Credit Snafu - Part 4

Alas, these broken mortgages... where did they go? Firstly, the mortgage brokers that initiated the mortgages promptly sold them to large banks. These banks, of course, had no desire to burden their own balance sheets with risky mortgage paper, so they had to sell them also, but who wants to buy a subprime loan with a high risk of default? There are those with a risk appetite but not enough to consume all of the loans

A solution was devised. The banks can create what are called Collateralized Debt Obligations, or CDOs. How do these work? First, you get together a whole lot of subprime loans. Then, you sell shares of these loans to other people. But, here is the trick, not all shares are created equal. Some are "senior" shares, and others are "junior" shares. What is the difference? When one of the many subprime loans defaults , it is assigned to the most junior shares, and when a mortgage payment comes in, it is first assigned to the senior shares. These share levels are called "tranches", and let's suppose there were five evenly sized tranches for the purposes of an example. If 40% of the subprime mortgages in the CDO defaulted, only the two most junior tranches would feel any pain. The three most senior ones would continue to get paid, and would not have any loss of assets. For this reason, the senior tranche could get a AAA credit rating, while the most junior tranche became known as the equity tranche, or in Wall Street lingo, "toxic waste".

To close, let's look at the reasons why this was done. Because a AAA credit rating has less risk, it can sell for a higher price (as was discussed in Part 1 post on risk and reward). Since a subprime loan is risky, it can be bought for a lower price. The difference between these prices can be profit.

Of course, that leaves you holding some "toxic waste". What to do? Buy insurance! This is called a credit swap. A bank can create a AAA quality CDO tranche, sell it for profit, and then pay someone else to absorb the losses if the toxic waste experienced defaults (like when you pay someone else to cover your losses in the case of a house fire).

And, since we all know that house prices go up 15% a year forever, that insurance can be bought very cheaply (wink, wink).