First-loss
|
Not to be confused with a first-order derivative.
Of potential claims against a given pool of assets, the “first-loss” is first one up against the wall when the revolution comes. This is to do with priority, preference and capital structure.
The first one for the early shower will be he whose claim is most subordinated. That will be the common shareholder, if there is one, and if not (in, say, a CDO or a structured note of some sort) it will be the one bringing up the rear in the security waterfall. That will usually be the noteholder or, if there are several tranches of Notes, the most junior, most deeply subordinated, noteholder.
It is only once the “first-loss piece” has been wiped out that the fellow holding the “second-loss piece” has anything to be worried about, much less the “super-senior” guy sitting at the top of the pile, usually clutching his a bogus triple-A rating like a chewed cuddly rabbit with one ear that smells like sick.
This was a great source of comfort, in the lead-up to the global financial crisis, for those holding the most senior tranche of the CDO squared products that, well, precipitated it. It became an even greater source of comfort, later, for everyone else with a taste for schadenfreude.
“The estimated loss on your average mortgage portfolio is about 5%,” these super-senior people would think, “and I have four tranches below me, absorbing up to 40% of the losses of this one. So I’m, like, literally as safe as houses!”
And so they were: as safe as the thousands of crappy, leaking, triple-mortgaged prefabs located on remote strips of recently-reclaimed Nevada desert that made up all most all of their portfolios.
Don’t shed a tear: it was all for the best.