Securitization Dissected

At bottom, securitization is not very complicated. The interest and principal payments paid on the pooled loans are paid to investors in a specific order, which is spelled out by the securities’ tranches—French for “slices.” Those investors who are particularly averse to risk buy the tranches viewed as most secure by the credit-rating agencies. Investors in these senior tranches get paid first, before all other investors. To add more protection, a pot of money from the loan payments is set aside just in case a large number of borrowers default.⁶ The tradeoff for all this protection is a lower return—investors in senior tranches receive lower rates of interest on their investment. Senior tranches make up the bulk of most securitizations; in the average residential mortgage-backed security (RMBS), for example, senior tranches account for 80% of the face value—also called the capital structure—of the security (see Figure 7.1).