remember, one of the key concepts in modern portfolio theory is the idea that diversification through disparate assets reduces risk, and makes the system safer. one of the innovations of securitization was the ability to diversify risky assets and pool them together into a new security. the ratings agencies looked at these securities, and concluded that the bigger the diversification, the less risky these instruments would be.

To add a further element of safety, the bonds were separated into slices called tranches ("tranche" is french for "slice"). remember, the capital structure is based on the order of who takes the losses (#4); the senior debt holders get paid first, while the equity holders get paid last. these securities were tranched in a similar manner: senior tranches (AAA) were paid first, equity tranches (BBB) were paid last, and the mezzanine tranche (A) was in the middle. the equity tranches took on the most risk and therefore deserved a higher yield (say, 10%), conversely the senior tranches took the least risk, and got the lowest yield (maybe 5%).

again, the ratings agencies thought this was ingenious, and by their quantitative risk models, the senior tranches were rated as safe as the safest, most trustworthy, most liquid instrument in the world: a US Treasury, which is backed by the full faith and credit of the gov't & taxpayer.

These became extremely popular with hedge funds, pension funds, and money market funds because they had the AAA credit rating of a UST, but came with a higher yield.


but remember, *all* loans, not just mortagages, were securitized in this manner, e.g. CLOs (commercial loan obligations), CFOs (fund obligations to private equity and hedge funds), CBO (for corporate bonds), etc.

CMO (mortgage obligations) are the ones most of us are familiar with, and 65% of this paper was rated AAA; the worst tranche, equity, was BBB and was still considered investment grade.

but lesser known were student loans, auto loans, credit card debt, and virtually every type of debt imaginable issued by the major banks had been done this way.

these effectively became the structure of the financial world in the west.