- Fannie Mae and Freddie Mac created mortgage backed securities in the 1970s. They bought loans from the bank and provided banks the opportunity to make more investments, while enabling more people to take loans. This paved the way for future developments in this sector. Tranche literally means section, slice or portion in French. In finance, tranche refers to a security that can be divided into smaller segments and put up for investment. Each security within the group might have different time spans and offers various types of benefits. Tranches allow investment in securities backed by mortgages that are feasible for the individual’s financial needs, offering varying rewards, risks and maturities.
Understanding Tranches
- Mortgage backed securities are split into tranches when they are sold by banks. Mortgage backed securities derive their value from a group of mortgages, which can be sold further or investors can hold onto them. Once all the mortgages in the pool are cleared, these securities lose their value. The tranches are usually built on the date of maturity or the scheduled date when the debtor had to pay off their mortgage.
- This enables sellers to adjust their investment plans to suit their financial needs. For example, an investor who wants a source of income for a long period of time will buy a security from a tranche with mortgages that will reach their maturity in 25 years. On the other hand, an investor looking to earn in a short span of time can buy a security from a tranche with mortgages that will reach their maturity in 3 years.
- Tranches are divided based on various characteristics. During the peak of the US housing bubble, many banks developed tranches, based on risk. Here, risks were determined by how strict the terms of the mortgage contract were. The stricter the terms, the stronger was the mortgage. This risk-based tranching is not common these days, given that mortgage requirements have been tightened. However, it hasn’t vanished completely.
- Tranches have been divided into various categories, based on the level of risk, credit ratings and interest rates:
- Senior Tranche: This is a triple A rated (AAA) tranche, with very low interest rates but it is repaid first, meaning that it has very low associated risk as well.
- Junior Tranche: This is usually given an investment grade rating. It does not get paid off as early as a senior tranche and offers an average rate of interest.
- MezzanineTranche: This is usually given below investment grade rating and has very high rates of interest. It is the riskiest type of trance, as it absorbs any losses before any other tranche.
Senior rated tranches have generally higher credit ratings than the other two lower rated tranches. Financial products like insurance policies, mortgages, loans and other debts can be divided into tranches.
Types of Tranches
Collateralised mortgage obligations (CMO) are a type of structured credit products. They aim to make money from mortgages or other forms of debts, leading to the entire cost of lending becoming cheaper for the overall economy. All the revenue from the CMO group of assets are pooled together. This is divided into various types of tranches. It allows investors exposure to the mortgage within the CMO. Here’s a look at these tranches.
1. Sequential Tranches
These are often referred to as “vanilla” CMOs because of the simplicity they offer. There are a number of tranches set up in a sequential order and they are made to retire in the same order. As the principal payments are made, the bonds in the first tranche will be paid off until it reaches maturity and then the payments are put into the next tranche in the sequence. This continues until all tranches have been paid off and retired.
2. Schedule Bond Tranches
It is divided further into 2 types:
- Targeted amortisation class (TACs): These are scheduled bond tranches that are paid on a predetermined schedule using a prepayment model. TACs only apply to the prepayment rate. If the rate is higher or lower, the holders of the bond will receive more or less principal than they would receive with prepayment rates.
- Planned amortisation class (PACs): These are designed to provide a stable flow of cash. They include companion tranches and redirect the risk of prepayment. Here, more than one tranche is active and when less prepayments takes place, the PAC takes priority. However, if prepayments are higher, the PAC gets the amount that was scheduled and the extra is put into a companion tranche.
3. Companion Tranches
These are used in PAC and are also called support tranches, as they support the main PAC, giving it stability and foreseeable cash flow. It also safeguards the PAC by taking on any extra principal when the prepayments are higher and delaying the receipt of principal when prepayments are lower than scheduled.
4. Z-Tranches
Investors in Z-tranches receive the principal payment and interest only after all other tranches have been paid off and retired, making it the riskiest of all the tranches. Investors will not be paid anything for a long span of time and if the mortgage is defaulted upon, the investors will be stuck. It also makes senior tranches more secure because senior tranches are paid off first. On the plus side, if the mortgage doesn’t default, it will provide a stable source of income throughout the investor’s lifetime.
Benefits of Tranches
- Tranches allow investors to develop a single class or multiple classes of securities with higher rating than the underlying assets. Senior tranches are insulated against risk of default on the underlying asset or mortgage, as junior tranches absorb all the losses.
- Tranch investments allow investors to diversify their portfolio, as it provides exposure to other classes of high rated securities.
- It provides investors the option to customise their investment strategies, based on their financial goals.
Risks
- Tranching can add complexity to your investment, since it requires deal-specific, detailed paperwork so that the desired features are provided under all circumstances.
- With increasing complications, it becomes tough for simple investors to understand these securities, exposing them to uninformed decisions.
- In case of default, different tranches may have different conflicting goals, which can lead to time consuming and costly lawsuits, called tranche warfare.
- Underestimation of risks by investors and over-rating of tranches by rating agencies, based on historical performance, have proven critical. The subprime mortgage crisis of 2008 exposed these factors.
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