Calculated Risk wrote a very important Piece on Tranches. The trouble comes in the form that a great share of the Readership might not understand the methodology of the financial system concerning tranches by reading the Post. Tranches are the means by financial institutions can make poor-risk loans with advantage to themselves. They sell the full range of loans–Good, Bad, and the Ugly. They bundle the loans to keep the loans they know are solid, and sell the loans which are Ugly or Bad–promising or suggesting a high rate of Return to Buyers. What they buy basically is the risk of the loan. Sellers get a commission for the Sale of a tranche, their share of the Take if the loan proves to be Good and Pays off, and dump the losses on the Equity Holders if the loans fail.
The Seller of tranches get Commissions for selling the initial loans, Commissions for selling the tranches, get most of the Value of the loans if they prove good, and avoids potential losses if the loans prove bad. The real Problem with tranches comes of their not being a form of Investment, just an Assumption of Risk Gamble where Odds are better at the Las Vegas tables, considering the quality of the loans. They remind of the ‘Bucket Shops’ of Old which actually did not Buy or Sell Stock for Investors, and could simply close up Shop if the Market ran against them. It is the legal Contract language that allows for Sellers to close up Shop in tranches. lgl