Page 100 - untitled

SUBPRIME LENDING 

less risky tranche received principal and interest payments first and was usually guaran-
teed by an insurance company. The more risky tranche received payments second, was
not guaranteed, and was usually kept by the company that originated the mortgages.
Within a decade, securitizations had become much more complex: they had more
tranches, each with different payment streams and different risks, which were tai-
lored to meet investors’ demands. The entire private-label mortgage securitization
market—those who created, sold, and bought the investments—would become
highly dependent on this slice-and-dice process, and regulators and market partici-
pants alike took for granted that it efficiently allocated risk to those best able and will-
ing to bear that risk.
To demonstrate how this process worked, we’ll describe a typical deal, named

CMLTI -NC, involving  million in mortgage-backed bonds. In , New
Century Financial, a California-based lender, originated and sold , subprime
mortgages to Citigroup, which sold them to a separate legal entity that Citigroup
sponsored that would own the mortgages and issue the tranches. The entity purchased
the loans with cash it had raised by selling the securities these loans would back. The
entity had been created as a separate legal structure so that the assets would sit off
Citigroup’s balance sheet, an arrangement with tax and regulatory benefits.
The , mortgages carried the rights to the borrowers’ monthly payments,
which the Citigroup entity divided into  tranches of mortgage-backed securities;
each tranche gave investors a different priority claim on the flow of payments from
the borrowers, and a different interest rate and repayment schedule. The credit rating
agencies assigned ratings to most of these tranches for investors, who—as securitiza-
tion became increasingly complicated—came to rely more heavily on these ratings.
Tranches were assigned letter ratings by the rating agencies based on their riskiness.
In this report, ratings are generally presented in S&P’s classification system, which as-
signs ratings such as “AAA” (the highest rating for the safest investments, referred to
here as triple-A), “AA” (less safe than AAA), “A,” “BBB,” and “BB,” and further distin-
guishes ratings with “+” and “–.” Anything rated below “BBB-” is considered “junk.”
Moody’s uses a similar system in which “Aaa” is highest, followed by “Aa,” “A,” “Baa,”
“Ba,” and so forth. For example, an S&P rating of BBB would correspond to a
Moody’s rating of Baa. In this Citigroup deal, the four senior tranches—the safest—
were rated triple-A by the agencies.
Below the senior tranches and next in line for payments were eleven “mezzanine”
tranches—so named because they sat between the riskiest and the safest tranches.
These were riskier than the senior tranches and, because they paid off more slowly,
carried a higher risk that an increase in interest rates would make the locked-in inter-
est payments less valuable. As a result, they paid a correspondingly higher interest
rate. Three of these tranches in the Citigroup deal were rated AA, three were A, three
were BBB (the lowest investment-grade rating), and two were BB, or junk.
The last to be paid was the most junior tranche, called the “equity,” “residual,” or
“first-loss” tranche, set up to receive whatever cash flow was left over after all the
other investors had been paid. This tranche would suffer the first losses from any