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SECURITIZATION AND DERIVATIVES 

For commercial banks, the benefits were large. By moving loans off their books,
the banks reduced the amount of capital they were required to hold as protection
against losses, thereby improving their earnings. Securitization also let banks rely
less on deposits for funding, because selling securities generated cash that could be
used to make loans. Banks could also keep parts of the securities on their books as
collateral for borrowing, and fees from securitization became an important source of
revenues.
Lawrence Lindsey, a former Federal Reserve governor and the director of the Na-
tional Economic Council under President George W. Bush, told the FCIC that previ-
ous housing downturns made regulators worry about banks’ holding whole loans on
their books. “If you had a regional . . . real estate downturn it took down the banks in
that region along with it, which exacerbated the downturn,” Lindsey said. “So we said
to ourselves, ‘How on earth do we get around this problem?’ And the answer was,
‘Let’s have a national securities market so we don’t have regional concentration.’ . . . It
was intentional.” 
Private securitizations, or structured finance securities, had two key benefits to in-
vestors: pooling and tranching. If many loans were pooled into one security, a few de-
faults would have minimal impact. Structured finance securities could also be sliced
up and sold in portions—known as tranches—which let buyers customize their pay-
ments. Risk-averse investors would buy tranches that paid off first in the event of de-
fault, but had lower yields. Return-oriented investors bought riskier tranches with
higher yields. Bankers often compared it to a waterfall; the holders of the senior
tranches—at the top of the waterfall—were paid before the more junior tranches.
And if payments came in below expectations, those at the bottom would be the first
to be left high and dry.
Securitization was designed to benefit lenders, investment bankers, and investors.
Lenders earned fees for originating and selling loans. Investment banks earned fees
for issuing mortgage-backed securities. These securities fetched a higher price than if
the underlying loans were sold individually, because the securities were customized
to investors’ needs, were more diversified, and could be easily traded. Purchasers of
the safer tranches got a higher rate of return than ultra-safe Treasury notes without
much extra risk—at least in theory. However, the financial engineering behind these
investments made them harder to understand and to price than individual loans. To
determine likely returns, investors had to calculate the statistical probabilities that
certain kinds of mortgages might default, and to estimate the revenues that would be
lost because of those defaults. Then investors had to determine the effect of the losses
on the payments to different tranches.
This complexity transformed the three leading credit rating agencies—Moody’s,
Standard & Poor’s (S&P), and Fitch—into key players in the process, positioned be-
tween the issuers and the investors of securities. Before securitization became com-
mon, the credit rating agencies had mainly helped investors evaluate the safety of
municipal and corporate bonds and commercial paper. Although evaluating proba-
bilities was their stock-in-trade, they found that rating these securities required a
new type of analysis.