Investment banks repackaged mortgages into innovative financial products that promised to boost returns for investors with little increase in risk. One widespread example is the collateralized debt obligation (CDO), which could be used to repackage mortgage-backed securities (MBS) into top-rated investment-grade bonds. Here’s how it worked:
1.
Investment banks purchased mortgages and pooled them into mortgage-backed securities. The safest portions, or tranches, of these MBS received the highest bond ratings of AAA/Aaa, while riskier ones received a medium-quality BBB/Bbb rating, slightly above junk bonds. Bondholders’ interest was paid out of the combined mortgage payments of homeowners. Holders of the safest securities received the lowest interest payments and holders of the medium-rated securities received the higher interest payments to compensate them for increased risk.
2.
Financial institutions seeking new markets purchased these mortgage-backed securities. Then they pooled them with other similarly rated MBS and sometimes derivatives and issued new securities, called collateralized debt obligations (CDOs).
3.
Similar to an MBS, the individual bonds for sale within each CDO were divided into several different tranches, or classes, with different interest rates and ratings. In a typical CDO, many of the bonds received the highest AAA/Aaa rating, even though they were collateralized by MBS that were in turn collaterized by subprime loans.
A smaller percentage received a BBB/Bbb rating or less. The lower-rated tranches in the CDO were designed to protect the highly rated tranches against losses. If underlying mortgages went into default, losses would affect the lowest-rated tranches first and the other tranches would not be affected until losses became more severe.
4.
Some of a CDO’s lower-rated tranches might have been repackaged into new CDOs.
This process of buying mortgages, creating MBS, and packaging these MBS into CDOs was designed to apportion credit risk to those parties who were willing to take it on. Instead of a lender maintaining the risk on its books, it could sell that risk to investors. It can be argued that this disassociation of risk from originators made some lenders less careful about whom they loaned money to. The elevated returns offered by MBS and CDOs arguably also made some investment firms less cautious about the creditworthiness of the loans they bought.
Meanwhile, economists point out that regulators may have been slow to respond to the developing crisis, since they assumed that securitization made the markets safer through diversification. In fact, the complex new investment products created out of subprime loans may have magnified the crisis in unforeseen ways.
The role of the ratings agencies
Why did the ratings agencies understate the risks of CDOs? Some critics point to the fact that the agencies are paid by bond sellers, not buyers, and that a significant portion of their revenues come from
the investment banks creating CDOs and other structured products. On the other hand, the agencies contend that their ratings were never intended as a substitute for investors’ own research to evaluate risk.
Still others contend that in theory it all worked on paper: Because default rates on subprime mortgages were historically low, the ratings agencies’ risk models underestimated the impact that widespread defaults in a declining home price environment could have on the value of these complex new investment products
