Credit Risk Management Practice Exam

Which piece absorbs initial losses in a securitized product?

1. Senior tranche

2. First-loss piece

3. Collateralized loan

4. Equity tranche

The correct answer is: First-loss piece

The first-loss piece is the component of a securitized product that absorbs initial losses. In the context of asset-backed securities, the first-loss piece is designed to absorb losses before other tranches are affected. This tranche is typically subordinated, meaning it has a lower claim on cash flows compared to other tranches, like the senior tranche. When a securitized product experiences losses, these are first taken by the first-loss piece, thereby protecting the more senior tranches from being hit until the losses exceed the amount of the first-loss piece. This structure incentivizes investors in the first-loss tranche to closely monitor the underlying assets since they bear the initial risk. As such, the first-loss piece serves as a critical layer of loss protection for the subsequent, more senior tranches, enabling the overall securitization structure to function effectively. In comparison, the senior tranche typically has priority in receiving payments and thus does not absorb initial losses, making it less risky. Collateralized loan refers to underlying assets (like loans) that are packaged into securities, but it does not specifically address loss absorption. The equity tranche, while it can absorb losses, is usually considered a form of subordinate financing or equity investment rather than the targeted first-loss piece defined in a