Gone4Good
Give me a museum and I'll fill it. (Picasso) Give me a forum ...
- Joined
- Sep 9, 2005
- Messages
- 5,381
i am not real clear on the financial instrument that was created that converted these very risky loans into AAA rated investments but i thought they were derivatives. am i wrong?
Derivatives were used to multiply the effect but turning subprime loans into Aaa rated securities happened without derivatives. It is simple structuring.
Consider a bunch of junk bonds. Each individual bond has a high probability of default and a low recovery in default. But even if every bond defaults, there will be some recovery on the portfolio. I can create a security that gets 1st priority on the recovery and cash flow of the portfolio and, as a result, will have a very high credit quality (low probability of default and high recovery expectations). Then I create a security with a 2nd priority on that portfolio and it will have a slightly lower credit quality . . . and so on and so forth until I create the last, unrated, "equity" tranche.
There is nothing inherently wrong or devious with this. The original intention was to use this "securitization" process to convert illiquid securities into liquid ones and take out the liquidity premium. If the securities were evaluated correctly there never would have been a problem. But somewhere along the way the process got corrupted. Rating agencies got paid to give high ratings to increasingly junky structures and portfolios. Institutional investors stoped caring what they were buying and deferred to the rating agencies. Derivatives were used to create new securities based on the old, increasingly junky ones.