The word “tranche” is French in origin meaning a ‘slice’, portion, or piece. When it comes to creating a mortgage backed security (MBS), tranches represent a ‘slicing’ of a MBS into specific investments inside an offering where each tranche gives investors a different yield and risk profile. The lower the risk, the lower the yield for the investor.

Tranche Defined

This ability to take a huge pool of subprime mortgages use them as the security for the MBS (also known as a mortgage derivative), allowed Wall Street to then sell all kinds of investor a piece regardless of their risk tolerance. Many institutional investor are very conservative, so they would never get involved in these types of investments if they could get a AAA rated investment.

Creating a subprime mortgage backed security that conservative investors would normally run from and convert it so at least a portion of the investment could be considered AAA rated…allowed Wall Street to find more capital for this market. Wall Street found that not only could they sell the AAA rated tranches, but there were plenty of investors willing to invest in the higher yielding, higher risk BBB and CCC tranches too.

This thirst of investors for these kinds of investments provided the capital the subprime wholesale lenders provided to fund the closing of all the mortgage broker sold subprime loans. Of course, we now know no matter how you slice it, if the collateral for the investment was a subprime mortgage pool, you were in trouble.

It’s important to note had Wall Street not created and promoted these investments to investors creating a big demand, there never would have been a subprime mortgage boom and bust.

Here’s a video to understand more about tranches…

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