Tranche

Tranche comes from the French word for slice. When loans are pooled and securitized, the resulting securities are often divided into tranches that are paid in a set order, sometimes described as a waterfall.

The senior tranche has first claim on the cash flows from the underlying loans. It is paid first and suffers losses last, so it is the safest and offers the lowest yield. Mezzanine tranches sit in the middle. The junior or equity tranche is paid last and absorbs losses first, so it is the riskiest and offers the highest potential return.

For example, a pool of loans worth 100 million might be divided into a senior tranche of 80 million, a mezzanine tranche of 15 million and an equity tranche of 5 million. If borrowers default and the pool loses 4 million, the loss falls entirely on the equity tranche. Only if losses exceed 5 million would the mezzanine tranche be affected.

Tranching allows a single pool of loans to appeal to investors with very different risk appetites. However, the 2008 financial crisis showed that the risks of some tranches, particularly those created from repackaged subprime mortgages, had been seriously underestimated, including by credit rating agencies.