A CDO equity tranche absorbs the first 3% of pool losses. The senior tranche absorbs only what survives once mezzanine is wiped out. Same pool, very different risk, and the gap between them is everything tranching is designed to engineer. The 2008 crisis didn't reveal that tranches were risky; it revealed that the correlation assumption inside the rating model was wrong, and once correlation rose, every senior tranche got repriced as if it had been mezzanine all along.
Structured credit pools credit assets and reissues them as tranched securities with reshaped risk. Pools include MBS (residential or commercial mortgages), ABS (autos, cards, student loans, equipment leases), CLOs (leveraged corporate loans), and CDOs (bonds, loans, or other ABS; CDO-squared layers another CDO on top). Mechanics are similar across types: assets sit in an SPV, the SPV issues tranches with different priorities, and tranche cash flows come from the pool through a waterfall.
Pool cash flows are paid out top down: senior fees (trustee, servicer, manager), senior tranche interest and principal (AAA/AA/A), mezzanine (BBB/BB), equity / first-loss residual, then excess spread.
Common mistakes
- Treating tranches as having the same risk as the pool. A senior tranche of a BBB pool can be AAA because subordination buffers losses. An equity tranche of an AAA pool can be junk because it absorbs first losses.
- Ignoring correlation in tranche pricing. Tranche prices depend on default correlation, not just average pool quality. Two pools with identical average PD but different correlation produce very different tranche prices. Trap: a question changes correlation and asks how senior tranche price changes; the answer is that senior is long correlation: price falls when correlation rises.
- Confusing compound and base correlation. Compound correlation is per-tranche and produces a non-monotonic smile. Base correlation is per-attachment and is monotonic. Market quotes are in base correlation. Trap: a question gives base correlations and asks for tranche prices via Gaussian copula; the answer requires the difference of two base-correlation tranche prices, not direct substitution.
Bottom line
- Tranching redistributes pool losses across senior, mezzanine, and equity tranches via a waterfall; equity absorbs first. Each tranche has its own attachment point, detachment point, and credit rating.
- Default correlation drives senior-tranche risk: senior is long correlation, equity short, mezzanine mixed. Higher correlation makes pool losses bimodal (small or catastrophic).
- Excess spread, overcollateralization, and subordination are the three primary credit enhancements. OC and IC tests redirect cash flow to senior tranches when pool performance degrades.
- CDS pays par minus recovery on default for a periodic spread, settled physically or in cash. CDS spread under no-arbitrage.
Exam shortcut
When a question asks for tranche P&L from a correlation move, identify whether the position is long correlation (senior, super senior) or short correlation (equity). When a question gives a CDS spread and asks for hazard rate, divide by (1 − R). Never use the raw spread.
The full lesson (about 3,559 words, 24 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
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