Banks loved mortgages. They’re collateralized lending, ie. they’re relatively low risk and generally earn a good return for the lender, if they have enough of them. However, there are limits as to how much lending a bank conduct, no matter how good the quality of the loan book. That’s because in previous financial crises, over-lending had caused banks many difficulties. So, regulators have set up some fairly strict limits to the banks’ loan books and generally the amounts of leverage - the amount of lending against the amount of capital held.

The problem was that mortgages are loans, which means they have to be booked in the ‘banking book’. On the other hand, securities like US Treasuries, German Bunds and corporate bonds are booked in the ‘trading book’ which has much lower capital requirement as they're considered as 'marketable securities'. So there is a strong motivation for banks to somehow exchange their heaps of mortgage loans for securities to obtain more favorable capital treatments.

When mortgage backed securities were first created, they were not traded at all because they looked very different from a normal bond. The maturity profiles were considered difficult to work out and hence these securities were difficult to value. They were 'ugly'. It was only when the brilliant traders over in Salomon Brothers (in the 1980s) worked out a way to estimate the maturity of the bonds, and hence the values of these securities, able to trade them and almost single-handedly created the market. Suddenly, what used to be an 'ugly bond' has a market and has liquidity - they have become 'marketable securities'.

Here's what happens when mortgage backed securities are created. The bank sells a pool of mortgages to an issuing vehicle which uses the pool of as collateral for series of bonds it issues. These bonds are typically split into segments ("tranches") of different risks and are sold to investors with different risk appetites. The proceeds from the sale of the bonds are pay to the bank for the acquisition of the mortgages by the vehicle. Sometimes the riskiest piece (the 'first loss piece') is sold back to the bank to demonstrate to the other investors the bank's confidence in the quality of the pool, but most of the time they are sold to people who have such risk appetite (and the return can be very rich). In a very short space of time, from the bank's perspective, a large pool of mortgages have converted to a large pile of cash and a small but very risky security, if it is not already picked up by someone already. Even if a full capital charge is required to cover this 'first loss piece', the bank saves a whole lot more by not having the mortgages on its books. Plus, it has a pile of cash which it can offer to borrowers. Magic!

This process is called ‘securitization’ and the securities created by this process are called ‘asset-back securities’ or ABS. To put it simply, it is a method of transforming a collection of interest-paying assets into a ‘marketable security’. Now, just imagine that process repeated many times, over and over again. Of course, not only mortgages have been securitized. Things like student loans, auto loans, credit card debts, consumer loans, corporate loans, commercial real estate loans, aircraft leases, film rights, music royalties, future payment flows, private equity participations, etc, all have been securitized. While the financial services sector has been described as innovative from time to time, a lot of time people just copy things off each other. Once they found something that appears to have worked for their purpose, in this case finding someone else to fund the mortgages and relieving regulatory capital, other people will just copy and repeat what it has been done until someone says stop. But no-one did say stop.

When you securitize a pool of mortgages, you ended up with a ‘mortgage-back security’, MBS. If the pool is a collection of residential mortgages, you have an RMBS, residential mortgage-back security. If the pool is made up of commercial mortgages, you have a CMBS; ‘c’ stands for ‘commercial’. If you securitize a pile of debt securities, you ended with a CDO, collateralized debt obligation; if loans, CLO, collateralize loan obligation. The alphabet soup just goes on and on.

At the inception of a typical securitization, the assets are the pool of interest-paying assets and the liabilities are the securities issued to the buyers. The equity (ie. the ‘first loss piece’) is at the bottom of the liability, which means it has the lowest payment priority and bares the loss first. The rest of the liabilities are typically divided to different ‘tranches’ to reflect the different risks and different payment priority. Of course, you get a higher coupon for taking higher risk by investing in one of the lower tranches.

CDOs themselves are an intriguing animal. As the name suggests, they are securities backed by a pool of other debts. The invention of CDOs allowed all kinds of crazy things to happen. Lets take an example: not every last bit of those ABS transactions were sold to investors; over time, it is entirely possible to have a collection of these ‘positions’ sitting around not being sold. Before too long, an institution can have a rather large collection of these ‘marketable securities’, weighing down the balance sheet and consuming capital. So a new variant of CDO was invented, CDO of ABS. In essence, you’re asking someone to fund a pile of assets that other people are unwilling to put their money into. Yet somehow, after creating a new CDO, someone was willing to buy them. Another little bit of magic!

What is really interesting is what has happened to the risk of in these CDOs. In an RMBS, you can look at the individual mortgages and see how the borrowers are servicing their loans. In a CLO, you can check up and find out whether the loans are serviced. Each borrower is itself a ‘risk’. In a CDO of ABS, the number of risks is many factors larger than a straight forward ABS. Of course, nobody who bought this stuff actually knew what they bought and this problem didn’t restrict to the complex deals, but also applied to the so-called simple ones. But how come people were so duped?