Loss Absorption Hierarchy

The loss absorption hierarchy defines the specific order in which different tranches of a structured product are required to bear losses from the underlying asset pool. This waterfall structure dictates that the equity tranche absorbs the first losses, followed by the mezzanine tranches, and finally the senior tranches.

This sequential process ensures that senior investors are shielded from early defaults, effectively concentrating the risk in the junior layers. The hierarchy is the defining characteristic of a structured product and determines the risk-reward profile for every participant in the deal.

Investors must clearly understand their position in this waterfall to accurately price their exposure. Any disruption to the cash flow distribution, such as a breach of coverage tests, can trigger changes in how losses are allocated, significantly impacting the value of the tranches.