To appeal to these investors, an investment bank would bundle up loans into what’s called a mortgage-backed security (MBS) —where actual houses could be secured in case of default — which investors could then collectively buy in a single transaction. If a real estate investor (or any investor, really) is looking for an immediate, large, but very risky, return, they can pay for a slice of the pie and take on those risks. If another investor wants the guarantee of money down the road, but not right now, they can purchase another part of the pie — but one with a far smaller return.
From the bank’s perspective, tranches work wonderfully to package and sell previously unsellable securities. Investors, too, usually wind up getting what they wanted. The tranche, then, is a tool of the trade — and helps each investor meet their needs.
There are three main types of tranches — senior, mezzanine and equity — each playing an important role in how investors invest in a given security. Here’s a quick breakdown:
- Senior Tranche — a senior tranche is the highest, and least risky, tranche of any given security. The senior tranche is the last tranche to lose money if a financial deal starts taking on losses. This conservative approach, however, gives the senior tranche the lowest rate of interest on any deal — making it attractive to investors who don’t like to gamble with money like insurance companies and pension funds.
- Mezzanine Tranche — a mezzanine tranche is the tranche sandwiched between the senior tranche and the equity tranche and receives a modest sum of money for taking on a modest size of risk. This is the typical territory of hedge funds.
- Equity (Junior) Tranche — a equity tranche, sometimes referred to as the junior tranche, is the riskiest tranche there is. It’s the Las Vegas high-roller of the financial world — yes, there may be great returns, but it also carries the biggest risk if a deal doesn’t work out, and is the first tranche to absorb any losses.
Tranches played a key role in what’s now referred to as the Great Recession — where the collapse of the U.S. housing market caused a global economic catastrophe that hasn’t been seen since the 1930s. The top U.S. investment banks were relying on MBSs to sell to investors. But the quality of the mortgages in those MBS were, well, toxic.
To make a long story short: smaller banks were issuing loans to borrowers looking to buy houses. Those borrowers would pay the banks back with monthly loans. Those banks would then package those loans — with the mortgages (houses) used as collateral in the event of a default — and sell them to larger banks. Those larger banks would then turn around and sell shares of those home loans to investors who were looking to profit from the monthly mortgage payments.
Normally this isn’t a problem, and is actually a fine way of making each party — from the borrower to the investor working for a pension fund — happy. But something happened that few expected: the source of quality homeowners, the ones who’d pay their mortgage on time, dried up. That left the banks with risky subprime borrowers — people with low credit ratings and who didn’t pay their mortgages on time. When those borrowers were included in MBSs, they were divided across multiple tranches — making it hard for investment firms to investigate what exactly they were buying. When those borrowers began defaulting on their payments, the value of their homes collapsed, causing a cascade of losses across all tranches — even the senior tranches.
These losses ended up shaking the confidence of the U.S. economy to the bone. Legislation has since been passed in order to help regulate and oversee the various aspects of finance. Tranches are a powerful tool and an important way of facilitating investments, provided the right information is available.
This article is a guest post from NerdWallet.com, a consumer decision-making website dedicated to unbiased, quantitatively-oriented recommendations.
Repost: from www.ifunding.co/blog