2+2=5

Excellent post describing how subprime mortgages are magically transformed from junk-grade debt into AAA investments by investment banks who will soon be looking for a taxpayer-funded government bailout (not to worry - their executives will keep their bonuses)....

Today I will follow a debt trail, from loan origination all the way to itsultimate existence as part of a credit derivative product. I will use a sup-prime mortgage loan as an example, but any debt obligation will do. Keep the question of the title in mind, it will make sense in the end.

Let's start two years ago with Ron and Ronda White, a couple in their early 30's with a combined income of $60.000 who have their eyes set on a $300.000 house to call home. They have saved only $5.000 to put down, which barely covers the closing costs. Their mortgage broker talks them into a $250.000 first mortgage ARM with an initial 2-year teaser rate of 2% rising to prime+1% thereafter and a $50.000 second, 30-year fixed at a whopping 10.5%. Despite the obvious problems apparent right from the start, such loans were made to hundreds of thousands of people. But no matter...

The two loans were immediately sold to investment bank XYZ who pooled them with other loans (creating Residential Mortgage Backed Security, or RMBS) and placed them inside a CDO. Using recent default data, the financial engineer employed by XYZ took 90% of the White's outstanding mortgage amount and placed it in CDO Tranch A, the supposedly safest portion rated AAA and paying 0.10% more than other AAA straight corporate bonds. The rest was apportioned 7% to Tranch B rated BBB, paying 1.5% more than equivalent bonds and the remaining 3% to Tranche C, also known as the "equity" tranche, which was unrated and paying 10% above Treasury bonds. In case of default, Tranche C gets hit first until it is exhausted, then Tranche B and, finally, Tranche A. This is a "cascade" or "waterfall" pattern, common to all such collateralized products.

Notice how 100% of a loan package that could be described as CCC has been turned into 90% AAA, 7% BBB and 3% NR. In plain terms, the "engineer" is betting that no more than ~3% of the total principal and interest will be lost, including recoveries from selling foreclosed real estate.

More at Sudden Debt.