First loss equity tranche

For our portfolio, the analysis of expected losses to the first loss equity tranche might look like that shown in Exhibit 22.13. Our binomial distribution indicates that there is a 29.7% chance of 1 default occuring. This default would generate a 70% loss (30% recovery) on Vm of the portfolio, or about 1.43% of the total notional amount. How-... 

On the liability side, the structure will have tranches whose allocations of income and loss are predefined. From most junior to most senior, the tranches include equity, mezzanine, senior, and super-senior. Equity, or first loss, is analogous to the equity in a company s balance sheet, and represents the residual interest remaining after other liabilities are paid off. The mezzanine, or middle tier of risk, typically represents low-rated tranches all the way up to AA risk. Senior usually refers to AA and AAA risk. Super-senior represents a level of risk that is deeply subordinated (usually by at least 10%) to AAA, and as its name implies is regarded as extremely safe. In a structure that is not uncommon, we will assume all of the liability tranches are unfunded except for the equity. ... 

The static, no-loss return of the various tranches in this case might have the profile shown in Exhibit 22.6. Here the equity tranche constitutes the first 50 million of risk, and is compensated for its position in the capital structure with a very high notional spread of 20.5%, or 10.25 million per year on 50 million notional. This spread represents the annual return to the equity holder in the scenario where no losses are incurred. Conversely, the most senior tranche of risk receives only 1.05 million per year on a notional position of 700 million. The low spread return of only 15 bps ( 1.05 million/ 700 million) underscores the perceived safety of the super-senior tranche. 

Because the SPV now owns the assets, it has an asset-and-liability profile that must be managed during the term of the CDO. The typical liability structure includes a senior tranche rated Aaa/Aa, a junior tranche rated Ba, and an unrated equity tranche. The equity tranche is the riskiest, since it is the first to absorb any losses in the underlying portfolio. For this reason, it is often referred to as t c first-loss tranche. 

Reserve accounts. The banks may also set aside cash reserves from the note proceeds in accounts, usually mantled by the servicing agent or a specialized cash manager, which provide first-loss protection to investors by absorbing losses before the equity tranche. 

As illustrated in Figure 15.1, in a securitization the issued notes are structured to reflect specified risk areas of the asset pool, and thus are rated differently. The senior tranche is usually rated AAA. The lower-rated notes usually have an element of overcollateralization and are thus capable of absorbing losses. The most junior note is the lowest rated or nonrated. It is often referred to as th.t first-loss piece, because it is impacted by losses in the underlying asset pool first. The first-loss piece is sometimes called the equity piece or equity note (even though it is a bond) and is usually held by the originator. 

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