Credit Risk Management Practice Exam

Which tranche is known as the lowest priority and bears the first loss in a securitization?

1. Mezzanine tranche

2. Equity tranche

3. Senior tranche

4. Subordinated tranche

The correct answer is: Equity tranche

The tranche that is known as the lowest priority and bears the first loss in a securitization is the equity tranche. This tranche takes on the highest risk because it is the first to absorb losses that occur within the underlying asset pool. If any defaults or losses happen, they are absorbed by the equity tranche before any other tranches get affected, meaning that investors in this tranche could potentially lose their entire investment if the losses are significant. The equity tranche is typically compensated for this higher risk by offering the potential for higher returns compared to other tranches. Investors in this tranche will receive residual cash flows after all costs and obligations to higher-priority tranches are met. This characteristic of first-loss position makes it a crucial part of the capital structure in securitization, as it helps to provide support and confidence for the more senior tranches. In contrast, other tranches mentioned, such as the mezzanine, senior, and subordinated tranches, do not occupy the first-loss position and have different risk-reward profiles. They rely on the performance of the equity tranche to remain protected from losses, which emphasizes the unique risk exposure associated with the equity tranche in structured finance.