What is a tranche?
I am studying Collateralized Mortgage Obligations (CMOs) - My understanding is that the product consists of mortgages which have real estate as collateral.
The mortgages are bundled in batches which constitute a "tranche."
One could have a CMO with five different tranches (also called slices, as in a share of pie).
Does this sound correct?
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A "tranche" in french is translated slice, as in a slice of bread or pie. So your statement is absolutely correct.
Tranches as you have said are like slices. Each tranche has a different risk/return characteristics.
Usually it follows waterfall model. Example, if there are 4 tranches, A/B/C/D in order of seniority, then Tranche A will be serviced First, will have less yield, and least risk. After Tranche A, Tranche B will be serviced next, and so on.
From the link -> my.firedoglake.com/jamess/tag/mortgage-fraud/
As we all found out during the real estate collapse, a "tranche" is a slice through a larger aggregate of investments. In that case,basically, the idea was to take the pile and, rather than having a single risk/return averaged over them all, to divide it into categories based on presumed risk. The lower-risk pile can then be offered at a higher price as a safer investment, while the riskier portion can be offered at a relative discount to folks who specialize in that kind of investment.
Nothing inherently wrong with the idea ... unless, as then, you delude yourself about the actual quality of the investments /loans in that tranche, and go mad recombining and re-tranching in the belief that somehow you can make a silk purse out of a sow's ear if you mince it and glue it back together enough times.
So don't panic... yet? ... but do make sure you understand exactly what you're buying into. And make sure they know what they're doing. Tranching can be a good way to manage risk... or a good way to fool yourself into believing you have managed risk.
NPR's deep analysis of the housing crisis had some excellent discussion of what the banks thought they were doing vs. what they actually wound up doing, which go into this better than I ever could. They're still available for download/streaming /podcast. The best seemed to be the collaborations between This American Life and Planet Money titled "The giant pool of money"
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