Sunday, October 17, 2010

The Subprime Debacle: Act 2" But once mortgage loan securitization happened, things got sloppy...they got sloppy by the very nature of mortgage-backed securities.
"The whole purpose of MBSs was for different investors to have their different risk appetites satiated with different bonds. Some bond customers wanted super-safe bonds with low returns, some others wanted riskier bonds with correspondingly higher rates of return.
"Therefore, as everyone knows, the loans were 'bundled' into REMICs (Real-Estate Mortgage Investment Conduits, a special vehicle designed to hold the loans for tax purposes), and then "sliced & diced"...split up and put into tranches, according to their likelihood of default, their interest rates, and other characteristics.
"This slicing and dicing created 'senior tranches,' where the loans would likely be paid in full, if the past history of mortgage loan statistics was to be believed. And it also created 'junior tranches,' where the loans might well default, again according to past history and statistics. (A whole range of tranches was created, of course, but for the purposes of this discussion we can ignore all those countless other variations.)
"These various tranches were sold to different investors, according to their risk appetite. That's why some of the MBS bonds were rated as safe as Treasury bonds, and others were rated by the ratings agencies as risky as junk bonds.
"But here's the key issue: When an MBS was first created, all the mortgages were pristine...none had defaulted yet, because they were all brand-new loans. Statistically, some would default and some others would be paid back in full...but which ones specifically would default? No one knew, of course. If I toss a coin 1,000 times, statistically, 500 tosses the coin will land heads...but what will the result be of, say, the 723rd toss? No one knows.

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