Subprime Soup

Submitted by Rich Toscano on March 6, 2007 - 9:53am

Confused by the alphabet soup of mortgage- and credit derivative-related acronyms? Seek comfort in this concise and simple explanation of the securitization process, courtsey of The Economist:

First, mortgage loans are pooled and used as security for bonds known as residential mortgage-backed securities, or RMBS. In one sense, this is good news; it takes the loans off the balance sheets of the banks that made them and thus disperses risk.

Most investors, however, want to buy the safest portions of the RMBS; those awarded the top AAA rating. These account for some 90% of the RMBS by value.

But someone has to buy the risky bit of the mortgage pool. And those buyers are the issuers of collateralised debt obligations, or CDOs. Such issuers buy portfolios of bonds and loans, and then divide them into tranches, according to risk. They sell those tranches to customers eager to own a diversified bond portfolio.

Nice work, Brits. How about another paragraph for good measure:

If the assets backing a CDO default, the holders of the riskiest tranches (known politely as equity and less politely as toxic waste) take the first hit. Those investors are subject to a squaring of risk; owning the riskiest slice of an asset backed by the riskiest kind of mortgages.

Makes sense. The problem is that the CDO builders employ mathematical models to decide how much risk can safely be transferred from the (so-rated) AAA tranches down to the lower-rated tranches. And these models apparently aren't so great. For instance, they give lots of points to diversification: but should diversifying across multiple subprime mortgages from, say, Los Angeles, San Diego, and Orange County really be all that comforting?

At the end, the models have to make assumptions about how much home prices will rise and how many people will default. It's abundantly clear that Wall Street analysts have to a great degree overestimated the former and underestimated the latter. It doesn't seem like we should expect expect any different from the Wall Street nerds who crank the constant stream of subprime CDOs.

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