Bundles of derivatives based on mortgages and other debt are called collateralized debt obligations (CDO). They include auto loans, credit card debt, mortgages, or corporate debt. They are called collateralized because the promised repayments of the loans are the collateral that gives the CDOs their value. Tranches—and more specifically, CDOs—were widely used during the 2008 financial crisis. Some experts believe they helped cause the crisis by hiding bad loans.
How Tranches Work
Derivatives are financial contracts that get their value from underlying securities such as stocks and bonds. Derivatives like put options, call options, and futures contracts have long been used in the stock and commodities markets. The buyer agrees to purchase the asset on a specific date at a specific price. Banks used derivatives to repackage individual loans into a product sold to investors on the secondary market. That allowed them to get rid of the risk of holding the loans until maturity. It also gave them new funds to lend. Most mortgage-backed securities (MBS) are based on adjustable-rate mortgages. Each mortgage charges different interest rates at different times. The borrower pays “teaser” low interest rates for the first three years; they pay higher rates after that. The risk of default is small during the first three years since the rates are low. After that, the risk of default is higher. The rates go up, making it more expensive. Also, many borrowers expect to either sell the house or refinance by the fourth year. Some MBS buyers would rather have the lower risk and lower rate. Others would rather have the higher rate in return for the higher risk. Banks sliced the securities into tranches to meet these different investor needs. They resold the low-risk years in a low-rate tranche and the high-risk years in a high-rate tranche. A single mortgage could be spread across several tranches.
Notable Happenings
In the 1970s, Fannie Mae and Freddie Mac created mortgage-backed securities. First, they bought the loans from the bank. That freed the bank to make more investments and allowed more people to become homeowners. In 1999, the safe and predictable world of banking changed forever. Congress repealed the Glass-Steagall Act. Suddenly, banks could own hedge funds and invest in derivatives. In a competitive banking industry, those with the most complex financial products made the most money. They bought out smaller, stodgier banks. This deregulation allowed financial services to drive U.S. economic growth until 2007. But they continued to write mortgages to generate the MBS. They lowered their lending standards to attract more borrowers. This also drove the expansion of the housing market, creating a bubble. How did banks determine the value of the MBS? They used sophisticated computer models that could analyze the various tranches. They hired college graduates, called quant jocks, to develop the models. The market rewarded banks who made the most sophisticated financial products. The banks compensated the quant jocks who designed the most sophisticated computer models. They divided the mortgage-backed security into specific tranches. They tailored each tranche to the different rates in an adjustable-rate mortgage. The MBS became so complicated that buyers couldn’t determine their underlying worth. Instead, they relied on their relationship with the bank selling the tranche. The bank relied on the quant jock and the computer model.
Risks of Tranches
The assumption underlying all computer models was that housing prices always went up. That was a safe assumption until 2006. When home prices fell, so did the value of the tranches, the mortgage-backed security, and the economy. No one could price the mortgage-backed securities. As a result, banks stopped lending to each other. The credit markets froze up. The secondary market freed banks from collecting on the mortgages when they become due. They had sold them to other investors. As a result, the banks weren’t disciplined in sticking to sound lending standards. They made loans to borrowers with poor credit scores. These subprime mortgages were bundled up and resold as part of a high-interest tranche. Investors who wanted more return snapped them up. In the drive to make a high profit, they didn’t realize there was a good chance the loan wouldn’t be repaid. The credit rating agencies, like Standard & Poor’s, made things worse. They rated some of these tranches AAA, even though they had sub-prime mortgages in them. Investors were also lulled by buying guarantees, called credit default swaps. Reliable insurance companies, like American International Group, sold the insurance on the risky tranches just like any other insurance product. But AIG didn’t take into account that all the mortgages would go south at the same time. The insurer didn’t have the cash on hand to pay off all the credit default swaps. The Federal Reserve bailed out AIG to keep it from going bankrupt. Without the bailout, all the companies and pension funds that owned credit default swaps would have also been threatened with bankruptcy.
What It Means for Individual Investors
Tranches are sophisticated financial products that allow investors to choose very specific risk and reward portions. Tranches from the early years of a mortgage bundle are low risk and low return. Z-tranches are the riskiest. They only pay out once the other tranches are paid. Individual investors should likely avoid tranches. They are a synthetic product that has very little relation to their underlying real assets. That makes it difficult to determine whether they are a good value. They are also very complicated. It’s hard to know whether they meet your asset allocation and diversification goals.
