Securities, Tranches, and Alphabet Soup

If a bank wants to free up its deposits to do more lending beyond its fractional reserve capacity, securitized loans are one way to go and structured investment vehicles (SIVs) are another.

In this post I’ll cover the mortgage backed securities (MBSs). They are simple in concept: banks originate a loan, then investors pay off the principle and collect the monthly payments. Banks earn dues by bundling loan packages, and charging to service the individual loans. For every dollar of securities sold to investors, that is a dollar freed up for the bank to lend

But it gets more complex, and the devil is in the detail. How it works is a bank takes a pool of loans, say 1000 mortgages, and bundles them together, and sells off shares. Not all shares are the same; they are ranked in different "tranches." AAA, AAa, Aa-, BBB, BB, B, and then “unrated” are the kinds of tranches you might see. When the borrowers mail in their monthly payments, shares in the AAA tranch get paid first, then AA next, and so on, and then B would be next to last, and “unrated” would be dead last. But by accepting more risk, the B tranch gets the highest interest rates, while the much safer AAA tranch gets the lowest interest rate… hardly more than treasury bonds.

But, say, 100 of our 1000 mortgages don’t pay, like when option payments adjust and the owner can no longer afford the mortgage, then the unrated tranch, who is paid last in the lineup, isn’t paid at all. Conversely, those who hold AAA paper will likely ride out the credit crunch, even with many foreclosures and a significant decline in house value, since AAA tranches are paid first. It would take a really major collapse of that pool of mortgages for the highest-rated tranches not to be paid.

Now, enter Credit Default Obligations (CDOs). MBSs are risky, especially subprime, but CDOs are the toxic waste of the market place. Banks have to keep the unrated tranches as directed by regulators to do. Only the lower-risk tranches can be sold to free up the balance sheet. If banks want to sell their loans to others, they have to keep the riskiest tranches. Fair enough. But banks can offset the risk with CDOs, which is basically bond insurance from private investors. CDO holders have to reimburse banks if the unrated tranches go bad. In 2007 this collapsed two Bear Stearns hedge funds. Investors were left with literally nothing. Basically their CDO fund was getting money from banks as premium payments, so to speak, until the subprime market went sour. When the worst tranches did go bad, the capital of those hedge funds reimbursed banks for their losses. In no time, those hedge funds were depleted to nothing.

So, the ability of banks to offload debt as MBSs is limited by their ability to accept the riskiest tranches, which is limited by the ability to offload the risk through the sale of CDOs. When people stop buying CDOs, MBSs grind to a halt. As of now, the CDO market is dead.

MBSs kept the credit market red hot. As long as banks could find buyers of securitized debt and CDOs, they could keep lending. But with enough banks now holding on to enough troubled tranches, without swap investors to bail out loses, all foreclosures in those MBS packages would be a square hit to their capital base. So the subprime market is also dead. The Alt-A market is soon to follow.