What is a Tranche?
A tranche refers to a segment out of a pool or package of debt instruments (e.g. bonds and mortgages). Lenders combine multiple tranches to sell as a securitized or structured product.
DID YOU KNOW?
Tranche comes directly from the French word “tranche,” which means slice or portion.
Each security has its own characteristics: level of risk, time to maturity, yield, etc. Lenders package different tranches to offer a wide range of products for all kinds of investors. For example, a securitized product primarily made out of junk bonds would be a high-risk, high-reward investment. Government-backed securities, on the other hand, carry minimal risk but do not have the potential to yield huge returns.
Securitized products became a major topic of discussion and research after the 2007-2008 subprime mortgage crisis. Mass defaults on mortgage-backed securities (MBSs) and collateralized debt obligations (CDOs)—two types of structured products—majorly contributed to the collapse of the global economy.
In this article, the Zero Theft Movement will explain what tranches are and see how they factored into the 2008 subprime mortgage crisis. You can, in the end, make your own judgment call: was their financial foul play involved?
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Dissecting Tranches
To dive a little deeper into tranches and securitization, let’s take a look at what different investors might consider when investing in structured products.
The securitization process for MBSs
Credit Rating
Buyers/investors essentially look at the various ‘baskets’ of loans, each having unique characteristics. Investors willing to take more risk might opt for a trache with a low credit rating (a.k.a ‘junior tranche’) but a high yield. More risk-averse investors will take tranches with a low yield but high credit ratings (a.k.a. ‘senior tranches’).
Credit rating is an assessment of the creditworthiness of the borrower or issuer of the debt in question. For instance, if a borrower with a less-than-ideal credit score receives a NINJA loan (i.e. a no income, no job, no assets loan), then you’d expect the loan to come with extremely high credit risk.
Loan Maturity
Another important characteristic to consider is the time of maturity, or the date when the borrower must fully pay back the loan with interest. This factor, along with the credit rating, contributes to the yield.
The later the maturity date, the higher the yield typically is. It’s a way of rewarding investors willing to hold onto an investment longer. Many young investors would likely want to invest in 20-year tranches, for example. The value will continue to accrue over time, and there’s often minimal chance they will need to liquidate any time soon.
For investors nearing retirement, they might want to invest in tranches that will mature in a year or two. That way they can make a bit of money off of money that would otherwise be sitting around.
Tranches in the Subprime Mortgage Crisis
Tranches and securitized products experienced a boom in the mid-2000s. Lending standards had loosened up considerably, and interest rates were deceptively low. Overzealous citizens pumped in trillions of dollars into the housing market, either by taking out teaser-rate mortgages or refinancing existing ones.
source: Economics Help
Susan Wachter, a professor at the University of Pennsylvania’s Wharton School of Business, discussed the housing bubble: “We had a trillion dollars more coming into the mortgage market in 2004, 2005 and 2006…That’s $3 trillion dollars going into mortgages that did not exist before —non-traditional mortgages, so-called NINJA mortgages…These were [offered] by new players, and they were funded by private-label mortgage-backed securities—a very small, niche part of the market that expanded to more than 50% of the market at the peak in 2006.”
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Lending Fever
The widespread lending fever and housing boom made MBSs and CDOs attractive to many investors. Many borrowers were taking on subprime mortgages, high-interest home loans for those with less-than-ideal credit scores. These mortgages, due to their high risk, often came with high yields as well.
Nevertheless, credit agencies had assigned a much higher credit rating to many of the funds, which contained subprime mortgages. Junior tranches, therefore, were presented as if they were senior tranches. Furthermore, the mixture of various tranches contributed to the false sense of security in securitized products. The supposed security of these assets even led to them being used as leverage to back trillions of dollars.
Early warning signs were masked while the housing bubble continued to expand. Subprime borrowers who missed payments could refinance their mortgages based on the inflated value of their home or could just sell their property for quick returns. By March 2007, the value of subprime mortgages had reached around $1.3 trillion.
The Crash
When the housing market crashed, the house built on stilts collapsed. Countless subprime borrowers defaulted on their loans. Some even disappeared (another reason for the NINJA loan moniker). Major investment banks who had invested in products containing tranches of subprime mortgage loans suddenly faced huge losses.
By July 2008, more than 20% of subprime mortgages were delinquent, and 29% of adjustable-rate mortgages had become seriously delinquent. Major global banks, deemed ‘too big to fail,’ held mortgage-backed securities and quickly attempted to dump them as soon as they could. Lehman Brothers and Bear Stearns fell apart, triggering the government to intervene with the Troubled Asset Relief Program (TARP) to prevent the fall of any more colossi.
Tranche Warfare, Were Major Investment Banks Guiltless?
Senator Carl Levin (D-Mich.) wrote the following in an article for The Hill: “[Goldman Sach’s] actions demonstrate that it often saw its clients not as valuable customers, but as objects for its own profit. This matters because instead of doing well when its clients did well, Goldman Sachs did well when its clients lost money.”
In the aftermath of the crisis, the Securities and Exchange Commission (SEC) launched an investigation into the major investment bank. The Agency, in a 2010 press release, charged Goldman Sachs with “fraud in structuring and marketing of CDO tied to subprime mortgages.”
The press release alleges that “Goldman Sachs structured and marketed a synthetic collateralized debt obligation (CDO) that hinged on the performance of subprime residential mortgage-backed securities (RMBS). Goldman Sachs failed to disclose to investors vital information about the CDO, in particular the role that a major hedge fund played in the portfolio selection process and the fact that the hedge fund had taken a short position against the CDO.”
Goldman Sachs responded by settling the charges for $550 million and agreed to reform its business practices.
The SEC investigated a number of investment banks and charged over 10 investment banks in regards to their practices with securitized products. Another major case worth noting was the one against Citigroup. The bank paid $285 million to settle charges that it had “[misled] investors about a $1 billion collateralized debt obligation (CDO) tied to the U.S. housing market in which Citigroup bet against investors as the housing market showed signs of distress.”
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Eliminate the Rigged Economy with the Zero Theft Movement
So, what do you think? Did investment banks rig the system against their clients? If so, these are the kinds of practices the Zero Theft Movement is attempting to identify and eradicate. Trillions could be potentially coming out of your pockets every year due to unchecked corruption and greed.
Yes or no, we at the Zero Theft Movement are dedicated to finding and eliminating the rigged parts of the U.S. economy so that American businesses and citizens can flourish. Our community works to calculate the most accurate estimate for the monetary costs of corruption in the United States.
We achieve this collectively through our independent voting platform. The public investigates potential problem areas, and everyone votes on whether (1) theft is or isn’t occurring in a specific area of the economy, and (2) how much is being stolen or possibly saved. Through direct democracy, we can collectively decide where the problem areas are and start working on addressing them systematically.
Only through hard evidence can we prove where the rigged parts of the economy exist and force Congress to hold all the bad actors accountable.
Standard Disclaimer
The Zero Theft Movement does not have any interest in partisan politics/competition or attacking/defending one side. We seek to eradicate theft from the U.S economy. In other words, how the wealthy and powerful rig the system to steal money from us, the everyday citizen. We need to collectively fight against crony capitalism in order for us to all profit from an ethical economy.
Terms like ‘steal,’ ‘theft,’ and ‘crime’ will frequently appear throughout the article. Zero Theft will NOT adhere strictly to the legal definitions of these terms (since congress sells out). We have broadly and openly defined terms like ‘steal’ and ‘theft’ to refer to the rigged economy and other debated unethical acts that can cause citizens to lose out on money they deserve to keep.