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474 Dissenting Statement

backing, all these securities are rated or considered to be AAA.
PMBS rely on a classifi cation and subordination system known as “tranching”
to provide some investors in the pool with a degree of assurance that they will not
suff er losses because of mortgage defaults. In the tranching system, diff erent classes
of securities are issued by the pool. Th e rights of some classes to receive payments of
principal and interest from the mortgages in the pool are subordinated to the rights
of other classes, so that the superior classes are more likely to receive payment even
if there are some defaults among the mortgages in the pool.
Th rough this mechanism, approximately 90 percent of an issue of PMBS
could be rated AAA or AA, even if the underlying mortgages are NTMs that have a
higher rate of delinquency than prime loans. In theory, for example, if the historic
rates of loss on a pool of NTMs is, say, fi ve percent, then those losses will be absorbed
by the ten percent of the securities holders who are in the classes rated lower than
AAA or AA. Of course, if the losses are greater than anticipated—exactly what
happened as the recent bubble began to defl ate—they will reach into the higher
48
classes and substantially reduce their value. It is not clear whether, in 2007 or 2008,
mortgage delinquencies and defaults had actually caused cash losses in the AAA
tranches of PMBS, but the rate at which delinquencies and defaults among NTMs
were occurring throughout the fi nancial system was so high that such losses were a
distinct possibility—obviously a matter of great concern to investors.
Th is means that investors in PMBS and government-backed Agency MBS
had diff erent experiences when the bubble began to defl ate. Th ose who invested
in Agency MBS did not suff er losses (the U.S. government has thus far protected
all investors in Agency MBS), while those who invested in PMBS were exposed to
losses if the losses on the underlying mortgages were so great that they threatened
to invade the AAA and AA classes. Even if no cash losses had actually been suff ered,
the holders of PMBS would see a sharp decline in the market value of their holdings
as investors—shocked by the large number of defaults on mortgages—fl ed the asset-
backed market. So when we look for the direct eff ect of mortgage failures on the
fi nancial condition of various fi nancial institutions in the fi nancial crisis we should
look only to the PMBS, not the MBS issued by the Agencies.
In addition, the default and delinquency ratios on the loans underlying the
PMBS were higher than similar ratios among the loans held or guaranteed by the
Agencies. Many of the loans which backed the PMBS were the self-denominated
subprime loans (that is, made by subprime lenders explicitly to subprime borrowers)
and were classifi ed in the worst-performing categories in Table 3. In part, the better-
performing characteristics of the NTMs held or guaranteed by the Agencies was
due to the fact that the Agencies were not buying for economic purposes—to make
profi ts—but only to meet government requirements such as the AH goals. Th ey did
not want or need the higher-yielding and thus more risky mortgages that backed
the PMBS, because they did not need higher yields in order to sell their MBS. In
addition, because of their lower cost funding, the Agencies could pay more for the
NTMs they bought and thus could acquire the “best of the worst.”

48 A thorough description of the tranching system, and many more details about various methods of
protecting senior tranches, is contained in Gary B. Gorton, Slapped By the Invisible Hand: Th e Panic of
2007, Oxford University Press, 2010, pp. 82-113.