Welcome to European Tribune. It's gone a bit quiet around here these days, but it's still going.
The investment bankers slice the MBS into several "tranches". These are known as Collateralized Debt Obligations, or CDOs for short. The idea is to create some higher risk assets and some much safer ones by slicing up the MBS into what are called equity (high risk), mezzanine (middle risk) and the much sought-after investment grade bonds (low risk).

Higher risk equals higher returns, of course, so the equity tranche of the MBS will earn the highest profits if things go well. But if things start to go wrong, the equity is lost first, and then the mezzanine. Even then, the investment-grade bonds could still get fully paid out. This persuades the credit ratings agencies to give the lowest-risk tranche a high enough credit rating to qualify for the critical investment grade rating.

In this way the investment bank has created a decent proportion of highly marketable bonds out of a package of low-quality mortgages. Fairly standard, for example, is to convert a large package of MBS into perhaps 80% investment-grade bonds, 10% mezzanine, and 10% equity.

Wow. This is clever. It's like the financial version of reprocessing nuclear fuel, selling the uranium and plutonium and then dumping all the nasty fission products in the sea without telling anyone.

The investment bank can have still more fun with this. Because what the underwriting institution would see is just a stream of income payments. And just like the boring mortgage streams that we started with, these CDS streams can be aggregated into a pool...then divided into tranches with different risk profiles...producing the magic of higher credit ratings for lower-risk tranches...plus concentrated risk in new toxic waste.

These people are far too clever!

Now they do not take all the nasty and useless waste and throw it in the sea, instead they concentrate it further and dump it into the freshwater reserve!

Maybe not the best allegory, but anyway. On top of that, have a look at this awful graph. It seems you don't get payed for risk anymore, which means that if you take on risks and everything goes down the drain, you are in far deeper trouble than you used to be when things went down the drain back in the olden days.

Off course, the people at SafeHaven are a bit biased and into gold. Such people are usually a bit weird. But so is all this CDO stuff.

Another reason to stay in oil, anyone?

Peak oil is not an energy crisis. It is a liquid fuel crisis.

by Starvid on Wed Jul 4th, 2007 at 08:12:09 PM EST
[ Parent ]

Others have rated this comment as follows:


Occasional Series