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image for OpenScout resource :: Tranching

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The structure of securitization deals, referred to as tranching , is standard. In those transactions, claims on cash flows generated by the collateral are split into several classes of notes, at least 3 and possibly more than 5. Each class is called a tranche and has absolute priority in the cash flows over the more junior ones. Typically, investors with increasing sophistication acquire tranches with decreasing seniority. This paper offers a model where such a slicing of claims into a stack of several debt like contracts arises endogenously as a value maximizing arrangement. It also predicts the relationship between the seniority of tranches and the sophistication of their acquirers. It considers the situation of an issuer of asset-backed securities facing heterogeneous financial institutions. The institutions differ in their abilities to screen the collateral and retail the securities. Tranching induces good screeners to specialize on junior tranches to save retail costs, leaving senior tranches to good retailers. This may boost the price of junior tranches by increasing information collection, and improve the liquidity of senior tranches by mitigating the Winner's Curse. The number of tranches, driven by the structure of the buy side, is arbitrary, and whether the sell side has private information or not about the collateral is irrelevant.

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