Understanding Tranches: Benefits & Risks of Structured Finance

Tranches were created relatively recently, through the development of structured financing. Structured financing broadly refers to the many ways large third party companies divide up risky financial products and sell the divisions to various investors. These financial products may be insurance policies, mortgages or other debts. Instead of buying a stake in a company, when an investor purchases a tranche, the investor is actually just buying a stake in the risk of the financial instrument. 

Tranche Example

A bank offers a commercial loan to a small business. The bank does not want to carry the risk of this loan for a lengthy period of time so it sells the loan to a special purpose company. If the loan is repaid on time, the original investment is paid, plus a high amount of interest. In an effort to spread risk, commercial mortgages are split into various tranches. Each tranche lasts a given period of time; there are five, ten and twenty year tranches. The individuals holding the long tranches stand to earn the most, but they are also assuming the greatest amount of risk. If the borrower defaults, the investors receive only a portion of their original investment in return.

Pros of Tranches

Tranches are an effective way to divide up spread risk between multiple individuals, instead of carrying it within one institution. Further, by dividing up portions of loans for resale, banks can receive immediate capital to continue issuing debts and fuel the economy. Without selling debts on the secondary market, a lender will eventually run out of funds. Selling the debts allows the bank to continue lending and allows an investor to participate in the highly lucrative business of lending. Through tranches, a third party offers a number of options to participate in the structured security, each with its own costs and risks. If everything goes well, all parties end up winning. 

Cons of Tranches

Unfortunately, all does not go well in a large number of cases of structured financing. If the borrower defaults, all investors stand to lose; this is why analysts have used the term "systemic risk" in relation to structured financing. One default can end up affecting the financial situation of dozens of other parties down the line. Further, investors do not often gain a clear picture of what they are investing in when they purchase a tranche. Since the option has been cut up and divided so many times, it is easier for a bank to falsify information about the possible risks of the tranche. This type of scenario greatly contributed to the credit market crash of 2007. Many companies who purchased mortgage-backed securities were unaware the underlying debt was a mortgage.