Tranche - Risks

Risks

Tranching poses the following risks:

• Tranching can add complexity to deals. Beyond the challenges posed by estimation of the asset pool's loss distribution, tranching requires detailed, deal-specific documentation to ensure that the desired characteristics, such as the seniority ordering the various tranches, will be delivered under all plausible scenarios. In addition, complexity may be further increased by the need to account for the involvement of asset managers and other third parties, whose own incentives to act in the interest of some investor classes at the expense of others may need to be balanced.
• With increased complexity, less sophisticated investors have a harder time understanding them and thus are less able to make informed investment decisions. One must be very careful investing in structured products. As shown above, tranches from the same offering have different risk, reward, and/or maturity characteristics.
• Modeling the performance of tranched transactions based on historical performance may have led to the over-rating (by ratings agencies) and underestimation of risks (by end investors) of asset-backed securities with high-yield debt as their underlying assets. These factors have come to light in the subprime mortgage crisis.
• In case of default, different tranches may have conflicting goals, which can lead to expensive and time-consuming lawsuits, called tranche warfare (punning on trench warfare). Further, these goals may not be aligned with those of the structure as a whole or of any borrower—in formal language, no agent is acting as a fiduciary. For example, it may be in the interests of some tranches to foreclose on a defaulted mortgage, while it would be in the interests of other tranches (and the structure as the whole) to modify the mortgage. In the words of structuring pioneer Lewis Ranieri:

The cardinal principle in the mortgage crisis is a very old one. You are almost always better off restructuring a loan in a crisis with a borrower than going to a foreclosure. In the past that was never at issue because the loan was always in the hands of someone acting as a fiduciary. The bank, or someone like a bank owned them, and they always exercised their best judgement and their interest. The problem now with the size of securitization and so many loans are not in the hands of a portfolio lender but in a security where structurally nobody is acting as the fiduciary.