The interest and principal payments paid on the pooled loans are paid to investors in a specific order, which is spelled out by the securities' "tranches" French for slices. Those investors who are particularly averse to risk buy the tranches viewed as most secure by the credit rating agencies. Investors in these senior tranches get paid first, before all other investors. To add more protection, a pot of money from the loan payments is set aside just in case a large number of borrowers default.
The tradeoff for all this protection is a lower return investors in senior tranches receive lower rates of interest on their investment. Senior tranches make up the bulk of most securitizations; in the average residential mortgage-backed security (RMBS), for example, senior tranches account for 80% of the face value also called the capital structure of the security.
After senior investors get their money, investors in the middlerated or mezzanine tranches receive theirs. Investors in these tranches are assured of payment under most circumstances, but if the economy suffers a recession or housing experiences a cyclical downturn, things could get dicey, and mezzanine investors might not get all their money back. Mezzanine tranches account for 18% of the average security's capital structure.
The remaining 2% is the riskiest slice of the security, known as the equity tranche. This portion isn't even rated by the credit-rating agencies. Investors in the equity tranche are the last to be paid, and thus may not get all their money back if too many borrowers default. Because of the obviously high risks, the returns can be large if all goes well.
Wall Street's securitization machine went into overdrive during the housing boom, producing a frenzy in the mortgage securities market. At its peak in 2005, more than $1.1 trillion in RMBS were issued and sold to investors. Another $1 trillion was sold in 2006. In the first half of 2007, leading up to the subprime financial shock of that summer, RMBS sales came in not far off the $1 trillion mark.
For any securitization to succeed, investors must be willing to buy each of the tranches. Banks themselves were first in line, picking up most of the senior-rated segments. Returns on these were low, but greater than the banks' were paying to their own depositors. Just as important, regulators required banks to hold very little capital in reserve against the chance these high-rated securities would default. The high rating meant there was very little risk or so regulators thought. Insurance companies and various types of asset managers bought the bulk of the mezzanine tranches.
These firms were searching for higher returns than the senior tranches offered and they didn't have the same regulatory constraints as the banks. Besides, the mezzanine pieces were still A-rated securities and the chance of default was thought to be relatively low.
The biggest buyers of the equity tranches were hedge funds. The managers of these investment pools knew they were taking bigger risks, but their clients demanded extraordinary returns, which are tough to generate without substantial risk and lots of leverage (borrowed money).
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1. The debt recovery claimant receives various documents from the court
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