​
If you have not met the word before

A pool of loans produces two things: money coming in, and losses. A tranche is a position in the queue for both. Investors in the same pool are not all treated alike. They are sorted into layers, and the layer decides two things:
  • When you get paid. Repayments enter at the top of the stack and work down.
  • When you lose. Losses start at the bottom of the stack and work up.
Sitting near the top means you are paid first and lose last, so you accept a lower rate. Sitting near the bottom means you are paid last and lose early, so you demand a higher one. That is the whole idea. Everything else is detail about where the boundaries sit.

​
Why anyone bothers

One pool of receivables suits almost nobody on its own. A pension fund cannot hold an unrated loan book; a credit specialist does not want a 7% return. Tranching cuts one asset into several risk positions, so each can be sold to the buyer who actually wants it. For the originator, that means the pool can be funded at a blended cost lower than any single investor would charge for the whole thing.

​
The three PRISM notes

Beneath all three sits the originator’s own money, which is destroyed before any investor loses anything. See first loss.

​
What tranching is not

Tranching does not reduce losses. It changes who absorbs them and in what order. A pool that loses 30% still loses 30%.
It also does nothing about the originator diverting cash or misreporting the loan book. A waterfall decides who loses first; it cannot stop money leaving through the wrong door. That is the problem that actually matters.