Question

The principal of $280 million for the underlying assets is backed an ABS with the senior tranche 72%, mezzanine 20% and equity 8%. The principal derived from the mezzanine tranche of the ABS is replaced by an ABS-CDO with the senior tranche 85%, mezzanine 10% and equity 5%. The principal derived from the mezzanine tranche of the ABS-CDO is further replaced by an ABS-CDO-CDO with the senior tranche 85%, mezzanine 10% and equity 5%. If the loss on the underlying assets is 10%,

1. what will be the loss (in %) to the mezzanine tranche of the ABS, and the loss (in %) to the mezzanine tranche of the ABS-CDO?
2. what will be the loss (in % and $) to the senior tranche of the ABS-CDO-CDO?

Answer 1

We find the weights of each tranche.

Level 1 ABS:

Senior = 72%

Mezzanine = 20%

Equity = 8%

Level 2: ABC CDO (Mezzanine is furthere replaced by ABS CDO)

Senior = 85%

Mezzanine = 10%

Equity = 5%

Level 3: ABS CDO CDO ( Mezzanine of ABS CDO is replaced by ABS CDO CDO)

Senior 85%

Mezzanine = 10%

Equity = 5%

Capital is as follows:

Capital at each level	L1	L2	L3
Senior	201.6	47.6	4.76
Mezzanine	56	5.6	0.56
Equity	22.4	2.8	0.28
	280	56	5.6

Remember that loss will be first suffered by Equity than Mezzanine and then with senior debt. After this loss of level 1 of mezzanine is further distributed to level 2 in the same order. And then loss of level 2 mezzanine is further distributed to level 3 in the same order.

Total Loss = 10% * 280 = 28

Level 1 absorption:

Equity absorbs 22.4 and rest 5.6 by mezzanine

Level 2 distribution of 5.6

Equity absorbs 2.8 and rest 2.8 by mezzanine

Level 3 distribution of 2.8

Equity absorbs 0.28 and rest 0.56 by mezzanine and rest 1.96 by senior

a) Loss to mezzanine tranche of ABS = Loss / Capital = 5.6 / 56 = 10%

Loss to mezzanine tranche of ABS CDO = Loss / Capital = 2.8 / 5.6 = 50%

b) Loss to senior tranche of ABS CDO- CDO = 1.96 / 4.76 = 41%

In amount terms it is 1.96$