Definition: A tranche is a way to slice into a bundle of loans so you can just invest in the portion with similar risk. For example, adjustable-rate mortgages often have different interest rates. They borrower pays a "teaser" low-interest rates for the first three years, and higher rates after that. There is a high probability that the loan will be repaid the first three years, because the rates are so low.

After that, there is less likelihood, not only because the rates are higher, but also because many borrowers often expect to sell the house or refinance before the three years are up.

When a bank goes to resell the mortgage on the secondary market, some buyers would rather have the lower risk, and lower rate, while others would rather have the higher rate in return for the higher risk. To meet this need, banks bundled these adjustable-rate mortgages. They resold the low-risk years in a low-rate tranche, and the high-risk years in a high-rate tranche. The tranche was a way to slice the bundle of loans in a different way.

How Did Banks Create Tranches?

The bundle of loans is called a mortgage-backed security. These were initially created by Fannie Mae and Freddie Mac to resell the mortgages for the bank, freeing the bank to make more loans and giving more people the ability to be homeowners.

However, in 1999 the safe and predictable world of banking changed forever. Glass-Steagall Act was repealed.

This allowed banks to own hedge funds and invest in complicated derivatives. As banking became more competitive, the banks that had the most complicated financial products made the most money, and bought out smaller, stodgier banks. The creation of mortgage-backed securities and the secondary market is one reason why the U.S. economy was so robust until 2007.

Despite its name, a mortgage-backed security is not a mortgage on a house that you can see to ascertain its value. It is, instead, a financial product whose value is loosely based on the value of the mortgages that backed the security. This value was determined by a computer model.

The college graduates who developed these computer models were known as quant jocks. They wrote the computer programs that determined the value of the mortgage-backed security.

Banks, and quant jocks, were rewarded by making ever-more sophisticated financial products based on ever-more complicated computer models. That's how tranches could be invented. They quant jocks designed the computer models to break the mortgage-backed security into tranches to take advantage of the different rates offered in an adjustable-rate mortgage. In no time at all, the mortgage-backed securities became so complex that buyers could no longer relate them to the value of the underlying mortgage. Instead, buyers had to rely on their relationship with the bank or hedge fund selling the tranche. The bank relied on the quant jock and the computer model.

What Was Bad About Tranches

The problem was, the computer models priced the tranches based on the assumption that housing prices always went up. And, until 2006, that was a pretty safe assumption. When the assumption when haywire, so did the tranches, the mortgage-backed security, and the economy.

When housing prices plummeted, no one knew what the value of the tranches were. This meant no one could price the mortgage-backed security.

Here's another complication. The secondary market meant that banks no longer had to collect on the mortgages when they become due. They had sold them to other investors. As a result, the banks weren't as disciplined in sticking to good lending standards. Many loans were made to borrowers with poor credit scores. These subprime mortgages were bundled up and resold as part of a high-interest tranche. Investors who wanted more return snapped them up. In the drive to make a high return, they didn't realize there was a good chance the loan wouldn't be repaid. The credit ratings agencies, like Standard & Poor's, made things worse. They rated some of these tranches AAA, even though they had sub-prime mortgages in them.

Investors were also lulled by buying guarantees, called credit default swaps. The were sold by solid insurance companies liked AIG, who sold the insurance on the risky tranches just like any other insurance product. However, AIG didn't take into account that all the mortgages would go south at the same time. The insurer didn't have the cash on hand to pay off all the credit default swaps. To keep from going bankrupt, they were bailed out by the Federal Reserve.

Examples: Tranche is the French word for slice.