Risk Management puzzles, solved step by step

Equity loses 100%, mezzanine 70% and senior nothing; the mezzanine is wiped out at a 15% pool loss. The Rs 120 crore loss fills the tranches from the bottom. Equity absorbs its full Rs 50 crore. The remaining Rs 70 crore falls on the Rs 100 crore mezzanine. The senior tranche starts losing only once pool losses pass 15%, the point where the mezzanine is gone.

How do losses move through a tranche stack?

Picture a building flooding from the ground up. The ground floor is soaked before a drop reaches the first floor, and the top floors stay dry until the water climbs to them. Losses fill the tranches from the bottom: each tranche loses nothing until the pool loss passes its attachment pointThe level of pool loss at which a tranche starts to lose money., and everything once the loss passes its detachment point. The equity attaches at 0% and detaches at 5%; the mezzanine attaches at 5% and detaches at 15%.

Why does thickness decide how risky a tranche is?

Because a thin tranche goes from untouched to wiped out over a small range of pool losses. The mezzanine is only 10 points thick, so a pool loss moving from 5% to 15% takes it from zero to total loss, while the same move barely registers on the pool as a whole. That is the leverage inside structured finance: the mezzanine's loss share moved 7 times as far as the pool's 12% average suggests from 5% onwards. A rating analyst evaluating the deal asks how likely the pool loss is to cross each attachment point, which depends heavily on how correlated the loans are.

Name the risks the structure does not remove. Correlation among the loans decides whether pool losses cluster at a few percent or occasionally jump past 15%. The collateral data may be weak. And the waterfall rules in the documents, such as when cash is diverted to protect senior holders, can shift losses between tranches in ways this simple loss-only picture does not show.

Net income falls Rs 7.5 crore, cash rises Rs 2.5 crore, and both sides of the balance sheet fall Rs 7.5 crore. Pre-tax profit drops 10, tax drops 2.5, so net income drops 7.5. The cash flow statement adds back the non-cash 10, leaving cash up 2.5. On the balance sheet, cash is up 2.5 and fixed assets down 10, total assets down 7.5, matched by retained earnings down 7.5.

How does a non-cash charge put cash in the bank?

Think of a shopkeeper who can deduct the wear on his delivery van from his taxable income. Writing the van down costs him nothing today, since he paid for it years ago, but it lowers the tax bill he pays this year. Depreciation moves no cash itself; the only cash effect is the tax it saves, 25% of Rs 10 crore, Rs 2.5 crore. That tax shield is the whole answer on cash, and the three statements are the bookkeeping that proves it.

What order do you walk it in?

Income statement first, because everything starts from net income. Then the cash flow statement: net income down 7.5, add back the 10 of depreciation because no cash left, and cash from operations is up 2.5. Finish on the balance sheet and prove it balances: assets fall by 10 of fixed assets less 2.5 of extra cash, 7.5, and equity falls by the 7.5 of lower retained earnings. Stating that both sides moved by the same 7.5 is the check the interviewer is waiting for.

Why does a credit analyst care?

Because a lender is repaid in cash, not in profit. A company whose earnings fall because of higher depreciation may be generating slightly more cash, so interest cover measured on net income and on cash flow can move in opposite directions. The limit: the tax saving is real only if the company is paying tax; a loss-making company gets no cash benefit this year, and a higher depreciation charge often reflects heavy past capital spending that the analyst should look at directly.