mortgage securities, hard to sell on their own, were pooled into collateralized debt obligations and tranched again, creating new senior classes with top ratings. The ratings relied on the assumption that defaults across different mortgage pools would not rise together. When house prices fell nationally, losses were far more correlated than models had assumed, and many highly rated tranches were downgraded or defaulted.
The episode showed that the value of a tranche is very sensitive to assumptions about default correlation, that thin tranches can move from full value to nothing over a narrow range of pool losses, and that repeated tranching makes it hard for investors to see the underlying assets.
Regulation
Post-crisis rules address these weaknesses. In the European Union, the Securitisation Regulation, which has applied since 2019, requires originators or sponsors to retain a material net economic interest of at least 5% in the transaction, obliges investors to carry out due diligence, restricts the tranching of existing securitisations and created a label for simple, transparent and standardised deals. Comparable risk retention rules apply in the United States. Bank capital rules under Basel III assign capital charges to securitisation exposures according to their seniority and thickness, with the most junior positions carrying the highest charges.