When you take a loan, the bank can “sell” your loan to an investor. What does that process look like, and why would an investor want to buy loans?
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The entire Collateralised Mortgage Obligation (CMO) market was built on this system. Imagine that you are a bank, and you have 100 homes worth $1 million each that you have lent them the money for. All you are going to do is collect interest on them for 20 years.
Some smart guys figured out that you could bundle all those mortgages together, pooling the equity, the mortgage payments and the debt payments, and then “slice” them up into different financial instruments. Each “tranche” (the French word for ‘slice’, BTW) offered up a different risk profile.
The most senior tranche would pay the lowest interest rate, but would have first dibs on the money in the payment pool. If there was a problem and some of the 100 people didn’t pay their mortgages on time, presumably these senior tranche holders wouldn’t be affected. That’s why they are paid the lowest interest rate.
The next level up only gets paid if all the senior tranches get paid first. Normally, this isn’t a problem, as most people strive to make their mortgage payments. But because there is *some* extra risk, they get a higher interest paid to them than the senior tranche.
Finally, there is a speculative tranche that only gets paid if everyone below is paid. It gets the highest interest rate, and carries the most risk. If a bunch of people can’t pay their mortgage because of recession, then the holders of this tranche might get nothing.
So, why would the banks do this? To make more money, which happens two ways: first off, banks can only lend so much money at one time. By selling off these mortgages, the banks can then create new mortgages and generate new fees. Second, the banks take their cut in terms of commissions and fees to bundle all these mortgages together.
Why would investors want it? If you were running a small pension fund for the municipal employees of Podunk, for example, the Fed’s push to near-zero interest rates means you can’t generate enough returns on the AAA-rated investments you are required by law to place the pension funds in to actually meet the outflow you need to pay off the pensions, and that problem was getting worse as more people retired. These CMOs, especially the higher rated tranches, offered higher rates that the pension fund managers were salivating for. And, wouldn’t you know, Standard & Poor’s and Moody’s bond rating services *never* found a reason not to give a AAA rating to these, even the highest and most speculative tranches.
And so we got the 2008 financial crisis.
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