Fixed Income Qbank Question

The most popular form of credit enhancement is the senior-subordinated structure. What does the senior-subordinated collateral structure shown below indicate? Senior tranche: $560 million Subordinated tranche: $40 million A) The subordinated tranche investor receives $40 million in repayment first. Then the cash flow goes to the senior tranche. B) The subordinated tranche is protected by the senior tranche. C) The first $40 million of losses are absorbed by the subordinated tranche. Your answer: A was incorrect. The correct answer was C) The first $40 million of losses are absorbed by the subordinated tranche. The loss of $40 million is applied to the subordinated tranche first and since it is large enough to absorb the entire loss, all $40 million is applied to the subordinated tranche. ***From my understanding, the subordinate layers of the tranche absorb the prepayment of principle first, and therefore bear more of the reinvestment risk then higher level tranches. So how is choice C better than choice A? FYI i went through both Schweser and CFAI and could not find anything on credit risk or losses related to tranches of a CMO. Only that the reinvestment risk is different for the different levels. Any thoughts??? Thanks!

spartan262 Wrote: ------------------------------------------------------- > The most popular form of credit enhancement is the > senior-subordinated structure. What does the > senior-subordinated collateral structure shown > below indicate? > > Senior tranche: $560 million > > Subordinated tranche: $40 million > > > A) The subordinated tranche investor receives $40 > million in repayment first. Then the cash flow > goes to the senior tranche. > B) The subordinated tranche is protected by the > senior tranche. > C) The first $40 million of losses are absorbed > by the subordinated tranche. > > Your answer: A was incorrect. The correct answer > was C) The first $40 million of losses are > absorbed by the subordinated tranche. > > The loss of $40 million is applied to the > subordinated tranche first and since it is large > enough to absorb the entire loss, all $40 million > is applied to the subordinated tranche. > > ***From my understanding, the subordinate layers > of the tranche absorb the prepayment of principle > first, and therefore bear more of the reinvestment > risk then higher level tranches. So how is choice > C better than choice A? > > FYI i went through both Schweser and CFAI and > could not find anything on credit risk or losses > related to tranches of a CMO. Only that the > reinvestment risk is different for the different > levels. Any thoughts??? Thanks! In the event of bankruptcy the repayment system is 1) Senior Debt, 2) Subordinate Debt, 3) Equity. Subordinate debt is more risky then senior debt, and therefore commands a higher required return. I think you are thinking of the “support” tranches in a CMO, not subordinate. This is level 2 stuff.

Yeah this ain’t level I stuff anymore. You learn about the equity tranch and the different credit risk faced by holders of different tranches at Level II.

Okay, great. Thank you. I wonder why Schweser put it in their Qbank. Either way, its locked up in my head just in case it does come up.

@spartan262 since lower grade (subordinate tranche) has higher credit risk the investors of subordinate get higher return , when there is a credit event the loss is first absorbed by subordinate tranche thereby the investor loses . option A is wrong because its says the “subordinated tranche investor receives $40 million in repayment first”