Question

Suppose the subprime car loans portfolio undergoes a 15% loss, what is the loss suffered by

(a)the equity tranche of the CDO?

(b)the mezzanine tranche of the CDO?

Explain in words how you obtained these numbers.

Answer 1

CDOs are basically collateralized debt obligations which helps to reduce the cost of lending to make it cheaper for the economy. The CDO's collections are based on different pool of cashflows which are bifurcated into various tranches depending upon the ratings. The highest is the 'AAA' rated tranche which is the senior most tranche. The middle or the mezzanine tranched ranges from 'AA' to 'BB' ratings. The lowest junk or unrated tranche is the equity tranche. Each ratings decide how much principal and interest each tranche recieves.

On the basis of ratings the senior most tranche is generally the first to absorb cash flows and the last to absorb mortgage defaults or missed payments, thus it has the most predictable cash flow and lowest risk. The lowest rated tranches usually only receive principal and interest payments after all other tranches are paid. Furthermore they are also first in line to absorb defaults and late payments.

Thus, as per the explanation above the loss suffered by the equity tranche would be the highest i.e. 15% as it is the lowest tranche of the CDO. The loss suffered by the mezzanine tranche would be to the extent which is not covered by the equity tranche, in case the equity tranche is able to absorb the entire loss the loss to mezzanine tranche would be nil.

Kindly check and let me know in case of any queries.