Low quality debt into high quality

Q: What went wrong with the process of securitisation?

A: This financial crises had roots in the way Mortgage market evolved. In the 1970s Federal Home loan mortgage corporation was established. It securitised the home loans by creating Mortgage Backed Securities and allowed US government to transfer market risk to investors. But a Wall Street investor cannot invest in sub-investment grade instrument. An MBS was a sub-investment grade security. To improve the quality of an MBS, they were pooled with other high quality debt instruments in the form of Collateralised Debt Obligation, CDO.

Q: What went wrong with CDOs?

A: CDO is a way of creating securities with different risk characteristics from a portfolio of debt instruments. These different securities are called tranches. The tranch which takes on the initial losses offers the highest return or yield. While the tranch which incurs residual losses receives the lowest return. In the year preceding the crises, outstanding CDO volume stood at $ 900 bn. Of which 17% was created from sub-prime mortgages.