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The break-even in the IRR profile of the AAAtranche is a multiple of the annualized historical average loss for BBB-rated corporates (10x in this case). The BBB-class hits the IRR of the portfolio at around 0.9 percent which is 4.5 times the historical average loss. Static synthetic mezzanines normally exhibit a lower rating stability than mezzanine notes of managed synthetic CDOs, depending on the skill of the manager.
Assumption: The 5-year cumulative default rate for BBB is around 1.60 percent, assuming a 40 percent recovery rate. This equals an annualized 0.2 percent expected loss rate. The size of the mezzanine tranches affects the expected loss (probability of loss unaffected). As the size of the mezzanine class decreases the expected loss tends to increase hyperbolically as seen (binomial expansion technique with a diversity score of 55 was used). The ratio of the expected tranche losses to the expected CDS portfolio losses would define the risk leverage. When the ratio is above 1 the mezzanine note has a greater expected percentage loss than the underlying portfolio. The percentage of the first loss class has a major impact on the leverage of the mezzanine class (assuming the same underlying exposure in size.

The senior and mezzanine return profile has an option-like feature, like short puts out-of-the-money (BBB) and far-out-of-the money (AAA) in return terms. When investment grade default rates rise significantly above their long-term historical average, mezzanine notes become impaired. On the other hand, CDS portfolio deterioration causes in general mark-to-market losses and might result in rating downgrades with respect to the notes.