Credit losses first impact Tranche C (Equity), followed by Tranche B (Mezzanine), and finally Tranche A (Senior). In a typical securitization structure, credit losses are allocated based on the seniority of tranches. The Equity Tranche (Tranche C) is the first to absorb credit losses as it is the riskiest and offers higher returns to compensate for this risk. Once the losses exceed the buffer provided by the Equity Tranche, they move up to the Mezzanine Tranche (Tranche B), which has a moderate level of risk. The Senior Tranche (Tranche A) is the most secure and is the last to be impacted by credit losses, as it has the highest priority in the cash flow structure.

B is incorrect because credit losses in securitization structures are not distributed equally among all tranches. Instead, they follow a specific order based on the seniority of each tranche.

C is incorrect as the Senior Tranche (A) is typically the last to be impacted by credit losses, not the first, due to its higher priority and lower risk compared to the other tranches.

D is incorrect because credit losses do not impact the Mezzanine Tranche (B) first. The Equity Tranche (C) is the first to absorb losses, followed by the Mezzanine and then the Senior Tranche.

Things to Remember

• Risk and Return Correlation: In securitization tranches, there is a direct correlation between the level of risk and the potential return. Higher-risk tranches typically offer higher yields to compensate for the increased risk of credit losses.

• Investor Risk Appetite: Tranching caters to a diverse range of investor risk appetites, allowing them to select tranches that align with their risk tolerance and investment goals.