Tranche Explained: Understanding Mortgage-Backed Securities

Tranche is a portion of a mortgage-backed security that's made up of mortgages that share certain common characteristics. "Tranche" is a French word that means "slice" or "portion. Mortgage-backed securities are backed by mortgage pools that are made up of many different types of mortgages. Each mortgage has different duration and brings in different profits. Tranches allow investors to buy securities backed by the types of mortgages whose terms fit their financial needs.

Understanding Mortgage-Backed Securities

Mortgage-backed securities are securities that derive their value from the value of a pool of mortgages. The investor can either sell mortgage-backed security to other investors of hold on to it. If the investor sells it, they will be able to make immediate profit. If the investor holds on to the security, they will earn smaller, but more long-term profit by receiving monthly payments. Those monthly payments are portions of the mortgage payments made by the home owners whose mortgages are included in the pool. Once all the mortgages in the pool are paid off, the securities will lose their value.

Understanding Tranches

When banks sell mortgage-backed securities, they usually split them into tranches. The tranches are usually based on the date of maturity, or the time when home owner is scheduled to pay off the mortgage in full. This allows vendors to customize their investment strategies based on their financial needs. For example, an investor who needs more money for a short period of time can buy a security from a tranche with mortgages are scheduled to mature in five years. An investor who wants a more long-term source of income can buy a security from a tranche with mortgages are scheduled to mature in thirty years.

Tranches may be further divided based on other characteristics. During the height of the housing bubble, many banks created tranches based on risk. In this case, risk is defined as the odds that the borrower may default on his or her mortgage. Risk was determined based on how strict the mortgage application terms were. The stricter the terms were, the stronger the mortgage was. The risk-based tranching has become less popular as the mortgage requirements tightened, though it hasn't vanished altogether.

Benefits of Tranches

The biggest benefit of tranches is that they allow investors to customize their investment strategies to suit their needs. For banks and financial institutions that assemble the mortgage pools, the tranches are incentives they can use to attract investors who would otherwise be weary of their products. 

Downsides of Tranches

While tranches give investors flexibility when it comes to investing strategies, they also introduce an additional layer of complexity into the investment process. New investors often make the mistake of investing in tranches that don't suit their long-term goals. Unless they can get advice from more experienced investors, they are probably better off investing in something less complex. Also, tranching mortgage pools can cause rating agencies to rate them too positively, which can lul investors into a false sense of security. Many experienced investors found this out the hard way when the housing bubble collapsed.