A DIAGNOSIS OF TRANCHING IN LIGHT OF SHARI’AH PRINCIPLES

Tranche is a French word which means: class, section, series, portion, slice, partition, or part of something. Tranching is done through subordination, which refers to “the process of prioritizing the order in which losses are allocated to the various layers of bonds” (Mason, 2008). Investment banks use tranching extensively in structured finance to appeal to different sections of investors. It allows different investors to enjoy different risk levels and returns, although they have claims on the same pool of assets. For example, let’s say there are three tranches in an ABS deal: AAA, BBB and an equity tranche. For payments of profit, AAA would get paid first, followed by BBB and then the equity tranche. On the contrary, in cases of losses, the equity tranche will absorb the losses first, followed by the BBB investors and finally, if any losses remain, then only it will go to the AAA investors. This, in a nutshell, is how tranching works. That’s why the equity tranche is usually named the first-loss position, because they are the ones that will first absorb any losses first.

Tranching is done to achieve a cheaper cost of funding on average. As we can see from the above illustration, the AAA investors bear very little risk because their position is cushioned by the equity tranche and the BBB (mezzanine) tranche. Thus they will be paid a lower return compared to the other two tranches; whereas, since the equity tranche bears the higher risk, they will obtain the highest return. By having these varying classes of investors and varying returns, the originator can arrange, on average, funding at a cheaper cost.