Posted 10 months ago

CMBS Part II: Opportunities through Tranching

This article will make more sense if you’ve already read Part I: Basic Structure that explains what a CMBS is, which introduces a case example that will be referenced below.

The Concept of Tranching

Remember how once Max sold Julie’s loan to Mateo, Max no longer had to worry about whether or not Julie continued to make her monthly payments? That “default risk” was passed on to Mateo. But once Mateo “securitized” Julie’s loan, that is, once he combined her loan with other loans he bought from Max and put them into a trust (thus creating a security), Mateo was also able to pass on the default risk.

Mateo no longer owns the loans. He cashed out using the money from Zoe and Amar. That means that Zoe and Amar are now the ones on the hook should Julie be unable to make her loan payments.

Naturally, Zoe and Amar don’t want to have to worry about whether or not they’ll get paid either. To address this concern, Mateo creates something called “tranches”. You can think of these as levels of priority. Just like a gold vs platinum membership, different levels come with different benefits.

In this case, the different levels (or tranches) come with a prioritization when it comes to payments being made. Those investors at the highest level get paid first and those investors at the lowest levels get paid last. This concept is not that different from senior and junior lien holders, if that metaphor helps.

Continuing the Example

Let’s say that Julie makes a partial payment one month. If Amar is ranked higher than Zoe, instead of them both receiving a partial payment, Amar may be paid in full, while Zoe only gets whatever is left over. For that added sense of security, that is, for the privilege of being ranked higher than Zoe, Amar earns a lower interest rate. While for taking on the additional risk that Julie may not always make her payments, Zoe earns a higher interest rate on the payments she does receive. Zoe and Amar both have the ability to choose where they want to be, that is, they decide which membership level or which tranche they want to invest in, knowing that taking on a higher risk will lead to higher returns, while lower risks will lead to lower, but steadier, returns.

In reality, there wouldn’t be only two investors and two levels involved. There could be two or three levels, or there could be twenty plus levels. Regardless, there will be an order established where there is a top ranked tranche, a tranche in second place, third place, etc. all the way down the line.

Whenever a payment comes in, the top level, or senior-most tranche gets paid first. However, if there’s a shortfall in the loan payments, the lowest level tranche is the first to take the hit. Remember that the lower ranked tranches are paid a higher interest rate in exchange for taking that additional risk.

Let’s go back to our example. When Julie originally paid her 6% interest rate, Mateo took 0.5% for himself. He then had 5.5% left to equally split between Zoe and Amar. But now there are multiple tranches, each with a different level of priority, and each expecting a different interest rate in return for the assumed risk. Thus, Mateo needs to change things up a bit.

He pays the lowest level tranche an interest rate of 5.5% (keeping that half a percent for himself). He then pays the next highest tranche a slightly lower interest rate of 5.0% (this time keeping 1% for himself). He continues to lower the interest rate for each successfully higher ranked tranche (for each successively safer investment level) and in the process takes a larger fee for himself. Remember, the riskier the investment the higher the interest rate and the lower the risk, the lower the return.

Everything Has to Come Together

Knowing that the people at the bottom are at the highest risk of losing money, most investors want to be part of the highest level tranches. Still, there has to be somebody at the bottom. Somebody has to take the loss if/when Julie can’t make her loan payments. Otherwise, the system just wouldn’t work. Without getting into the details, there are investors who are big enough risk takers that this isn’t a problem.

In theory, the system works in such a way that everyone benefits. Julie gets the loan she needs to buy an office building. Max earns a fee for every loan he creates and has a continual source of money by selling loans to Mateo that he can use to keep originating new loans. Mateo gets money from individual investors like Zoe and Amar and gets paid a percentage of the interest earned from loans in repayment. Zoe and Mateo collect regular payments over time, making money off the interest paid by borrowers like Julie. They also have the ability to choose how much to invest and what kind of risk/reward scenario they’re comfortable with.

I won’t get into the details, but if there are enough investors below Zoe and Amar who are seeking a higher interest rate and willing to take on more risk, it makes the investments in the higher tranches that much safer. With more risk takers, there are more people to accept the inevitable losses that comes from borrowers not making payments.

In the final part of this series, we’ll move from the theoretical to reality and discuss real world problems that arise with commercial mortgage backed securities.