Securitisation and CDO's Explained

Firstly I just want to explain with the use of a few diagrams as to what securitisation and certain derivatives are and how they work, as understanding this is key to understanding how the sub-prime mortgage crisis escalated to the level it did.

Securitisation is a structured finance process that involves the pooling and repackaging of cash-flow-producing financial assets into securities (MBS’s, CDO’s, etc.), which are then sold to investors, removing from the institutions that originate them. General practise was for the originator to sell them to a Special Purpose Vehicle (SPV), removing them from their own corporate balance sheets, which was important since the Basel Capital Adequacy requirements had made it more costly for banks to keep assets on their balance sheets. This is one of the main reasons why it was so difficult to estimate the extent of bailouts required after the crisis.

These structured products were they sliced up into “tranches” in order to enable investors to decide upon their own exposure to risk. For example the details of C.D.O.’s are complicated, but basically they’re designed to transfer most of the risk of toxic loans to experienced investors, who earned a commensurate return for taking on the high level of risk, while leaving other investors with assets that were supposed to be, excuse the pun, as safe as houses.