Question

You hold a portfolio of mortgages $100.

If 5% of these morgages default, you will lose exactly $___________. If 12% of these morgages default, you will lose exactly $_____________.

A bank has used $100 million morgages to create the following tranches:

45% of AAA

25% of AA

18% of A

7% of B

5% of residual/equity

Imagine that you invest your $100 in the BBB tranch. If 5% of the underlying morgages default, you will lose exactly $_____________. If 12% of the underlying morgages default, you will lose exactly $______________. Hint: Think of the water cascade!

Sit back and compare these two investment choices (directly into morgages, versus indirectly via tranches). See how the risk profile is very different? This is what surprised many investors just before the GFC. The stuned faces in the "Big Short" as well as "Margin Call" reflect the sudden realization of this underlying risk.

Answer 1