101 Concepts for the Level I Exam

Concept 83: Credit Tranching and Time Tranching

ABS are often created with different types of tranches. The aim is to redistribute prepayment risk and credit risk efficiently among the different tranches.

Credit tranching

  • The focus is on redistribution of credit risk – Losses resulting from default of the borrowers whose loans are in the collateral.
  • Any credit losses are first absorbed by the tranche with the lowest priority and after that by any other subordinated tranches, in order.

Time tranching

  • The focus is on redistribution of prepayment risk – uncertainty that the actual cash flows will be different from the scheduled cash flows as set forth in the loan agreements because borrowers may choose to repay the principal early to take advantage of interest rate movements.
  • With sequential tranching, principal repayments flow first to one tranche until its principal balance is repaid and then to the second sequential tranche until its principal value is paid off, and so forth.

Some structures can have both credit tranching and time tranching.